Economic value added and reported accounting results
Published accounting profit figures are more complicated than operating cash flow less economic depreciation as featured in Table 3. For reasons of prudence, losses are often recognised at an early date and accruals accounting makes many timing adjustments to cash flow in converting it to accounting profit.
As we are really interested in economic profit rather than accounting profit these adjustments have to be eliminated or added back in. The consulting firm Stern-Stewart have identified 164 performance measurement issues in its calculation of EVA® from published accounts. The adjustments mainly involve:
- Converting accounting profit to cash flow
- Distinguishing between operating cash flows and investment cash flows
They include such issues as treatment of stock valuation, revenue recognition, bad debts, the treatment of R&D, advertising and promotion, pension expenses, contingent liabilities etc. Whist it is unlikely that you would have to make 164 adjustments in the exam some simple changes may be required! Some of these are demonstrated in Table 4 which includes a calculation of EVA® from a set of published results. See Table 4.
Conclusion: this company has added value for its shareholders.
- Interest paid is added back as this will be charged in the imputed capital charge. Borrowings are added to the capital base as profits must cover the cost of borrowings (see geared companies above).
- R&D is considered an investment in the future in the same way as expenditure on capital equipment. £2.1m is therefore removed from the P&L account. At the same time the last say 5 years R&D expense (assumed £13.4m) is added back to the balance sheet. This will increase the capital base and thus the imputed capital charge. A small charge for R&D may remain in the P&L to reflect the economic depreciation of the capitalised value.
- Advertising is a market building investment and is removed from the P&L. The last say 5 years advertising expense is added to the capital base (assumed £15m). A small charge for advertising may remain in the P&L to reflect the economic depreciation of the capitalised value.
- Goodwill represents the premium paid for a business on acquisition. Again this is an investment in the future and similar adjustments as for R&D and advertising apply. The cumulative advertising write off of (assumed) £8.9m is added to the capital base.
- The tax figure will include tax relief on debt interest. As this will be allowed for in the weighted average cost of capital it should be adjusted out. The tax bill will rise to 4.08 + (30% * £1.6m)= £4.56m.
- This is an assumed 15% WACC applied to the adjusted capital employed. Note that WACC would be calculated following the approach outlined in geared companies above.
- No adjustment is made for depreciation as this is assumed to approximate economic depreciation on physical assets as discussed above.
Arguments for and against Economic Value Added
- It makes the cost of capital visible to managers. Under conventional management accounting performance measures the only profit and loss charge for capital is depreciation on the asset. Under the economic value added approach managers will also be charged the financing cost of capital employed. This should cause managers to be more careful in investing new funds and to control working capital investment. It can also lead to under-utilised assets being disposed of. To improve their performance managers will have to:
– Invest in positive NPV projects; or
– Eliminate negative NPV operations; or
– Reduce the firms Weighted average cost of capital.
Or hopefully all three.
- It supports the NPV approach to decision making. If managers pursue negative NPV projects they will eventually find that the imputed capital charge outweighs earnings and will lead to a deterioration in their reported performance.
- Economic Value added does not measure NPV in the short term. Some projects have poor cash flows at the beginning but much better ones at the end (and vice versa). Projects with good NPVs may show poor economic value added in earlier years and thus be rejected by managers with an eye on their performance measure. Managers who have a short-term time horizon (possibly due to impending promotion or retirement) could still make decisions that conflict with NPV and thus the maximisation of shareholder wealth.
If we return to projects being considered by companies A and B but this time alter the pattern of cash flows (but not the NPVs) the point will be clearer. Table 5 illustrates this point.