Pros and Cons of U.S.-GAAP and IFRS The broad conceptual difference between GAAP and IFRS is that GAAP is rules-based and IFRS is principles-based. As such, the IFRS is considered more thoughtful, transparent and reflective of the true nature of each transaction.
Pros IFRS is less detailed than U.S. GAAP [i] , thus reducing complexity that masks economic reality
IFRS is easier to use (principles-based) and will result in better reporting (substance over legal form)
IFRS is a “global” approach;comparability to financial statements from other countries that have already adopted IFRS [ii]
Reduce costs for companies and smooth cross-border investing for investors
Cons Management is given more discretion in the interpretation of economic events due to the lack of specific rules
Enforcement and cultural interpretations vary (risk of comparability) when individual countries added their own exceptions to the rules, defeating the purpose of a global standard
Accounting under IFRS tends to lead to higher earnings [iii] , thus inflating earnings of U.S. companies and misleading investors
More extensive audit procedures are required to test the reasonableness of financial reporting determinations made by management
IFRS on relevance, reliability and decision usefulness IFRS places more emphasis on relevance than reliability. Reliability is associated with accuracy but faithful representation simply means to capture the economic substance, thus giving management the opportunity to reflect the true economic phenomena that the transaction purports to represent rather than be constrained by its accuracy of information.
The adoption of ‘fair value accounting’ in IFRS will incorporate more timely information about economic gains and losses. Incorporating more information in the financial statements will typically make them more informative and improve decision usefulness for users. However, for fair value accounting to be relevant, there must be an active market with observable market prices where managers cannot materially influence. When an active market is not available, fair value accounting becomes ‘mark to model’ [iv] accounting and firms report estimates of market prices, which may not be a faithful representation [v] of the underlying asset or liability.
In my view, reliability is a necessary precondition that must be met for information to be relevant. Fair value measures can be considered reliable only if the variability in the range of reasonable fair value estimates is not significant.
Therefore, there is the risk that speculative future income may be used to justify reporting the asset at a higher carrying amount, which, in turn, would result in reporting a speculative gain. It also means that a significant proportion of a company’s reported income could well be represented by calculated net present value growth, not the results of real transactions.
In addition, powerful local economic and political forces will lead to an uneven implementation of the IFRS, thereby leading to increased information processing costs, by burying accounting inconsistencies at a deeper and less transparent level than more readily observable differences in standards. Hence, investors may be misled into believing that there is more uniformity in practice than it actually is.
Therefore, only when there is balance between relevance and reliability, decision usefulness of financial statements to report on stewardship and provide useful information to present and potential investors can be achieved.
Improvement in accounting quality and valuation of firms Although the adoption of the IFRS in the U.S. will inevitably impose hefty transition costs [vi] , the move will presumably improve accounting quality and the valuation of firms as it: reflects economic gains and losses in a more timely fashion than U.S. GAAP, makes earnings more informative and provides more useful balance sheets (with fair value accounting)
With improved financial statement information, this should lead to more-informed valuation in the equity markets and consequently, lower risk to investors. Small investors are less likely than institutional investors to be able to anticipate financial statement information from other sources so improved financial reporting quality allows them to compete better with professionals and reduces the risk of adverse selection [vii] .
Reducing the cost of processing financial information will also increase the efficiency in which the stock market incorporates it in prices and thus, with better firm valuation, investors can be expected to gain from increased market efficiency. Corporations might also benefit from a reduction of its cost of capital with increased market depth [viii] and lower bid-ask spread [ix] .
With fair value accounting, reported earnings are less noisy and hence, accounting information are more accurate and more ‘value relevant.’ However, investors in the U.S. will need to be more discerning in distinguishing between objective andsubjective figures, between realised gains and losses, and gains and losses based on hypothetical calculations.
With the adoption of IFRS, the balance sheet becomes the primary vehicle for conveying financial information to investors. As all assets and liabilities are recorded at fair value on balance sheet date, the Price/Book ratio will be equal to 1.0.
Consequently, accounting quality is improved as the balance sheet satisfies the valuation objective while the income statement provides information about the risk exposure [x] and management’s performance.
The Modigliani-Miller Proposition I Theory (MM I)
According to many research of corporation finance, the capital structure decision is one of the most fundamental issues facing to the executives and management level. The corporate finance is a specific area of finance dealing with the financial decisions corporations make and the tools as well as analysis used to make these decisions. The discipline as a whole may be divided among long-term and short-term decisions and techniques with the primary goal being maximizing corporate value while managing the firm’s financial risks. Capital investment decisions are long-term choices that investment with equity or debt, and the short-term decisions deals with the balance of current assets and current liabilities which is managing cash, inventories, and short-term borrowing and lending. Corporate finance can be defined as the theory, process and techniques that corporations use to make the investing, financing and dividend decisions that ultimately contribute to maximizing corporate value.Thus, a corporation will first decide in which projects to invest, then it will figure out how to finance them, and finally, it will decide how much money, if any, to give back to the owners. All these three dimensions which are investing, financing and distributing dividends are interrelated and mutually dependent.
The capital structure of a company refers to a combination of debt, preferred stock, and common stock of finance that it uses to fund its long-term financing. Equity and debt capital are the two major sources of long-term funds for a firm. The theory of capital structure is closely related to the firm’s cost of capital. As the enterprises to obtain funds need to pay some costs, the cost of capital in the investment activities is also the main consideration of rate of return. The weighted average cost of capital (WACC) is the expected rate of return on the market value of all of the firm’s securities. WACC depends on the mix of different securities in the capital structure; a change in the mix of different securities in the capital structure will cause a change in the WACC. Thus, there will be a mix of different securities in the capital structure at which WACC will be the least. The decision regarding the capital structure is based on the objective of achieving the maximization of shareholders wealth.
With regard to the capital structure of the theoretical basis, most well-known theory is Modigliani-Miller theorem of Franco Modigliani and Merton H.Miller (1958 and 1963). Yet the seeming simple question as to how firms should best finance their fixed assets remains a contentious issue.
2. Modigliani-Miller Proposition I
The Modigliani-Miller Proposition I Theory (MM I) states that under a certain market price process, in the absence of taxes, no transaction costs, no asymmetric information and in an perfect market, the cost of capital and the value of the firm are not affected by the changed in capital structure. The firm’s value is determined by its real assets, not by the securities it issues. In other words, capital structure decisions are irrelevant as long as the firm’s investment decisions are taken as given.
The Modigliani and Miller (1958) explained the theorem was originally proven under the assumption of no taxes. It is made up of two propositions that are (i) the overall cost of capital and the value of the firm are independent of the capital structure. The total market value of the firm is given by capitalizing the expected net operating income by the rate appropriate for that risk class. (ii) The financial risk increase with more debt content in the capital structure. As a result, cost of equity increases in a manner to offset exactly the low cost advantage of debt. Hence, overall cost of capital remains the same.
The assumptions of the MM theory are:
1. There is a perfect capital market. Capital markets are perfect when
investors are free to buy and sell securities
investors can trade without restrictions and can borrow or lend funds on the same terms as the firms do
investors behave rationally
investors have an equal access to all relevant information
capital markets are efficient
no costs of financial distress and liquidation
there are no taxes
2. Firms can be classified into homogeneous business risk classes. All the firms in the same risk class will have the same degree of financial risk.
3. All investors have the same view for the investment, profits and dividends in the future; they have the same expectation of a firm’s net operating income.
4. The dividend payout ration is 100%, which means there are no retained earnings.
In the absence of tax world, base on MM Proposition I, the value of the firm is unaffected by its capital structure. In other words, regardless of whether a company has liabilities, the total risk of its securities holders will not change even the capital structure is changed. As the weighted average cost of capital unchanged, so must the same as the total value of the company. That is VL = VU = EBIT/ requity where VL is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity, VU is the value of an unlevered firm = price of buying a firm composed only of equity and EBIT is earnings before interest and tax. Whether or not the company has loans or the loans for high or low, investors are all accessible through the following two kinds of investment on their own to create the desired type of earning.
1. direct invested in the company’s stock borrowing
2. if shares of levered firms are priced too high, investors will try to take advantage of borrowing on their own and use the money to buy shares in unlevered firms. The use of debt by the investors is known as homemade leverage.
The investors of homemade leverage can obtain the same return as the levered firms, therefore, for investors; the value of the firm is not affected by debt-equity mix.
The MM Proposition I assumptions are quite unrealistic, there have some implications, (i) Capital structure is irrelevant to shareholder wealth maximization. (ii) The value of the firm is determined by the firm’s capital budgeting decisions. (iii) Increasing the extent to which a firm relies on debt increases both the risk and the expected return to equity – but not the price per share. (iv) Milton Harris and Artur Raviv (1991) illustrated the asymmetric information that firm managers or insiders are assumed to possess private information about the characteristics of the firm’s return stream or investment opportunities. They will know more about their companies’ prospects, risks and values than do outside investors. Then it cannot fulfill the assumption of perfect market.
Based on the inadequate of MM Proposition I, Franco Modigliani and Merton H.Miller revised their theory in 1963, which is MM Proposition II.
3. Modigliani-Miller Proposition II
The Modigliani-Miller Proposition II Theory (MM II) defines cost of equity is a linear function of the firm’s debt/equity-ratio. According to them, for any firm in a given risk class, the cost of equity is equal to the constant average cost of capital plus a premium for the financial risk, which is equal to debt/equity ratio times the spread between average cost and cost of debt. Also Modigliani and Miller (1963) recognized the importance of the existence of corporate taxes. Accordingly, they agreed that the value of the firm will increase or the cost of capital will decrease with the use of debt due to tax deductibility of interest charges. Thus, the value of corporation can be achieved by maximizing debt component in the capital structure. This theory of capital structure for the study provided an important and analytical framework. According to this approach, value of a firm is VL = VU = EBIT (1-T) / requity TD where TD is tax savings. MM Proposition II is assuming that the tax shield effect of each is the same, and continued in sight. Leverage firms are increased in interest expense due to reduced tax liability, has also increased the allocation to the shareholders and creditors of the cash flow. The above formula can be deduced from the company debt the more the greater the tax saving benefits, the greater the value of the company. The revised capital structure of the MM Proposition II, pointed out that the existence of tax shield in a perfect capital market conditions cannot be reached, in an imperfect financial market, the capital structure changes will affect the company’s value. Therefore, the value and cost of capital of corporation with the capital structure changes in different leverage, the value of the levered firm will exceed the value of the unlevered firm.
MM Proposition theory suggests that the higher the debt ratio is more favorable to corporate, but though borrowing adds an interest tax shield it may lead to costs of financial distress. Financial distress occurs when promises to creditors are broken or honored with difficulty. Financial distress may lead to bankruptcy. The trade-off theory of capital structure theory in MM based on the added risk of bankruptcy and further improves the capital structure theory, to make it more practical significance.
3.1 Trade-off Theory of capital structure
According to Myers (1984), a firm that follows the trade-off theory sets a target debt to value ratio and then gradually moves towards the target. The target is determined by balancing the tax benefits of using debt against costs of financial distress that rise at an increasing rate with the use of leverage. It so predicts moderate amount of debt as optimal. But there is evidence that the most profitable firm in an industry tend to borrow the least, while their probability of entering in financial distress seems to be very low. This fact contradicts the theory because if the distress risk is low, an increase of debt has a favorable tax effect. Under the trade-off theory, high profits should mean more debt-servicing capacity and more taxable income to shield and therefore should result in a higher debt ratio.
3.2 Pecking Order Theory of capital structure
The pecking order theory stems from Myers (1984) argues that adverse selection implies that retained earnings are better than debt and debt is better than equity. Firms prefer internal finance and if external finance is required, firms issue debt first and issue equity only as a last resort. The pecking order explains why the most profitable firms generally borrow less because they have low target debt ratios but they don’t need outside money. As in Baskin (1989), asymmetric information affects capital structure by limiting access to outside finance. Managers know more than outside investors about the profitability and prospects of the firm. Information problems are particularly acute with common stock, announcement of stock issue can drive down the stock price.
The capital structure decision is one of the most fundamental issues in corporate finance. Regardless of which kind of capital structure, to achieve one of the most optimal capital structures, the company should be mixture of equity and debt and it cannot only focus on equity or debt. Equity is a cushion and debt is a sword, debt is always cheaper than equity, partly because lenders bear less risk and partly because of the tax advantage associated with debt. In general, there are differences in the capital structures of different industries; they are having their own characteristic. The most important thing is the company’s liquidity is sufficient or not. In making the decision of how to allocate the fund in which type of assets, the company has to consider and compare the different factors such as NPV, IRR and payback period. In evaluating the NPV, IRR and payback period, cash inflow is fund of the vital element. Therefore the company should know how to obtain the financing and how to invest it. They should carefully to allocate their resources to maximize the firm value.
Baskin, J. (1989) ‘An empirical investigation of the pecking order hypothesis’, Financial Management, Vol. 18, pp.26-35
Harris, M. and Raviv, A. (1991) ‘The theory of Optimal capital structure’, Journal of Finance, Vol. 48, pp.297-356
Merton H. Miller. (1977) ‘Debt and Taxes’, Journal of Finance, Vol. 2, pp.261-275
Modigliani, F and Miller, M.H. (1958) ‘The cost of capital, corporation finance and the theory of investment’, The American Economic Review, Vol. 48, pp.261-97
Modigliani, F. and Miller, M.H. (1963) ‘Corporate income taxes and the cost of capital: A correction’, The American Economic Review, Vol. 53, pp.433-443
Myers, S.C. (1977) ‘Determinants of corporate borrowing’, Journal of Financial Economics, Vol. 5, pp.146-75
Myers, S.C. (1984) ‘The capital structure puzzle’, Journal of Finance, Vol. 39, pp.575-592