Lenta, LLC
ADJUSTMENTS FOR ECONOMIC VALUE-ADDED
(PART 1)
The present article is divided into 2 parts following
the logical concern. For the 1st part we are to find out what are
the type 1 adjustments for EVA calculation and for the 2nd part we
are to finish with the type 2 and 3 of the adjustments.
The shareholder value creation is becoming an answer
to the pressure of the investors and councils. Many approaches are available.
Among them, the Economic Value added
(EVA), developed by Stern Stewart & Co. To correct the improprieties
erceived in financial statements, some users of EVA adjust the income numbers
based on the Generally Accepted Accounting Principles (GAAP), expecting that
such adjustments may produce more trustworthy values and generate an
environment favorable to a management behavior closer to the optimum. Besides
that, this work investigates the correlation between the Controller
understanding and the use of the company adopted accounting methods.
According to Frezatti (2003, p. 13), Copeland (1995)
and Rappaport (1981), value-based management reconciles the interests of the
chief agents, since it orients the planning process, through the setting of
goals, to balance the short, medium and long-term objectives, i.e., the value
of the organization and the daily managerial results, guaranteeing the
optimization of shareholder value.
Doucouliagos (1994, p. 877) considers that decision
makers take into account the cognitive skill of exercising rational choices
that are limited as regards gathering, processing and analyzing information, in
other words, the decision maker is obliged to do so with limitations imposed by
his or her own cognitive limitations, and by various numerical issues.
The potentiality of information in the hands of the
decision maker must be understood to permit its adequate use, taking into
consideration the limitations of information systems, such as the available
methodology, the handling potential, sources of information, temporal
conditions and traits of the business (Frezatti, 1996, p. 8).
In this approach, the discussion of the work is
focused on the type of information that can make decision-making feasible. Said
information is identified, gathered, prepared and placed at the disposal of the
decision maker, changing into a model that allows the agent to make the
decision.
In this study accounting proposes to act as an
adequately structured database, founded on a defined methodology, which does
not eliminate risks of error, but permits a better explanation of the causes,
providing feedback to the company’s value projection and allowing the manager
to decide about the demands related to the various decisionmaking processes
associated with the organization, from various approaches or outlooks.
Frezatti (2003, p. 19) observes that there are two
ways of describing the connection between accounting and decisionmaking and the
appraisal of performance at the organization. The first through the
observation, analysis and tracking of economic events already verified,
implying the distribution of dividends or future investment potential. The second,
based on the fundamentalist theory, pursuing the projection of results that
depend on the scenarios perceived by the decision maker and by the capacity to
translate these elements into numerical information.
The consequence of this approach is that the
organization starts to have a proactive outlook as it seeks to control its own
future by reviewing its business strategies and projected results in order to
protect the value of the company.
In this context, this paper contains a discussion of
the interaction and conflict between the prescriptive approach, which
presents how information should be gathered and prepared for the decision
process, and the descriptive approach, whose real interest constitutes
identifying how the information is actually gathered and prepared (Hendriksen
and Breda, 1992, p. 198).
Furthermore, the authors of this paper also consider
it important to understand, by means of an onsite survey, the status quo of
companies in the country in terms of the mix of managerial information, seeking
in empirical evidence traces that enable us to understand (or emphasize) the
issue, its limitations and opportunities. From this perspective, the question
that the authors intend to answer is: is there a relation between the
definition of the method adopted by Managerial Accounting in the organization
and the controller’s perception in relation to the method of approximating the
book value to the economic event and its respective frequency of use? Along
this line of reasoning, the general objective of this study is to verify
whether there is a relation between the definition of the method adopted by Managerial
Accounting in the organization and the controller’s perception in relation to
the method of approximating the book value to the economic event.
Using the knowledge acquired by the review of
literature, the following objectives are required for this paper:
1. Identify the use of accounting instruments for management at the
organization via Managerial Accounting;
2. Investigate the possible correlation between the controller’s perception
of understanding as concerns the approximation of the book value and the
economic value and the use of methods adopted by the organization from May to
October 2003;
3. Observe whether the adjustments defined in managerial accounting
approximate the book value and the economic value according to the controllers’
perception;
Value calculation
and management methodology
According to Steiner, apud Frezatti (2003, p.
39), the long-term indicator that can be used in the strategic planning process
should be: linked to the organization’s purpose, i.e. mission and values;
subject to measurement during a certain period of time; feasible in terms of
attainment; acceptable by the people from the organization; flexible; motivating;
understandable (simple); capable of producing a commitment by those that will
be developing the actions; participative, in its definition, by professionals;
and consistent at the various hierarchical levels and in the organization.
Various alternatives are available and are mentioned
in literature as potential long-term financial indicators suitable for monitoring
the development of operations from the perspective of the unification of the
understanding of economic events. According to Frezatti (2003, p. 32) the
indicators include those that connote: Internal variable (return on
investment - ROI, discounted cash flow and residual income) and External
variable (value of the company and its MVA). The residual income (RI)
approach related to the internal variable is summarized and transcribed below.
Residual Income
According to Johnson and Kaplan (1996, p. 143): “the
development of the RI procedures is usually attributed to General Electric
Company, even though the idea of mandating an explicit capital charge on
investments, in the computation of net income, already figures in various
foregoing literary works from this century [20th century]. The concept of
residual income only appears in managerial accounting literature in the 60s.”
Anthony, apud Frezatti (1998, p. 62) defines
residual income “(...) as a value that is obtained by subtracting the cost of
invested capital from income. This capital cost is obtained via the
multiplication of the value of assets employed by a given rate.”
In simple terms, residual income is what remains for
the organization after it remunerates, pays and returns financial resources consumed
in its process, thus involving the shareholders, financial institutions,
suppliers, employees and service providers.
Various alternative metrics that summarize economic
performance have appeared since the topic is widely studied in international academic
circles. In relation to the residual income method we have: Economic Value
Added (EVA) by Stern Stewart; Total Business Return (TBR) by Boston Consulting
Group; LEK by Alcar Consulting Group; Shareholder Value Added (SVA) by
Rapapport; HOLT by Holt Value Associates and Cash-flow Return on Investment
(CFROI).
Frezatti (1998, p. 59) describes some strong points of
the calculation of residual income:
1. Presents a simplified conceptual language;
2. Constitutes an additional product of accounting and not its rival;
3. Affords the analysis of internal performance (remuneration policy),
analysis of investment (for acquisition/merger/takeover purposes) and market
analysis of the organization;
4. Determines the income that remunerates all the stakeholders involved,
taking the risk into consideration;
5. Permits the preparation of benchmarking, when used in external analysis,
through the comparison of the organization’s performance in terms of operating
return, capital cost and investment management;
6. Permits the reduction of accounting distortions through the suggestion
of adjustments.
The author (2001, p. 49) also indicates some
limitations in the implementation of this value:
1. Subjectivity related to the criteria defined for each organization: the
need for assumptions about the share of own and third party funds in the
calculation of the opportunity cost; and difficulty in understanding the
meaning of economic result;
2. Complexity of the instruments for its implementation in the
organization, calling for maturity from the management group and a refined
information system.
Carvalho (1999, p. 43-44) declares that the
performance of valorization based on a simple criterion (EVA) tends to encourage
managers to manipulate the performance indicators, distorting the benefits and
the limitations of use of the indicator. He also adds, as a negative aspect,
that the indicator discerns the added value arising from the success of
strategic decisions and investments from a past accounting period, not
considering the evaluation of the organization, to the effect of knowing
whether it is acting to guarantee its sustainable competitive advantage.
The author (1999, p. 49-50) observes that the use of
EVA at companies has produced some effects, with an emphasis on:
1. Enhanced awareness of the value of capital on the part of management;
2. More enterprising management, seeking alternative ways of increasing the
value of the organization, although in a more adequately planned fashion;
3. Performance appraisal henceforth uses as parameter the profitability
offered by the market in the investment of the capital involved and no longer
against results of the sector;
4. Business unit management indicator and operational and functional
indicators, permitting the tracking of the potential gain of each implemented
improvement.
Necessary adjustments in the accounting data for the
obtainment of the economic result
Frezatti (2001, p. 50) analyzes the accounting
principles presented by Hendriksen (entity, continuity, periodicity, conservativeness,
monetary common denominator, realization, comparison of income and expenses
related thereto and competence of the year) with the objective of verifying its
validity both in the economic result approach and in the result by accounting
principles, so that, in cases where differences occur, some type of adjustment
is identified to maintain equality.
To this effect, three types of adjustments are
identified: adjustment to obtain the economic operational result and the base
of investments that produces said result; adjustment to expurgate values that
do not necessary imply economic/cash impact; and adjustment to expurgate
non-recurrent gains and losses.
Young (1999, p.12) suggests that the organization
should consider one of the four following situations before it opts for an
adjustment:
1. Is there is distortion or bias caused by the accounting practice that
result in a behavior below the expected level?
2. Will the adoption of the adjustment provoke an improvement in the
managerial behavior thereby stimulating actions that aid in the creation of
value?
3. Are the benefits resulting from the improvement of managerial
performance greater than the costs resulting from the alterations in accounting
practices?
4. Are the adjustments more efficient in attaining the desired objectives
than alternative or control mechanisms?
In other words, applicability might or might not occur
in the organization, not only due to the organization’s concern about assuming
a standpoint with respect to the adjustment needed to bring about the desired
economic result, but also due to the actual judgment and common sense of the
manager when these adjustments are evaluated from the perspective of Managerial
Accounting.
Type 1 Adjustments
The result prepared in accordance with accounting
principles underestimates information related to the remuneration of
shareholders arising from the use of own capital in the organization, producing
distortions in comparison to the economic result, which determines net
information on all the factors to be remunerated (conservative outlook).
Accordingly, some adjustments should be made in order
to permit the adequate determination of income, the identification of
investments in financial resources that have produced said income and the
comparison with the cost of capital.
According to Frezatti (2001, p. 53) type 1 adjustments
are adjustments of the moment, since the moment can make the result different
at a given instant, and although compensated at another moment, the present
value will not be compensated. The following items were selected for this group:
research and development, amortization of goodwill, leasing, deferred income
tax and depreciation.
Research and development (R&D)
Young and O’Byrne (2000, p.212) argue that expenses
with R&D are investments; in some cases they pay for themselves, and in
others not, but this does not mean that they are not investments. Hence the
authors advocate the capitalization of these expenditures. Another aspect in
favor of capitalization is related to the dysfunctional behavior of the
officers and directors.
In the opinion of Young (1999, p. 5) the practice
prevents officers and directors from having unfavorable behaviors in relation
to R&D investors, as they are evaluated by the result expected from the
business unit and this is unfavorably influenced on the short term as a result
of the appropriation of expenses, and favorably influenced on the long term
when the investment benefits occur (the same manager that decided on the
investment is not always the one that will manage the business two or more
years later on).
Goodwill and respective amortization
Young and O’Byrne (2000, p. 239) observe that the core
of the issue is how goodwill is classified. Along these lines, the authors
present three classification options:
1. Consumable fixed assets that are recovered
through positive amortization rates;
2. Non-consumable fixed assets, which do not
suffer value alterations and do not require amortization rates;
3. Assets that suffer alterations in their value, and that are recognized through negative amortization rates.
If the goodwill is considered a non-consumable fixed
asset, realized amortization should be added to the income in order to restore
the original value of the invested capital.
Nevertheless, Young and O’Byrne (2000, p. 240) observe
that the analysis continues to present a performance measurement problem, since
the write-off of direct goodwill against income does not alter the business
evaluation analysis, but incorrectly implies the perception of the first year
as extremely poor in terms of performance. In any year chosen for the
write-off, the income, which is apparently bad, will not be related to the
operational performance of the business in any way. Once again, the figures
seem to say that acquisition destroys value, even though investors are gaining
a return corresponding to the cost of capital on the market value every year.
According to Young and O’Byrne (2000, p. 243), even
though negative economic depreciation is a perfectly correct solution to the
acquisition problem, it is more common for companies to use a pro-forma annual
base to prevent the discouragement of value-generating acquisitions. Hence the
acquired goodwill is included in a pro-forma base, in the capital invested in
the previous year, eliminating the bias of incentive plans against acquisitions.
To complete this, he suggests that companies up their goals for improvement, in
that acquisition leads to stable growth in income.
Leasing
According to Martins (2002, p. 3), lessees believe
there is a gain when recording in the form of rent. However, if we observe that
the total installments paid to the lessor correspond to the total cash price of
the purchase of the asset plus increases due to the loan, and that this value
corresponds to the total depreciation of the asset plus the financial charges,
then the difference lies in its distribution over the course of time and not in
the total expenses.
This more rapid appropriation undervalues operating
income during the period in which the company is disbursing the installments.
On the other hand, after the payment of the installments, there is an
overvaluation of operating income and consequently of its profitability, until
the end of the useful life of the asset, since the only expense to be entered
is the residue of depreciation which, by the way, is symbolic, seeing that the
value of the asset has already been paid and entered in full.
Martins (2002, p.3) draws our attention to the fact
that the lessee does not pay less income tax for the prepayment of expenses,
since the lessor includes the cost of this tax that it pays when allocating the
revenue of the installments (financing of this anticipated income tax at the
lessor). It is for this reason, concludes the author, that the financing rate
of leasing is higher than the normal financing rate.
The author (2002, p. 3) adds that the merit of
commercial leasing lies in the timeframe and in the scope of the financed part
(100%) and not in the tax benefits, which do not really exist. However, if the
lessee does not record the lease in this way, he or she ends up paying for the
financing of the tax, which burdens the lessor and, without the counter entry
of postponing his or her own tax, incurs an effective fiscal and financial
loss.
Young and O’Byrne (2000, p. 247) also analyze the
influence of the accounting of leasing as a rent expense and conclude that the
treatment undervalues the invested capital, as leasing is actually a debt. In
performing the adjustment, the estimates of debts with third parties and own
capital change, and consequently lead to the change of the weighted average
cost of capital.
Likewise, operating income is also undervalued, since
part of the leasing payments refers to interest, which should be classified as
a financial expense, and not form the operating income (the tax benefit of interest,
in turn, should also be subtracted from operating income).
The authors (2000, p. 252) observe that the effects of
adjustments are only significant at companies with large volumes of leasing
operations. However, if the authors take into consideration the allocation of
the good as an asset, and its corresponding depreciation in accordance with the
term of its useful life, they will realize that this change will have a
significant influence on the interpretation of performance, and thus provoke
changes of behavior in officers and directors. Hence, according to Frezatti
(2001, p. 55), one should reverse the amount of leasing amortization from income,
and from previous periods, and constitute it in the balance sheet to form part
of the invested capital, to be allocated in the future.
Deferred taxes
Leão et al. (2000, p. 5) informs that deferred
income tax entered as income is determined in a residual fashion, i.e.,with a
difference between the initial and final balances of tax assets and liabilities
deferred for the period. Using this logic, Young and O’Byrne (2000, p. 221)
conclude that deferred tax liabilities always remain in the balance sheet, providing
the company has situations that are benefited by postponement.
To this effect, as older temporal differences are
reverted, new ones appear, so that deferred tax is more like own capital than
third party capital. Hence since the liability will not be paid, the respective
expense should not be recognized. However, according to the authors, the chief
problem of this logic is the fact that it only occurs in the case of deferred
taxes derived from depreciation at a company with maintenance of the investment
level. In addition to this problem, Young and O’Byrne (2000, p. 221), specify
another two that make it impossible to adequately evaluate the value of
business:
1. The values of the free cash flow are underestimated, since tax liability
is not recognized in terms of present value;
2. The return on the invested capital is below the economic return.
For the first problem, the alternative suggested by
the authors (2000, p. 222) is the recognition of the deferred tax expense in
terms of present value. Leão (2000, p. 8) alleges that theoretically,
said procedure could even eliminate the account of deferred taxes in situations
where the period of time is long or infinite, to bring its present value close to
zero.
However, overlooking the theoretical side, and passing
over to the practical side, there are other difficulties involved such as the
choice of discount rates and the accurate determination of future years in
which the sums will be taxable or deductible.
In relation to the second problem, Young and O’Byrne
(2000, p. 219) declare that, although the deferred tax expense does not
sensitize the cash of the current period, it could reflect on a significant
economic cost, since by ignoring the deferred tax liabilities, this could cause
the company’s performance to be overestimated. In this respect, Frezatti (2001,
p. 55) proposes reversing the amount of allocation of deferred income tax from
income and forming the balance sheet amount that will constitute the invested
capital, in order to correct the operating income and the base
of investments.
Depreciation
The most logical basis for the distribution of the
cost of goods appears to be directly related to the accrued benefits, i.e., the
net value of services rendered by the good in the different accounting periods.
However, FIPECAFI (1994, p. 210) presents three advantages in the use of the
decreasing method:
1. Fiscal advantages: the higher quotas of
depreciation at the beginning of the useful life mean lower taxes, although it
is know that at the end, the taxes will be higher, as the depreciation quotas
are lower;
2. Reduction of the risk of loss: on
account of the fact that the estimate of the useful life is almost always precarious,
when a good is written off prior to the end of depreciation, the rest of the
cost to be amortized is recorded as loss. Now, the lower the balance, the lower
the loss to be allocated (e.g.: obsolescence of the asset);
3. Greater uniformity in costs: when
the goods are new, the need for maintenance and repairs is insignificant.
However, as they become older, there is a growth in
maintenance and repair expenses, which is offset by the decreasing quotas of
depreciation, resulting in more uniform overall costs.
Young and O’Byrne (2000, p. 229) are against the use
of the decreasing method. The authors argue about the distortion caused by the
depreciation of the straight-line method, when presenting increasing returns on
the invested capital. If the company uses the method of decreasing quotas of
depreciation, this distortion is accentuated.
They add that for the accounting rate of return to be
equal to the economic rate of return, one must adopt the amortization fund
method, which presents amortization quotas that are growing enough to maintain
the return on invested capital constant and equal to the economic return
throughout the period. Another form of equalizing the two rates occurs when the
project sports decreasing operating margins in the period.
The authors (2000, p. 236) conclude that the
amortization fund method (which presents increasing quotas of depreciation) is
not adopted by companies, as it reduces the result in currency, which provokes
difficulties in explaining the slump in performance throughout the period (in
spite of the fact that the rates of return on invested capital have remained
constant). This situation produces dissatisfaction among managers, if it is
linked to bonus plans in accordance with the economic-financial performance.
They state that companies usually adopt the
straight-line method of depreciation due to the favorable treatment for fiscal
purposes. It is generally in the interest of taxpayers to exploit the highest
deductions admitted by law to recover invested capital as soon as possible
through savings in the income tax arising from accelerations due to the
increase in the number of shifts, to tax incentives and others.
Hence, the economic result can be interpreted as much
more or much less favorable in a given period than it really should be as a
result of the creation of compatibility between the real benefit and
allocation, capable of provoking incorrect reactions and decisions on the short
term. According to Frezatti (2001, p. 65) although understanding this effect is
a simple task, no concern is perceived on the part of the organization in
making the benefit compatible with allocation regardless of the impact
experienced on the short term.
REFERENCES
1.
CARVALHO, E. L. de. A relação
entre o EVA (Economic value added) e o valor das ações na Bolsa
de Valores do Estado de São Paulo. São Paulo, 1999. Dissertation
(Master’s Degree in Accounting and Controllership) – Economics, Administration
and Accounting College of São Paulo University.
2.
COPELAND, T. et al. Valuation:
measuring and managing the value of companies. New York: Wiley, 1995.
3.
DOUCOULIAGOS, C. A note on the
evolution of Homo Economicus, Journal of Economic Issues, vol. XXVIII, Sept.
1994.
4.
FIPECAFI. Manual de contabilidade das
Sociedades por Ações – aplicável também às
demais Sociedades. 3. ed. rev. and current. São Paulo: Atlas, 1994.
5.
FREZATTI, F.
Contribuição para o estudo da complementaridade do lucro e do
fluxo de caixa na gestão de negócios no ambiente empresarial
brasileiro. São Paulo, 1996. Thesis (Doctor’s Degree in Accounting and
Controllership) – Economics, Administration and Accounting College of
São Paulo University. Valor da Empresa: avaliação de
ativos pela abordagem do resultado econômico residual. Cadernos de Estudos,
São Paulo,
6.
FIPECAFI, v. 10, n. 19, p. 57-69,
Sept./Dec. 1998. Contributeção para o estudo do Market Value
Added como indicador de eficiência na gestão do valor: uma
análise
das empresas brasileiras com ações negociadas em Bolsa de Valores
no ambiente brasileiro pós-plano real. São Paulo, 2001. Thesis
(Livre-Docência em Contabilidade e Atuária) – Economics,
Administration and Accounting College of São Paulo University.
7.
FREZATTI, F. Gestão de valor
na empresa: uma abordagem abrangente do valuation a partir da contabilidade
gerencial. São Paulo: Atlas, 2003.
8.
HENDRIKSEN, E.; BREDA, M. F.V.
Accounting Theory. 5. ed. Boston, IRWIN, 1992.
9.
JOHNSON, H. T.; KAPLAN, R. S. A
relevância da contabilidade de custos. 2. ed. Rio de Janeiro: Campus,
1996.
10.
LEÃO, L. de C.G.; SANTOS, A.
dos; LUSTOSA, P. R.B. Impostos diferidos: crepúsculo ou amanhecer do
princípio da competência? In: Brazilian Accounting Congress, n.
16, Brasília: Federal Accounting Council, 2000.
11.
MARTINS, E. Contabilidade de Custos.
4. ed. rev. São Paulo: Atlas, 1992. A posição do Conselho
Federal de Contabilidade com relação ao arrendamento mercantil:
aplausos!.
12.
RAPPAPORT, A. Selecting strategies
that create shareholder value. Harvard Business Review. p. 139-149, May/June 1981.
13.
REIS, E. A. dos. Aspectos da
depreciation de ativos sob a ótica da gestão econômica.
São Paulo, 1997. Thesis (Master’s Degree in Controllership and
Accounting) – Economics, Administration and Accounting College of São
Paulo University.
14.
VAN HORNE, J. Financial Management
& Policy, London, Prentice-Hall, 1975.
15.
YOUNG, S. D.; O’BYRNE, S. F. EVA and
value-based management: a practical guide to implementation. McGraw-Hill, 2000.
16.
YOUNG, S. D. Some reflections on
accounting adjustments and economic value added. Journal of Financial Statement
Analysis. New York, v. 4, Iss.2, p. 1-13, winter 1999.