(EVA) Accounting Practice
Although Economic Value Added (EVA) is not a new concept in economics and financial theory and is based on the 19th century concept of “economic profit,” it has only been widely adopted recently by business firms as an accounting practice. In this paper we shall describe what EVA is, and look at its pros and cons from the point-of-view of the company adopting the practice and the investors. We shall also discuss how EVA differs from some other emerging accounting practices and the major issues relating to EVA as compared to other commonly used accounting principles. Finally, the possible problems and opportunities that a company adopting EVA principles can face shall be examined.
What is Economic Value Added (EVA)?
Economic Value Added (EVA) is the after-tax cash flow generated by a business minus the cost of the capital it has invested to generate that cash flow. It represents the “real” profits rather than the “paper” profits that a business earns and is increasingly in corporate finance for business planning and performance monitoring. (Keen, 1999)
In other words Economic Value Added is not the straightforward accounting “profit” that we get by subtracting the costs minus revenue. In EVA we take into account the “cost of capital” that is invested in the business and the cost of capital includes both debt and equity. Hence if we invest, for example, $100,000 in a business and get $110,000 as revenue the profit is not simply ($110,000 minus $100,000 = $10,000) since the $100,000 at the time of investment had an opportunity cost that has to be accounted for before we determine our “real” profit. If the opportunity cost of $100,000 at the time of investment was $120,000, i.e., the investor could earn $20,000 by investing his/her money elsewhere, the $10,000 “paper profit” would actually be a “loss” in real terms.
EVA is also a proprietary trademark of Stern Stewart & Co., a global consulting company.
Pros and Cons of EVA-Shareholders’ & Company’s Perspectives
EVA is mainly focused on increasing value for the shareholder. Adoption of EVA accounting principles makes the firm’s management more accountable to the suppliers of equity capital, i.e., the shareholders. EVA figures also keep the shareholders informed about how much “value” has been added to their investment.
Adoption of EVA accounting practices prevents managers from thinking that the cost of capital is free and enables the businesses to focus on adding “value” to the firm while providing the financial managers a better tool for . For example, a London-based firm (United Distillers & Vintners Ltd.) used EVA to analyze which of its the best returns. Since Scotch Whiskey required longer storage periods, it did not generate as much profit as vodka, which could be sold within weeks of being distilled. As a result of the EVA analysis, management at United Distillers decided to focus more on vodka production and sales instead of Scotch. (Shand, 2000)
So the main “pros” of EVA are that it accounts for the cost of capital and reflects the risk of project unlike most other accounting measures. It also aligns the managerial actions in line with shareholders’ value (and hence shareholders’ interest) and provides superior incentive compensation than those based on traditional accounting measures.
On the other hand, the main “cons” of EVA are:
EVA can be short-sighted. For example, cash flows of pharmaceutical, high-tech, and Internet companies are typically negative for a long period at their start. EVA is biased toward projects that have .
EVA calculations can be manipulated by managers to maximize their values in the near terms at the expense of future, more distant EVA values
It is relatively complicated as compared to traditional measures such as IRR (Internal Rate of Return), NPV (Net Present Value), ROI (Return on Investment), and EPS (Earning per Share) since it requires a number of accounting adjustments, e.g., adjustments to the definition of dollar investment (historical? book value? replacement cost?) (Bennet, 1999; M. kel inen,1998-Section on “The main problems with EVA in measuring operating performance”)
How Does EVA Differ from Other Emerging Accounting Practices?
While there is no doubt that EVA is far superior to traditional accounting measures, it has to compete with other emerging accounting practices that are also “value-based” measures such as Cash Flow Return on Investment (CFROI), Cash Value Added (CVA), Shareholder Value Added (SVA), Adjusted Economic Value Added (AEVA) and Refined Economic Value Added (REVA). Although some of these emerging accounting practices are similar to EVA in many ways and in some cases even avoid certain drawbacks of EVA (being more cash-flow based), EVA is the most commonly used accounting measure among the newer, “emerging” measures. The most probable reason for its popularity is its relative simplicity as other value-based measures are based on more subjective data than EVA. As we have noted earlier, even the relatively simple “EVA” is more complicated than most other traditional accounting concepts, and the main hurdle in successful implementation of a “value-based” accounting measure is its difficulty in committing to and understanding the concept. The more complicated the measure, the less likely it is to succeed. (M kel inen, 1998. “EVA vs. other Value-based measures.”)
Major Issues Facing EVA
Successful implementation of EVA needs commitment from the top management and understanding of the concept to lower level managers such as divisional heads of production, sales, marketing departments. A comprehensive training program can facilitate understanding, while commitment can be achieved by a suitable compensation / bonus system. It is, therefore, important that manager compensation is tied to EVA without delay. (M kel inen, 1998. “Implementing EVA control inside Organization.”) Moreover, decision making authority must be decentralized for implementing EVA successfully. Managers whose EVAs are computed and evaluated must be empowered to make decisions in not only the way they produce products and services, but also in their choice and source of investment and capital.
Anticipated Problems and Opportunities
While adopting EVA it must be remembered that no accounting tool is a magic wand. Although most studies indicate that several firms that have adopted EVA have shown increase in stockholders’ value (and their share prices), there are other notable firms such as Microsoft and Intel that have created wealth for their shareholders without EVA. It is also important to note that the EVA concept has not been sufficiently tested in high interest rate environment.
At the same time, businesses that have thus far operated without the required awareness that capital is not a free resource but has an opportunity cost, are more likely to benefit from adopting EVA as an accounting principle. Such firms can look forward to “adding value to the shareholders’ capital” which ought to be the ultimate aim of most businesses.
Keen, Peter. (1999). “Economic Value Added.(EVA)” Every Manager’s Guide to Business Processes. Retrieved on April 20, 2003 at http://www.peterkeen.com/emgbp007.htm kel inen, Esa. (1998). “Economic Value Added as a Management Tool.” Retrieved on April 20, 2003 at http://www.evanomics.com/
Shand, Dawne. (October 30, 2000). “Economic Value Added.” COMPUTERWORLD. Retrieved on April 20, 2003 at http://www.computerworld.com/managementtopics/management/itspending/story/0,10801,53001,00.html
Stewart, Bennet (1999) “What is EVA?” Stern Stewart & Co. Web site. Retrieved on April 20, 2003 at http://www.sternstewart.com/evaabout/whatis.php
This cost reflects both the time value of money and compensation for risk — the more risk associated with a firm, the greater the firm’s cost of capital.
Stern Stewart & Co. coined the term “Economic Value Added” but not the concept
Companies that adopt EVA usually have bonus compensation schemes that reward or punish managers for adding value to or subtracting value from the company