Relevant to ACCA Qualification Paper P5
A successful performance measure evaluates how well an organisation performs in relation to its objectives. Since the primary objective of commercial organisations is normally assumed to be the maximisation of the wealth of its shareholders, it follows that performance measures should evaluate this. In practice, many organisations use profit-based measures as the primary measure of their financial performance. Two problems relating to profit in this area are:
Economic Value Added – or EVA – is a performance measurement system that aims to overcome these two weaknesses. EVA was developed by the US consulting firm Stern Stewart & Co, and it has gained widespread use among many well-known companies such as Siemens, Coca Cola and Herman Miller.
EVA is based on the residual income technique that has been used since the early 20th century. Residual income is a performance measure normally used for assessing the performance of divisions, in which a finance charge is deducted from the profits of the division. The finance charge is calculated as the net assets of the division, multiplied by an interest rate – normally the company’s weighted average cost of capital.
Division A made a profit of $10,000 during the most recent financial year. The capital used by the division (equity plus long-term debt) was $70,000. The weighted average cost of capital of the company is 13%, and this is used when calculating the finance charge. The residual income of Division A was therefore:
Finance charge 9,100 (70,000 x 13%)
Residual income 900
The finance charge of $9,100 represents the minimum return required by the providers of finance on the $70,000 capital they provided. Since the actual profit of the division exceeds this, the division has recorded residual income of $900.
EVA is similar in structure to residual income. It can be stated as:
EVA = NOPAT – (k x capital)
Where: NOPAT = Net operating profits after tax.
(k x capital) is the finance charge, where k = the firms weighted average cost of capital
capital = equity plus long-term debt of the company at the start of the period.
This formula will not necessarily be given in the exam, so you need to learn it.
NOPAT means net operating profit after tax. This profit figure shows profits before taking out the cost of interest. The cost of interest is included in the finance charge that is deducted from NOPAT when calculating EVA. Two approaches to adjusting for interest are taken. Either:
An extract from the income statement of Alpha Inc shows the following:
Operating profit 1,000
Interest charge (100)
Profit before tax 900
Tax at 25% (225)
Profit after tax 675
NOPAT is either:
Profit after tax 675
Add after tax interest (100 x 75%) 75
Operating profit 1,000
Less tax charge adjusted to exclude
tax relief on interest (225 + (100 x 25%)) 250
The major departure from residual income is the adjustments made to reported financial profits and capital. Proponents of EVA argue that profits calculated in accordance with financial reporting principles do not reflect the economic value generated by the company. There are three main reasons for these adjustments:
Stern Stewart famously remarked that, for some companies, 160 adjustments were made to the accounting profits in calculating NOPAT. The Paper P5 exam will test only the most common adjustments, which are as follows:
Tax charge per income statement X
Less increase (add reduction) in deferred tax provision (X)/X
Add tax benefit of interest X
Cash taxes X
Note: no further adjustments are made in respect of the tax on the other items adjusted for during the calculation of NOPAT.
The adjustments can be summarised by the following table:
The finance charge
The finance charge is calculated by multiplying the capital employed by the weighted average cost of capital (WACC). Capital employed is taken to mean equity plus long-term debt, and it is normal to take capital employed at the start of the year. In practice, the best approach is to start with capital employed from the published statement of financial position, and then to make the adjustments mentioned in the section above.
Further information is as follows:
Calculate Economic Value Added (EVA).
Note: The research and development expenditure on both Project X and Project Z was expensed in the income statement in accordance with financial reporting standards. Since it is considered to be market building expenditure, however, it is added back to profits in the year it was incurred, and added back to capital employed at the end of the year in which it was incurred, when calculating EVA.
Such capitalisation should also be amortised over the period that it brings benefits. Therefore, in the case of Project X, this has been amortised over the two years during which the company sold products based on it. Project Z has not been completed yet, so no amortisation has taken place.
A reconciliation of the balance can be shown as follows:
Project Z Project X Total
$000 $000 $000
Balance at 1 January 2009 0 1,500 1,500
Expenditure incurred during 2009 500 0 500
Less amortisation during 2009 0 (750) (750)
Balance at 1 Jan 2010 500 750 1,250
In the second part of this article, to be published in the next issue of Student Accountant, we will focus on interpreting the calculated EVA , and its use as both an organisational performance measure and divisional performance measure.
Nick Ryan is lead tutor for performance management subjects.