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This paper begins by taking a look at the Economic Value Added (EVA) method of reporting and assessing companies against the traditional ways that accountants use. It goes on to show the shortcomings of such traditional methods, and the reason why EVA should be the alternative that companies need.
Finally, we take a look at the result for the company when the EVA method was introduced and the benefits derived for both the staff and management and the shareholders.
The established methods of historical data reporting as it pertains to accounting are in essence very relevant in today's world of corporate finance and accounting. What has changed in modern society is the application of these principles to the benefit of firms' performance as they try to paint pictures of the final records of the operations in the industry.
As more data from research becomes available researchers discover more efficient ways of doing things. One such new method is the Economic Value Added (EVA) method. This method gives a better evaluation of the economic profit that corporations make as compared with the more traditional methods employed by the General Accepted Accounting Practices (GAAP). Although there is nothing fundamentally wrong with the GAAP and the data reported, what is necessary is a new structural arrangement that displays the way that the data is reported in an easy-to-understand format. This format should be one that clarifies what is done, how it is done and why. Essentially, reports that are submitted are to aid decision makers such as managers, investors and other speculators in making informed decisions. These decisions are what determine whether stocks are traded, whether the company are really trading at a value that truly reflects what is stated.
ECONOMIC VALUE ADDED
EVA is a method that is used to calculate the real economic profit that a company makes. It is calculated by the net operating profit after taxes (NOPAT) less a charge on the opportunity cost of any invested capital. The EVA method unlike pure accounting methods which uses earnings before interest and taxes (EBIT), posits that businesses report profit after operating costs and capital are covered.
THE WEIGHTED COST OF CAPITAL
Many companies use a weighted average cost of capital (WACC) to determine the projects that are worth keeping and those to dispose of. This WACC is a blended cost of all the capital: common stocks, bonds, preferred stocks, long-term debts are all added in the calculation of WACC. In other words the company uses this to see how much interest it has to pay for every dollar it finances. According to the type of company the capital structure mix could be a ratio of between 20 percent debt and 80 percent equity mix. New fast growing companies may have a 20/80 ratio whereas older stable companies can have a 60/40 ratio debt to equity structure. This mix is really the decision of the management team and should be maintained if the company is to keep its progression.
THE SHORTCOMINGS OF TRADITIONAL ACCOUNTING
Traditional accounting has many merits, but there are some noticeable weaknesses that must be addressed so as to strengthen its validity when reporting for corporate governance. These new ways of reporting can radically change the world of reporting and give stakeholders a clearer picture of what is really happening in the firm at any given time.
Owners invest equity capital in their business. Accountants view this equity as free. Unlike debt finance, in which there is interest charges there is no penalty to the company nor is there a charge associated for using this capital. The result then is that in the final report the firm is reported as making much more profits than it actually has, since the charge for equity usage was not subtracted. Equity cost though, is not a tangible cost that can be placed in an accountant's book. It is an opportunity cost; a cost that would be incurred (or profit gained) if that capital was invested at some risk to the stockholders.
There is a vast difference in accounting and economic profit. As an example to clarify the position: a firm's accountant has reported a net income of $100M. On its balance sheet there is a shareholder's capital of $2B with cost of equity of 10%. According to Economic Value Added method the firm is actually operating at a loss of $100M. This can be demonstrated by the following equation:
Economic Profit = Accounting Profit - Cost of Equity
Economic Profit = $100 - (10 X $2B)
Economic Profit = -$100
This clearly demonstrates that the accounting methods may mislead stakeholders on the reality of the business on matters that concern their going concern.
From an accounting perspective, the cost of equity is assumed to be zero. Although it is impractical to predict what the exact cost will be, an informed estimate can be entered and used in the accounting process. By assuming that the use of shareholders' capital is done at no cost to the company, is a serious flaw in the accounting process.
DEBT AND EQUITY
Another accounting practice that is questionable is the practice of over reporting profits when financed by debts and understating it when financed by equity. This could be so because management only has to cover the interest on debt financing, with the final figures giving an incorrect inflated earnings figure. If financed with stock, the firm will have to produce higher profits to maintain its earnings per share rates. That being so, management can manipulate the books to reflect anything they wish even to the detriment of the companies that they run.
To counteract this anomaly, a system of accounting, or net operating profit after taxes (NOPAT) a term proposed by Joel Stern was introduced. In this system, profit was calculated after taxes and charges were subtracted. This gives the Economic Profit or EVA, which can be defined as NOPAT minus the Cost of Equity and debt. Also associated with this system is the fact that firms should continue to hold to the practice of keeping the ratio of debt and equity capital financing structure at one of a third and two thirds.
Another flaw in the accounting process that abounds is that of downplaying the importance of research and development (R&D) spending. R&D is that department that gives firms the competitive edge. It should be categorize as asset earnings and placed in the books as such and charged over the period when its likely worth would expire. In accounting practice, the R&D charge is treated as a cost and entered thus on the balance sheet. The reason for this is that bankers that lend to corporations need to have tangible assets in lieu of granted money.
What is not quite noticeable is the true value of "soft'' assets such as software, people with knowledge, the setting up of better customer service systems, better technology and innovative inventions; yet these items are not given any value on the accountants books. Sometimes it is not easy to see or even calculate the direct revenue that some of these assets bring to the firm but the indirect value by reason of its spread and interaction with other systems can exponentially expand the overall value of the corporation. In some companies the learning curve of valued workers can be considered a true form of intangible assets. When a new worker would take considerable time to assess whether some system would work or not a "knowledge worker'' would be able to decide within a matter of some minutes because of the experience he has, saving his company considerable time and money.
This form of cost accounting can be used just like in the full cost accounting process utilized by accountants, where they spread the cost over the successful business units and those that lose money.
THE MIXING OF OPERATIONAL AND FINANCIAL RETURNS IN PENSION PLANS
In accounting, pension plans are not treated as assets and liabilities. Many governments make it mandatory that pension funds pay some sort of retainer by law for pensions. Even in bankruptcy a company's pension fund is given priority over lenders and other claimants on the company's assets. But pension liabilities are no where visible on the company's balance sheets as liabilities and assets.
These are costs that have already been incurred and cannot be recovered irrespective of future actions. In other words, the gains or losses incurred when disposing assets are irrelevant on the balance sheets. The disposition should enable the firm to realise a higher value of shares in the long run after the disposition of that particular asset. New decisions should bring about new value for the firm.
THE VALIDITY OF EVA IN PROMOTING TOTAL COMPANY PROFITABILITY
When EVA is properly used in a company, the situation is a win- win situation as the firm gains when both the investors gain share value and employees perform as though the company belongs to them as well.
Research has shown that employees' participation has many merits as well as disadvantages. Some of these advantages are: that productivity is higher, there may be increased performance and the marginal cost of one new worker is minimized if there is active profit sharing in lieu of wages. Some of the disadvantages are that workers may have to face a greater risk and not be adequately compensated; managers may not have exclusive rights to make controlling decisions since workers now have greater say in what the company does.
The active participation of employees in the profit sharing of companies has its drawbacks too, in that the price of shares is controlled by economic factors and managers have no control in its fluctuations. There is not a distinct link between the salaries received and the performance when sharing in profitability is practiced. Hence there is no incentive to employees, also the money distributed to owners and to employees are at variance, when employees get paid the owners usually have to take a lesser share value; and when there is a greater share value to owners the workers usually forfeit their deserved bonuses.
Using options as incentive for performance is looked upon with suspicion by many learned scholars who are not convinced that it is the wisest thing to do: their argument in part is that management cannot be sure of the correct type of option to offer or if the offer will have the effect that is expected. Some think that using options will cause the management to think in terms of the long term returns of the stocks rather than the periodic performance of the company.
COOPERATION BETWEEN COMPANIES AND WORKERS
In the past the relationship between management and unions was one of confrontation and heated negotiation. This method has now changed in the interest of modern methods. There is now communication, the introduction of change management techniques, best-practice principles, the encouragement of up-ward mobility from within, and paying attention to the voice of the employees via the human resource department.
Many employers have difficulty in accepting employees in the decision making machinery. They counter that this would lessen the effect of the middle management. The reality is that if the managers and employees work to achieve a common goal then the entire firm would benefit from the final success of the company.
Many executives and managers from the 'old school' believe that decisions must be made by top managers only and handed down to subordinate staff; they strongly reject the idea of sharing of decision making. Their hierarchical nature of their company are incapable of recognising that workers are capable of making important inputs into the proper governing of the company. Also, they hate relinquishing the prestige and wealth that their positions afford them. Managers many times work counter to the owner's objectives, instead they focus on the immediate payback that they may receive for the running of the company. Many such managers do not see training of employees as investments.
THE CASE FOR EVA
When Dr. Franz Scherer took the decision to offer the employees of Sirona profit sharing throughout the firm, his actions won the favour of the entire working population. The planned programme consisted of gaining the acceptance and involvement of all staff, with the redesigning of the payment options; the employees were shown that if they achieved the EVA target, then they were guaranteed the same salary package that they received previously, with a possibility of surpassing it. The acceptance of the workforce was achieved and finally the acceptance from the shareholders.
I believe that the shift for the introduction of EVA is a welcome new way of seeing and doing things in the corporate world. As more information becomes available to researchers and business analysts, they take deeper look into the operations of the firms; better systems replace the old ones that may have served their purposed in their times. More efficient methods are emerging that should make corporate governance transparent as profit grows and shareholders receive value for money invested.
While traditional accounting methods have their value, the values and targets that are aimed for are skewed, so that the figures that are reflected are really not indicative of true performance of the entire company but only represent certain section or units of the firm.
Modern analysts correctly identified these erroneous measures and suggested that companies use an economist perspective instead of using the general accepted accounting practices for the firms total performance assessment. In time, it is hoped that this new system of doing things will be widely accepted as the norm in the corporate world.