The image below shows the returns of the S&P 500 over that last decade. It’s clear that we are living in a boom and bust economy now more than perhaps ever. The first boom and bust was the internet bubble. The second was the real estate bubble. The third is yet to be determined. My personal investment advice is to tread lightly. As the last 10 years show, the S&P 500 has never quite reached 1600. Of course this may be gravity not destiny.
Capital markets are vital to modern market economics because they act as both “midwifes” and “undertakers.” Capital markets act as midwifes by issuing funds to firms looking to grow or take on new projects. Lenders issue funds to firms that have the highest probability of success and therefore repayment. This steers resources towards firms the market will likely respond positively to. Capital markets act as undertakers when they refuse to issue funds to firms because their performance does not merit continued investment. When capital markets act has undertakers they effectively steer resources away from inefficient firms and towards efficient and productive firms. Most Americans have no complaint about the way capital markets act as a “midwife” to create new enterprises. Many, however, object to the way they act as an “undertaker” to destroy existing enterprises. On the surface the destruction of enterprises is very troubling; however, the undertaker role is very beneficial to society.
The capital markets respond to the reaction of the market to the firm. The market directs resources towards the production of products that are of the highest value in the eyes of the consumer. If an enterprise is underperforming it could be because of poor management, too high of prices, or simply a bad products. In the case of a poor performing enterprises, the market will direct resources toward companies with higher value. In reality it is the consumer, not the capital market, that determines which enterprises succeed and which fail.
Suppliers of funds cannot continually invest or be expected to invest in enterprises that are not performing. By allowing enterprises to fail, capital markets are insuring the market remains in equilibrium. Society benefits because “destroying” poor performing enterprises encourages efficiency, good management, low prices, and the production of good products. Failing enterprising also free up resources for potentially better firms looking to grow or take on new projects. If capital markets’ undertaker role was somehow restricted, all that would be accomplished is an inefficient allocation of resources. The market would remain in disequilibrium, and potentially better firms would be deprived of the capital they need.
The impact on the enterprises’ employees cannot be ignored. The only thing a failing firms can produce well is unemployed workers. Again, on the surface unemployment is very troubling; however, the labor markets work similarly to capital market. Left uninterrupted, workers will not go through extended periods of unemployment because it is not in their best interest. Failed enterprises free up labor to work for new enterprises that are more productive. The result is a more productive workforce. Also, sense wages have a tendency to reflect the marginal revenue product, it is almost guaranteed that workers new wages will be higher than before or enjoy new benefits that had not been available previously.
Any government attempt to reduce the impact of failing enterprises employees would affect the market’s efficiency. By providing unemployment benefits the government is making unemployment more financially attractive. Those who are receiving benefits might delay looking for a job or maintain unreasonable expectations about future jobs. Despite the good intentions of unemployment benefits, they are not a replacement for actual work. Moreover, there is no need of unemployment benefits. The market allocates resources where they are needed, and workers’ self-interest will insure that they do not go through extended periods of unemployment. Furthermore, I believe people are generally good and willing to help those in need. I believe charity could/should replace government interference.
The weak-form efficient market hypothesis and behavioral finance theory are in contrast. The weak-from efficient market hypothesis states that, because all investors are rational and all historical information is already incorporated into current stock prices, no investor can consistently achieve returns higher than warranted by a stock’s risk. The behavioral finance theory states that investors are not rational. Therefore, the market cannot be efficient, thus it is possible to achieve excess return on the market. Behavioral finance theorists have disputed the efficient-market hypothesis both empirically and theoretically. Behavioral finance theorists point to ideas and concepts like gambler’s fallacy and winner’s curse as proof that investors are not rational.
There is proof that investors are not always rational. For instance, take gambler’s fallacy. Gambler’s fallacy is the belief that the more a specific outcome is observed in a series, the likelihood the opposite outcome will occur in the future increases. Investors fall victim to gambler’s fallacy when they sell a stock after its price has gone up a number of trading days because they feel further increase is unlikely. Conversely, investors might hold a stock after its price has fallen a number of trading days because they feel further decline is unlikely. Gambler’s fallacy is irrational because past events do not change the probability that events will occur in the future. Gambler’s fallacy, applied to investing, cannot coexist with the weak-form efficient market hypothesis. Weak-form states that all historical information is already incorporated in current stock prices, thus historical information cannot be profited from. If the weak-from efficient market hypothesis is correct, then buying and selling stocks is a game of chance rather than skill. A rational investor would consider a firm’s financial position, risk, and the effect of the portfolio before buying it. Despite gambler’s fallacy being irrational, investors sometimes behave this way.
Winner’s curse provides more proof that investors are not rational. Winner’s curse is the tendency for the winning bid in an auction to exceed the intrinsic value of the item purchased. Winner’s curse has a number of explainable causes including incomplete information and emotions. Regardless of the cause, the item being auctioned is awarded to the bidder with the greatest overestimation. Paying more for something than what is worth is not rational behavior. Theoretically, if markets were efficient, no overestimation would occur. However, the market has experienced overestimations and corrections. Stock bubbles, such as the dot-com or housing bubble, prove that people buy stocks at irrational prices beyond their true values.
There are two standards in the field of accounting. The first is created by the Financial Accounting and Standards Board (FASB), whose power is derived from the United States’ Securities and Exchange Commission (SEC). The second is created by the International Accounting Standards Board (IASB), which is an independent, privately funded accounting standard-setter based in London, England. The FASB publishes its standards in the Generally Accepted Accounting Principles (GAAP) and the IASB publishes International Financial Accounting Standards (IFRSs). GAAP and IFRS do not agree on every issue. The growing complexity in international business and the increase rate of international investing has increased the need for a common standard. Since 2002, FASB and IASB have been working to converge U.S. GAAP and IFRS. One of the major efforts in the convergence has been reconciling differences between U.S. GAAP and IFRS financial statement presentation. The goal is to create a common standard for the form, content, classification, aggregation and display of line items on the face of financial statements (McClain, 2008).
The use of accounting and all financial reporting comes to a focal point in the creation and presentation of financial statements. Thus, it is vitally important that the objectives of financial reporting be clearly defined. U.S. GAAP defines the objective of financial reporting as, “The objective of general purpose external financial reporting is to provide information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions” (FASB, 2006). IFRS defines the objective of financial reporting as, “The objective of general purpose financial statements is to provide information about the financial position, financial performance, and cash flows of an entity that is useful to a wide range of users in making economic decisions” (IFRS, 2011). FASB’s and IFRSs’ objectives are very similar in nature; however, the way they present the information is very different.
The first major difference between U.S. GAAP and IFRS financial statement presentation isthe statement’s title. Within this difference there is a similarity, both U.S. GAAP and IFRS recognize four main financial statements. U.S. GAAP titles their financial statement’s Balance Sheet, Income Statement, Retained Earnings and Cash Flow Statement. IFRS titles their financial statements, in comparative order, Statement of Financial Position, Statement of Comprehensive Income, Statement of Changes in Equity and Statement of Cash Flows. Differences in titles is hardly material but is worth mentioning for the sake of comparison.
Another difference between U.S. GAAP and IFRS is the number of financial periods required to be reported. U.S. GAAP requires firms to follow SEC guidelines which,apart from start-up companies,require balance sheets to be reported for the two most recent years while other financial statements must report three years. IFRS, on the other hand, only requires comparative information for one year (US GAPP vs. IFRS).
The main difference between FASB and IFRS financial statement presentation is formatting. This difference is very visible when comparing the Balance Sheet/Statement of Financial Position. At first glance, the Balance Sheet and the Statement of Financial Position appear much different. One trained in U.S. GAAP will immediately notice that the IFRS Statement of Financial Position does not balance. This is due to the fact that IFRS does not separate assets and liabilities. Instead, assets and liabilities are netted together into business sections. The sections are titled with familiar accounting terms such as operating, investing and financing. Management is giving the freedom to make fair judgments as to which sections individual asset or liability accounts belong; however, management is required to disclose their basis for their classifications (Benzacar, 2009). Dividing assets and liabilities into business sections explains the differences in title. IFRS cannot legitimately call the Statement of Financial Position a Balance Sheet, because it does not have a clear balance. Underlying the presentation format, the Statement of Financial Position still balances.
Another difference found on the Statement of Financial Position is that firms may not be required to provide subtotals for short-term and long-term assets or liabilities. IFRS states, “An entity must normally present a classified statement of financial position, separating current and noncurrent assets and liabilities. Only if a presentation based on liquidity provides information that is reliable and more relevant may the current/noncurrent split be omitted” (IFRS, 2011). Again, IFRS gives management more freedom then U.S. GAAP.
IFRS’s Statement of Comprehensive Income is comparable to U.S. GAAP’s Income Statement. These financial statements have a lot in common. Both financial statements provide subtotals for discounted operations, net income and other comprehensive income. The main difference between these statements is that everything above discontinued operations is divided into the same sectionsused in the Statement of Financial Position. For example, the operating section includes sales, cost of goods sold, expenses and depreciation. These accounts are subtotaled into total operating income. The investing section would include dividend revenue, any relative expenses. These accounts are subtotaled into total investing income. Each section has its own subtotal that contributes to the firm’s overall net income.
Two elements missing from the Statement of Comprehensive Income is the income from continued operations and extraordinary items sections. IFRS requires that firms fit all items into one of the sections.
Compared to U.S. GAAP, IFRS requires firms to further differentiate line items by function and nature. For example, cost of goods sold must be subdivided into materials costs, labor costs, and overhead. Furthermore, details for general and administrative expenses must also be disclosed. Requiring further differentiate results in greater transparency, as well as, a much longer statement than U.S. GAAP (Benzacar, 2009). IFRS does allow firms to condense their statements as long as the details are reported in the statement’s notes.
The main problem in the U.S. GAAP IFRS disparity, as it relates to financial statement presentation, is not layout, rather it is uniformity. U.S. GAAP and IFRS financial statements are both functional presentations. Problems arise when comparing statements across the two standards.
There are obvious advantages to financial statement uniformity. By adopting IFRS, U.S. firms could present their financial statements in the same way as foreign competitors. This would result in ease of use forinternational investors wishing to make comparisons. This could make it easier for U.S. firms to raise capital abroad. Furthermore, large conglomerate firms, with subsidiaries aboard, may already being using IFRS. It could be relatively easy for large firms to make the transition. Bill Brushett, a Canadian CPA, feels U.S. firms should willingly present their financial statements according to IFRS. Brushett said,
As a business changes, so does the audience for its financial statements. If you’re not speaking the right financial language to new stakeholders, your company could suddenly find itself at a significant disadvantage… If youchoose not to adopt IFRS, your potential suppliers and customers may opt to do business with another company whose financial statements are more understandable and transparent to them (2).
Despite the advantages, there are numerous potential disadvantages for U.S. and foreign firms as a result of the convergence. Firms, especially smaller firms without foreign subsidiaries, will need to change programming within their accounting system. Firms will need to adjust their processes and controls to comply with new financial statement presentation guidance (US GAAP Convergence, 2011). Overall, the U.S. GAAP IFRS convergence will result in incremental costs to many firms that may outweigh the benefits.
The international business community seems to think financial statements need overhauled. In 2008, accounting firm Grant Thornton conducted a survey. The survey asked 200 chief financial officers and senior controllers of international firms whether U.S. GAAP financial statements are too complex for the average investor. 67% said yes (Leibs, 2008).
IFRS has a distinct advantage over U.S. GAAP. According to the IFRS, approximately 120 nations permit or require IFRS for domestic companies. U.S. GAAP is only required in the U.S. Because of the acceptance of IFRS, U.S. firms should adopt IFRS. However, the SEC should only require IFRS if they transition to rule based standards. Rules bases standards have a number of advantages including clarity in application and reduction of risk to investors. IFRS’s current principles based standards allow for too much manipulation and managerial discretion. There is no room for variations in financial statement presentation by different companies in similar industries. Financial statements need to be uniform.
The IASB has some concepts in common with the FASB; however, there are more differences than similarities. U.S. GAAP and IFRS both provide excellent principles; however, the United States should continue to comply with U.S. GAAP. Firms where the benefits outweigh the incremental costs, should report their financial statement in both standards. The SEC, American investors, and American firms will likely never fully accept IFRS or the IASB, because it moves control over financial standards abroad (Cellucci, 2010). Regardless of the effect of the convergence on financial statement presentation, U.S. firms will likely always follow some version of U.S. GAAP because U.S. GAAP has the support of the SEC and U.S. firms pay taxes under U.S. laws.
To be successful, a firm must effectively allocate resources in a way to create a good or produce a service that meets the wants and needs of society. The firm must create a good or produce a service in such a way as to generate a profit. Firms will seek to sell their goods or services at the highest price the market will permit while buying resources at the lowest prices the market will allow. Moreover, to be a great firm they must anticipate future wants and needs, learn from competitors, and take on risk. By providing for society wants and needs, firms are, by nature, giving back. A firm will not survive without a finger on the pulse of what societal wants.
A firm is nothing more than a black box of inputs and outputs. Firms are legal fabrications (Jensen, 1976). The people inside the firm are the ones who make all the business decisions. Therefore, the people within a firm, by creating a good or producing a service are the ones giving back to their fellow man. Because a firm itself is nothing, men and women in business are in constant service to their community. Profit is merely the measure of the effectiveness of the good or service to meet society’s wants or needs. The generation of profit creates new wealth which a firm can use to amplify the amount of goods it can produce and services it can provide.
People working within profitable firms, as members of a community, have a responsibility to help those that are less fortunate through acts of philanthropy. Firms should operate in a way that actively recognizes that along with the generation of wealth, comes the responsibility to contribute to the well-being of those around them. Acts of philanthropy play a vital role in improving the quality of life found within any society.
After establishing that the creation of products and services is an act of giving back to a community; firms are made up of the people working inside of them; and that along with profit comes the responsibility to act philanthropically, one comes to the conclusion that business is an overty Christian occurrence. Service to others is one of the most important characteristics Jesus taught his disciples. Christian businessmen and women cannot compartmentalize their lives in such a way that they forget about service to others from 9:00am to 5:00pm. Christian businessmen and women need to stay focused on the teaching of Jesus and resist the temptation to focus on dollars of profit rather than people in need.
Sinking fund provisions require the issuing firm to retire a percentage of bonds each year after a period of time. For example, a firm would retire 4% of bonds issued each year starting 5 years into a 30 year bond. Firms can handle sinking fund provisions two ways. Firms can buy their bonds back on the open market, or firms can call bonds at par using a lottery system of bond serial numbers.
Movements in interest rates dictate which method the firm will employ. The price of bonds has an inverse relationship with changes in interest rates. The firm will always choose the least costly method. Thus, when interest rates rise the firm will buy bonds on the open market because their bonds will be selling at a discount. Conversely, if interest rates fall the firm will call bonds using the lottery system method. Since sinking funds usually do not require a call premium, the firm would rather call their bonds at par than pay the premium the market would require.
Sinking fund provisions are effective at reducing risk for investors, but despite their protection they can actually harm investors. If interest raise rise and the firm purchases bonds on the open market investors will not recover their full investment. Investors will only receive the discounted market price. The investor will experience negative capital gains and a positive current yield by reinvesting at the higher rates; however, the expected total in the year of the call will be negative. Overall, the investor will lose money if the reinvestment is yielded to maturity (note table). On the other hand, if interest rates decrease and the firm calls bonds at par, investors will be forced to accept less than market value for their bonds. Moreover, investors will be forced to reinvest at the lower rate. In this case investors will experience zero capital gains and a reduced but positive current yield. Thus, the expected total in the year of the call will be equal to the coupon rate of the reinvestment. In the end the investor will lose money; although significantly less than option 1.
It’s important to remember that since interest rates can fluctuate it would be possible for a firm to switch back and forth between these two methods throughout the duration of a bond’s life.
In any ownership structure less than a 100% sole-proprietorship there will be agency conflicts between managers and shareholders. Managers will choose to pursue their own self-interest rather than the interest of the shareholders. Manager-shareholder conflict can play out a number of different ways. Managers could choose to raise their salary, sacrifice long-term growth for short-term performance or even defraud earnings to inflate his or her results. The managers-shareholders conflict hurts the shareholders directly, as the firm endures costs of keeping managers in check. Shareholders can attempt to limit agency conflict by properly aligning incentives. For example, shareholders can give managers stock options or partial ownership of the firm. These efforts may prove futile because in many cases such compensation packages are less than desirable to managers. Most managers want to be rewarded for their efforts immediately. Moreover, many managers will reject stock compensation plans because the firm’s earnings are affected by economic factors that are not under managerial control. It’s worth mentioning that as stakeholders in the firm, managers do have a vested interest in the firm success. Unless a manager is attempting to leverage a position at another firm, overall manager’s self-interest is in same general direction as the firm’s.
Agency conflict between creditors and managers is much different. Managers and shareholders alike only need creditors as so far as to accomplish a task. Managers and shareholders borrow money expecting a return at least larger than the interest paid on the loan. Creditors judge the risk of the venture and determine their rate of return accordingly. The main issue causing the conflict– trust. The tendency is for shareholders, through the work of managers, to attempt very risky ventures with bondholder’s money because they have more to gain and an equal amount to lose from an unsuccessful risky venture compared to an unsuccessful safe venture. There is a balancing act managers and shareholders must play in determining how much to mislead creditors. Ventures that are too risky could force the firm into bankruptcy. This is costly for shareholders because creditors have first stake on company assets. Also if creditors feel they have been materially mislead they may choose to not work with the firm again. Overall, the moral hazard involved in the creditor-manager relationship drives up the cost of capital. Again these costs are endured by the shareholders directly.
The main difference between the two conflicts is time. The manager-shareholder conflict is perpetual whereas the manager-creditor conflict is temporal. Creditors want to get their money back plus interest over a given period of time whereas shareholders want continuous growth over the life of the firm. Moreover, some firms do not use credit therefore their creditor conflict costs are very low. However, even firm with no or little creditor conflict cost have manager-shareholder conflict costs.