Baitshepi Tebogo

A critical analysis of the Economic Value Added method

Table of Contents

Abstract ....................................................................................................................................... 3 1. 2. 3. 4. 5. 6. 7. 8. 9. Introduction .......................................................................................................................... 4 Equity capital is costly ......................................................................................................... 4 Operating and Financing Decisions ..................................................................................... 5 Pension Plan Accounting ..................................................................................................... 7 Full Cost Cash Accounting ................................................................................................ 10 Value of an Acquisition ..................................................................................................... 11 Depreciation ....................................................................................................................... 11 Performance Evaluation and EVA ..................................................................................... 12 Conclusion ......................................................................................................................... 14

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Abstract
This paper provides a critical analysis of the Economic Value Added (EVA) method. It is based on 2 articles written by Stern Stewart: Accounting is Broken, Heres How to Fix It, A RADICAL MANIFESTO, and The Capitalist Manifesto, The Transformation of the Corporation, Employee Capitalism. EVA has been hailed as an innovative value facilitating technique since it tends to focus managements attention on value creating activities rather than on short term gains. This much is appreciated, but the promoters of EVA, Stern Stewart went on to trash the accountancy profession, and this is where the author of this paper disagrees. Stern Stewart makes sweeping allegations against the practice of accounting without indicating, which version of accounting he is against. In this paper, differences between the Financial Accounting Standard Board (FASB) and the International Accounting Standard Board (IASB) are highlighted. Other than that, the report further goes on to applaud Stern Stewart for their work on EVA, and how EVA could promote amicable working relationship between managers and employees.

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1. Introduction
Economic Value Added (EVA) is a performance evaluation method developed by Stern Stewart to focus managements attention on value creating activities. Unfortunately, most performance measurement metrics are accounting based, which makes them easily manipulated. What, partly, makes this manipulation and smoothing of financial results possible is the fact that accounting standards differ depending in which jurisdiction financial statements are prepared. These discretions, in a way, give managers an opportunity to manipulate accounting systems to enable their companies register positive and consistent financial performance. However, there might be light at the end of the tunnel. The International Accounting Standard Board (IASB) and the United States Financial Accounting Standard Board (FASB) signed the Norwalk agreement in 2002, the purpose of which is to work towards convergence of accounting policies and practices. This move is likely to enhance the management of corporations, especially those with a global presence.

2. Equity Capital

Shareholders invest their money in companies either because they expect to get dividends payments or expect capital growth. It is true that equity has a cost, but at the same time there is a need to look at what type of cost it is. In the case of equity, a company faces no obligation to pay dividends to shareholders, especially if it has not performed well. The arguments made by Stern Stewart seem to suggest that dividends be paid regardless of the companys performance.

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Although it might be a good idea to factor in the cost of equity; how is that going to be done without introducing arbitrariness in measurement? Stern Stewart makes comparisons with finance costs from debt financing; but debt financing costs are usually agreed at the time the financing is arranged, and as such are definite. With equity costs, it is likely that arbitrariness would be introduced into the accounts, as the opportunity cost of equity may not be precisely measured. Stern Stewart, however, admits that the cost of equity cannot be measured precisely; and that is because it is not easy to determine specifically what the individual investors opportunity cost of capital is.

3. Operating and Financing Decisions

Stern Stewart also argues that debt financing exaggerates performance; and he does not seem to appreciate its advantage. The fact is that, interest payments tend to create a tax shield, which enhances earnings. And, this would be good for the same shareholders he argues are not served well by debt financing. It is well known that equity holders have a residual interest in the companies they have invested, meaning that if a cheaper source of financing can be found they stand to benefit, financially. In other words, after all creditors have been paid what remains belong to equity holders. It is, however, not clear from Stern Stewarts article whether he is arguing for more equity financing, since he is not in favour of debt financing. However, issuing new equity has the consequence of diluting earnings and control for existing shareholders. To prove his disfavor for debt financing the author cites the Enron debacle. In the case of Enron, however, the problem was not the use of debt financing, necessarily, but the fact that Enron used off balance sheet accounting. That is, it employed special purpose vehicles to hide its debt. I, however, must acknowledge that there is, generally, a temptation to use and hide debt by some

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companies in an attempt to portray lower gearing, and hence a lower risk. But, responsible managers are cognizant of the fact that it is important not to hide such information from shareholders or potential shareholders. Such disclosure would enable all interested stakeholders to ascertain the gearing level of a company, and hence the amount of risk it poses. Actually, it is in response to stories such as those of Enron that the International Federation of Accountants (IFAC) has made the teaching of ethics a core component of accountancy education. So, the problem is more ethical than attributable to accounting failures. Consequently, if it becomes apparent that a company has become highly geared, lenders might become wary of advancing more loans. That is, usually, the case since loans to be advanced might have to be secured on a borrowers assets; but, a highly geared company is more likely to have, already, used most of its assets as collateral. The problems that Enron faced or created by using special purpose vehicles were a result of the rule based approach used in the US under the FASB. It is likely that in other jurisdictions, where the principles based approach is used, as under the IASB, this problem might not have arisen. That is, the substance of the transactions by Enron or the special purpose entity would have been scrutinized to establish their true nature, and in which entitys books they should have been reported. Thanks, partly to the Enron problems indications are that the US is moving towards a principle based approach and away from an entirely rule based approach. Evidence of this can be garnered from the ongoing cooperation between the FASB and the IASB, after the Norwalk agreement of 2002. As of now and given differences in accounting policies and practices EVA remains the best method for measuring a companys performance and evaluating whether value is being created

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for shareholders. EVA does this by ensuring that any arbitrary accounting treatment is eliminated and replaced with an economic value. For instance, as Stern Stewart points out, by ensuring that the cost of all financing is included in calculating the economic profit, it becomes easier for management to more effectively evaluate which projects add value over the long term. Stern Stewart argues that accounting does not factor in all the costs of financing a business. His contention is that the best way to determine the costs of all sources of finance is to use the weighted average cost of capital (WACC). By taking into account all the costs of finance WACC, therefore, provides a valuable and uncontroversial metric for assessing a projects worthiness. That is, the opportunity cost of all financiers are catered for, hence Stern Stewarts contention is valid. Under financial accounting, finance charges are usually deducted when determining accounting profit; but in calculating economic profit, finance charges are not, and this is because they are, already, a part of capital charge. The capital charge arises by applying the WACC to the economic capital employed. The WACC acknowledges the fact that some of the finance might be coming from lenders, ordinary shareholders, preference shareholders etc. To avoid double counting, it is, therefore, necessary that finance costs not be dealt with separately; but as part of WACC.

4. Pension Plan Accounting

Under IASB, IAS 19 Employee Benefits deals with accounting for pension liabilities and assets. Companies which use defined benefit scheme are supposed to show in their books the net liability or net assets. In fact, a company is supposed to come up with a schedule showing present value of plan liabilities. At the same time, it is supposed to arrange for plan assets to be
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invested with 3rd parties to help protect the interests of employees. The values of pension plan obligations and plan assets are also subjected to actuarial scrutiny. Any differences between accounting values and actuarial values are regarded as actuarial gains or losses and adjusted accordingly in the books of accounts. So, the argument that accountants do not treat pension accounts as true liabilities and assets does not hold at least under the IASB rules. Furthermore, IAS 19 allows for the gains or liabilities to be recognized in the income statement using a 10% corridor method or the faster recognition method. The adoption and application of International Accounting Standards (IASs) has now become mandatory in most countries, especially after the Norwalk Agreement. Still under IAS 19, current service costs, which represent the present value of benefit entitlement, are recognized in the period as expenses. Once more, in the context of IASB, Stern Stewart arguments are not valid since the current service costs are accounted for at their present values. It might have been the case that this was the practice in the past; or could be the practice under US FASB rules. Under current IASB rules, the practice is to account for these costs at present values, as elucidated earlier. In addition, these current service costs increase plan obligations, contrary to Stern Stewarts contention. Stern Stewart points out that by investing plan assets, at a relatively higher return, than the required return on plan liabilities accountants are under the belief that they are creating value. The author, however, notes that this usually entails a higher level of risk. As such investors, normally, respond by demanding a higher return, thereby increasing the cost of capital and eliminating any short term gains in the process. This makes for a good observation, but the question is: how quickly do investors, usually, take to respond to these changes. I posit that there are arbitrage gains to be made under these circumstances.

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Stern Stewart goes on to put another argument that accountants understate the true service costs by mixing up operating decisions with financing decisions. That is, rather than showing costs gross, accountants net them off against gains. And, the consequence is that where returns on plan assets are higher than interest cost on plan obligation, then service costs are understated. The fact is that, gross service costs (under IASB rules, especially) are disclosed in notes. However, the author should only be querying the netting off of service costs; not that they are understated, since notes to financial accounts normally accompany published financial statements. However, I agree with Stern Stewart that the plan assets and liabilities as well as service costs be shown without netting. Netting, without doubt, could provide an opportunity for fraudulent activities to flourish. Stern Stewart further argues that accountants tend to overstate expenses and hence depress profits. However, this does not appear bad, but rather sound, since it reflects prudence. It is better not to overstate income. I believe the consequences would be dire if accountants were overstating profits, only to have shareholders excitement dashed. In that instance, it is very likely that the criticism would be harsher. In any case, if profits turn out to be more favorable it is the shareholders who stand to benefit. Stern Stewarts criticism does not end there, but extends to the treatment of deferred tax. Of course, it is legal for accountants to ask questions which the author has rightly pointed out. He chastises accountants for asking: what if a company fails to prosper, and no longer generate tax deferrals? That is, it is plausible to assume that they may no longer be deferred tax hence it is prudent to make provisions for that.

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It is a valid argument, however, that provision for bad debts could be used to smooth profits. However, Stern Stewart fails to acknowledge the positive benefits that could result from such an exercise, which is that accountants are, once more, being prudent. The provision for doubtful debts is usually a certain proportion of credit sales, which is established from previous experience. Based on that fact, accountants are then in a position to estimate the likely expenses resulting from defaults on payment. According to FASB rules, development costs are expensed but under IASB criterion they are capitalized and armotised over their useful life. The arguments made by Stern Stewart are, therefore, valid to the extent of accounting practice in the US. It may not be a smart move to capitalize all costs on the basis that they are intangible. The capitalization if it were to happen would have to follow strict criteria like the one set by the IASB in IAS 18, Intangible Assets. Failing to do this might lead to companies inflating their net assets, unnecessarily.

5. Full Cost Cash Accounting

According to IAS 36, Impairment of Assets- assets should not be carried at a value more than their recoverable amount. The recoverable amount is the higher of an assets net realizable value and the value in use. The net realizable value is the amount obtainable from the sale of an asset in an arms length transaction between knowledgeable, willing parties less costs of disposal. Value in use, on the other hand, is the present value of estimated future cash flows expected to arise from the continuing use of an assets and from its disposal at the end of its useful life.

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The contention by the author that an accountant would simply compare book values with the selling price of an asset and possibly reject such a transaction as loss making, does not hold at least in the case of IASB rules. That is, assets are tested for impairment and if found to have been impaired are adjusted to their economic value (recoverable amount).

6. Value of an Acquisition
Stern Stewart, also, brings forth a point I agree with, which is on enlightening investors on what to expect as returns for their investments. That is, returns on own shares come in the form of dividends and capital growth. In other words, the author is pointing out that returns should not be looked at in terms of earnings per share (EPS) only, as this represents what accrue to investors in the short term. In the long term, an investor benefits from the appreciation in the EVA which may be reflected in higher share price.

7. Depreciation
It is true that depreciation consideration could lead to dysfunctional decision making. The fact is that accounting profits tend to be favorable when a company is using highly depreciated assets with negligible net book values (NBVs). The lower NBV imply that depreciation charges would be lower hence reported profits tend to be higher. This could then tempt managers to be reluctant in replacing old assets, which, may not be in the long term interest of the company. On the contrary, EVA ensures that economic depreciation is higher later in the life of an asset. Managers, therefore, have nothing to fear in the short and medium term about investing in nonPage 11 of 14

current assets. This, has the effect of encouraging goal congruence by ensuring that managers make decisions that will benefit them, as well as the organizations for which they work; in case their performance is evaluated on the basis of profit metrics.

8. Performance Evaluation and EVA

The benefits of EVA are further espoused by Stern Stewart, European office. According to Stern Stewart, Europe a focus on EVA rather than short term profit focused metrics would tend to increase the wealth of shareholders. And one of the ways to ensure that EVA is encouraged is to ascertain that performance evaluation systems use the principles of EVA. By adopting this approach, employees and their managers are more likely to start thinking more like shareholders, and the decisions they make would benefit the organization tremendously. Stern Stewart further points out that EVA is an approximation of economic profit. He also, rightly, points out that accounting profits are prone to error since they are based on arbitrary rules. Furthermore, an innovative EVA driven performance management system is being propagated by Stern Stewart, Europe. This system would neither have an upper nor a lower limit. This would help in preventing gaming. In other words, there should be no restrictions on the amount of bonuses employees could receive. According to the author, whatever bonus is payable to employees should be pooled into some sort of central account, from which future payments could be made. This proposed practice is mainly intended to encourage sustainable improvement in EVA by preventing gaming as pointed out earlier. This sounds like a fantastic idea and is worth trying. One of the issues brought forward by Stern Stewart, Europe is that using EVA for performance evaluation tends to promote goal congruency by encouraging both managers and employees to
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work cooperatively. In consequence, shareholders tend to have more confidence in the company since they are more likely to believe that their companys management is working towards improving shareholders interests. A company is said to be making true profit if the actual return is more than the required return. Stern Stewart, Europe points out that, investors have to be fully compensated for their investment. And, if actual returns are more than what investors would have made had they invested in the next best alternative then true profit would have been made. This assertion makes sense since it means that a company could be generating positive returns and at the same time making all major stakeholders financially satisfied. One of the arguments brought forward on why accounting based reward system is flawed is that it tends to encourage managers to know how they can increase their rewards; rather than knowing how they can increase a companys value. If EVA is introduced alongside performance based reward systems, managers and employees tend to trust each other. This is because both groups realize no one is likely to benefit by making short term and dysfunctional decisions. As such, they realize that value can only be added if they work congruently as a team. It has already been demonstrated that creation of value is beneficial to most stakeholders within an organization. Where value is destroyed, then measures should be taken to ensure that does not recur. In the UK the belief that value can be created by having more participation of employees in company affairs was promoted by the Thatcher government. The Blair government carried on with the same message, albeit intensely. The belief was that there would be value added when employees buy shares in companies they work for. Such investments would likely eliminate the
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them and us mentality. This argument is valid since in most organizations, managers consider expenditure such as employee training, as being discretionary when it should be treated as an investment for the future.

9. Conclusion
EVA is a ground breaking concept on value creation, and is most likely to eliminate most of the performance evaluation problems besieging corporations. Most performance evaluation methods rely a lot on accounting conventions, which can easily be manipulated; but EVA through the use of economic concepts, focuses the attention of managers on value creating activities.

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