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  • EVA in its basic form resembles residual

    2018-11-03

    EVA in its basic form resembles residual income – the profits remaining after deducting the cost of capital in investments (Pattanayak, 2009). Thus EVA in its basic form states that an organization is adding value when after the tax earnings before interest are higher than the weighted average cost of capital of the resources employed (Helfert, 1997). In 1950s, General Electric applied the concept of residual income for measuring performance in their decentralized divisions (Stewart, 1994). However the concept of residual income as a performance measurement tool was not found to be valid and could not generate interest among business executives until 1990s. In 1991, Stewart modified residual income by making a series of accounting adjustments to standardize the residual income closer to an economic cash flow basis, parallel to economic measurement concept and labeled it as EVA (Biddle, Bowen & Wallace, 1997; De Wet, 2005; Ho et al., 2000; Pattanayak, 2009; Pattanayak & Mukherjee, 1998; Stark & Thomas, 1998; Tsuji, 2006). The basic aim of these adjustments was to make an EVA model closer to the real economic value of the firm. Moreover, it was asserted that these adjustments would tend to enhance the validity of EVA as a performance measurement tool since the real economic value enables management to monitor and control more efficiently the use of the invested capital (Kyriazis & Anastassis, 2007; Pattanayak & Mukherjee, 1998). Thus, it naturally follows that EVA attempts to measure the true economic profit generated by the firm and serves as a metric for knowing the company׳s success (or failure) over a Rosiglitazone cost of time (Stewart & Stern, 1991). EVA also finds support in the classical finance theory that asserts that corporates must strive to maximize the wealth of stockholders (Palliam, 2006). Further, it suggests three conceptual pillars in support of EVA. First, cash flows are more reliable than accruals (Biddle et al., 1997; Ho et al., 2000; Palliam, 2006; Tsuji, 2006). Second, certain expenses are, in economic reality, actually long-term investments because they are capable of generating revenue in long run (Ho et al., 2000; Lehn & Makhija, 1996) and lastly, it suggests that value is not created until a minimum level of returns (threshold level) is generated for shareholders. EVA does not only serve as a measure of financial performance but is also regarded as the centerpiece of a strategy development and implementation process. Further, it is widely recognized that EVA can serve as an analytical framework for evaluating alternatives. As an evaluating tool, EVA can be used to identify a set of variables shaping payoffs and also find ways to improve them. EVA can also be used to benchmark performance and find out what׳s working and what׳s not working. Furthermore, being a single measure EVA tends to eliminate the conflict and confusion by integrating all the business issues from strategy to all the operating decisions. This single measure simplifies and speeds up decision making, strengthens communication channels, enhances teamwork and reduces parochial behavior (Ehrbar, 1999). Moreover, it is suggested that successful value-based management companies keep the technical accounting aspects of EVA simple, making very few changes to their accounting practices. They devote time and effort in identifying and assessing the operational factors, or value drivers that have the greatest influence on the creation of economic profits (Fletcher & Smith, 2004). Further, implementation of EVA will tend to establish a link between performance and shareholders׳ wealth. Since EVA has been widely accepted as a performance measure, a number of Fortune 500 companies, for instance, SPX Corp., GE, and Chrysler, and in India, for instance, Tata group, Infosys and Hero Motors, report EVA as additional information in their annual reports. Even though EVA is considered as a superior measure of performance, it too suffers from certain limitations. One major limitation of EVA is that it is over reliant on financial metrics like the amount of capital invested, profit margins, cost of capital etc. Empirical studies have shown that these metrics are often incapable of indicating future performance (Fletcher & Smith, 2004). Further, it is regarded that EVA has high financial orientation. The computation of EVA relies heavily on revenue realization and expense recognition. For getting better financial results, managers of the companies can manipulate these financial numbers (Horngren, Foster & Datar, 1997). For instance, revenue recognized in a fiscal year can be manipulated by giving preference to the larger and profitable customer orders and delaying smaller and less profitable orders. This practice will boost EVA but would have an adverse effect on customer retention and satisfaction. Similarly a company can reduce expense recognition by delaying or cancelling expenditures in favor of better financial results. For instance, a company can terminate the employee training program and thereby tend to save the consultation fees which increases EVA but puts the commitment to work at halt. Another major problem connected with EVA is that managers in pursuit of increasing EVA tend to use fully depreciated assets; such practice lowers the asset base in the books of accounts and also ensures no depreciation is charged or recognized, thereby increasing EVA. The examples cited above determine the choice to be made by the manager between personal gains or corporate welfare. From the companies׳ perspective, these practices are considered as unethical or even dysfunctional. However, from the perspective of managers, high reliance on EVA to measure their performance is considered as dysfunctional because it fails to depict the true level of performance at a particular point of time. Thus, manipulation of accounting numbers would be genuine in case managers know that they have improved the performance dramatically but is not immediately reflected in books of accounts (Brewer et al., 1999; Pustylnick, 2011).