garrod1 - On Accounting Flows and Systematic Risk Neil...

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On Accounting Flows and Systematic Risk Neil Garrod University of Glasgow Dusan Mramor University of Ljubljana Address for correspondence: Neil Garrod, Department of Accounting and Finance, University of Glasgow, 65-71, Southpark Avenue, Glasgow G12 8LE, Scotland, U.K. Tel: 00-44-141-330-5426 e-mail: n.garrod@accfin.gla.ac.uk 1
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On Accounting Flows and Systematic Risk Abstract The body of work that relates accounting numbers to market measures of systematic equity risk was largely undertaken in the 1970s and early 1980s. More recent proposals on changes in accounting disclosure of risk mean that a rigorous theoretical model of the relationship between accounting measures and market measures of risk is timely. In this paper such a model is developed. In addition, the assumptions required to develop the model are explicitly identified. By so doing it becomes possible to identify the potential cross-sectional differences which drive the empirical relationship between accounting and market based measures of risk. The model developed highlights a clear relationship between accounting and market measures of risk which can be exploited in situations where accounting data alone is available. It also provides a framework within which the environmental factors leading to cross-sectional differences between companies can be further explored. 2
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On Accounting Flows and Systematic Risk I. Introduction Work that relates accounting numbers to market measures of systematic equity risk was largely undertaken in the 1970s and early 1980s (Ryan, 1997). More recent proposals on changes in accounting disclosure of risk (Scholes, 1996) mean that a theoretically sound model of the relationship between accounting measures and market measures of risk is timely. In addition, the finding that earnings variability is the accounting variable related most strongly to systematic equity risk (Beaver et. al., 1970; Rosenberg and McKibben, 1973; Myers, 1977) suggests that a disaggregation of this number into the operational aspects of a firm which drive the earnings number might improve the empirical relationship between accounting estimates of beta and its market realisation. In this paper a rigorous theoretical model of the relationship between accounting flow variables and systematic market risk of equity is developed. Identification of this relationship is helpful on a number of fronts. Firstly, the instability of market betas over time means that ex post measures of market risk are not good predictors of future risk. Identification of an appropriate relationship between accounting variables and market risk could lead to improved predictive models of future market risk. Secondly, financial models of risk (e.g. CAPM) do not identify the operational factors and environmental contingencies which influence risk. An accounting model gets closer to the identification of economic fundamentals which drive such relationships. Finally, interest in this relationship is further fuelled by being of practical use in situations where market
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garrod1 - On Accounting Flows and Systematic Risk Neil...

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