The Association Between Market Determined and Accounting Determined Risk Measures
ALTHOUGH the accounting profession ~lkhas accepted the premise that the purpose of accounting is to facilitate decision making, the implementation of this approach within the area of financial statement preparation has been impeded by an inability to specify the decision processes of external users of accounting data. Recent research in portfolio theory provides some a priori and empirical knowledge of the decision processes of one external user, the investor in the firm's securities. This study extends that research in terms of its implications for accounting. The accounting system generates information on several relationships that are considered by many to be measures of risk. Previous research would suggest that financial statement ratios can be used as measures of default risk, but little is known of their association with the concept of risk as defined in portfolio theory. The problem is compounded by the fact that portfolio theory specifies its risk measures solely in terms of market determined interactions (i.e. security price variables) An issue of paramount concern to the accounting profession is what is the relationship between the accounting determined and market determined measures of risk? An answer to this question is central to a meaningful evaluation of accounting data in at least three respects. 1. Our knowledge of risk determination is incomplete as long as we do not know what exogenous variables (i.e. nonprice data) are impounded in assessments of security prices and price changes. Observed prices (and price changes) are the net result of the decision processes of the entire investing community. They are also the ultimate decision variables that determine both what return and what risk an investor incurs during his holding of a security. We cannot hope to construct an accounting system or evaluate the current system in terms of a decisionmaking criterion without a knowledge of the interaction between the accounting data and the market price variables. In particular, this study will examine the contemporaneous association between the accounting determined and market determined measures of risk. By doing this, we intend to determine what accounting data are impounded in the market