Magazine article The CPA Journal

The Truth about Economic Value Added

Magazine article The CPA Journal

The Truth about Economic Value Added

Article excerpt

In Brief

In Search of Reality Does a bottom line reflecting only GAAP give a true picture of a company's performance? Using GAAP based financial statements, the authors take us through some of the adjustments that are necessary to reflect economic profit. Among other items, they demonstrate how a loss from operations may actually be hiding a positive economic net operating income or how some current operating expenses written off under GAAP will be providing future benefits. They advocate the determination of economic profit as a significant means for understanding performance evaluation in both for-profit and not-forprofit organizations.

A detailed example helps fill in the details.

Recently, business magazines and journals have included articles extolling the benefits of economic value added (EVA), hereafter referred to as economic prof it, a tool that can be used to evaluate the performance of almost any business. The use of the economic profit concept is credited by several large companies, such as AT&T, Briggs and Stratton, and Coca-Cola for enhanced performance. One widely held belief among managers of these firms is that using the concept more closely aligns the interests of managers with those of shareholders.

Using the concept is not limited to for-profit enterprises; several public sector and not-for-profit enterprises are also interested. For example, the U.S. Postal Service has hired Stem Stewart, a consulting firm specializing in economic profit calculations to assist in implementing the concept as a performance measurement. EVA is also Stern Stewart and Co.'s trade name for their method of calculating economic profit.

Many investors have also adopted economic profit analysis, using it to evaluate a company's potential for long-term stock price appreciation.

Background

The idea of calculating economic profit is neither new nor complicated. Alfred Marshall originally suggested that a firm must do more than generate net income as defined by generally accepted accounting principles. To survive in the long term, firms must generate sufficient profit to cover the cost of all invested capital. Economic profit performance measurement applies the actual cost of capital-including both debt and equity-used by the business to determine if a company is actually generating economic value.

Calculating a company's economic profit initially appears to be rudimentary: Begin with after-tax operating income and deduct a charge for the cost of equity capital. This method, however, is incomplete. To properly calculate economic profit, adjustments must be made to after-tax operating income and then the total capital investment in the company computed. The necessary adjustments to after-tax operating income include subtleties frequently overlooked when calculating economic profit.

While the information needed to compute economic profit is generally available in GAAP-based financial statements, reconsideration and rearrangement of some balance sheet and income statement amounts are necessary. Whether justified or not, many articles in the business press concerned with calculating economic profit include criticism of GAAP-based financial statements and the resulting treatment of certain expenditures. For example, while GAAP calls for deducting interest charges on debt when calculating net income, it ignores the cost of equity capital. …

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