Lenta, LLC
ADJUSTMENTS FOR ECONOMIC VALUE-ADDED
(PART 2)
Type 2 Adjustments
Type 2 adjustments are those that present the need to
expurgate values that do not necessarily imply economic impact or cash. The
effects of adjustments of inventory movement and on allowances for guarantee,
doubtful accounts and contingency are evaluated in this group.
Inventory valuation (LIFO/FIFO)
According to FIPECAFI (1994, p. 144-5), the
attribution possibilities of this unit value (always based on the cost or value
of acquisition) are: FIFO, LIFO and mobile weighted average:
1.
FIFO:
reversal in sales at the cost of the first purchases, i.e., the first
merchandise purchased is sold or consumed first. Souza (2000, p. 32) observes
that, from the accounting perspective, at the end of the accounting period, the
inventory assets and liabilities will be evaluated by the most recent market
values;
2.
LIFO:
write-off in sales at the cost of the last purchase, i.e., the last merchandise
purchased is consumed first. Souza (2000, p. 32) clarifies that in this case
the company evaluates its inventory by historical values, recording in income
the products evaluated by the most recent values. In an economy with growing
inflation, the tendency to allocate the most recent costs to products made
normally provokes a reduction in accounting profit and consequently, in income
tax. However, according to Martins (1992, p. 99), when this inventory is used,
the entire income not formerly previously will be recorded at this moment;
3.
Mobile weighted average: meaning a criterion in which the average value of each unit of
inventory is altered by the purchases of other units at a different price.
According to Martins (1992, p. 99), the method avoid the control of costs per
batches of purchases, like in the previous methods, but entails a higher
calculation number at the same time as it avoids extremes, providing and
average purchase value as the acquisition cost.
Martins (1992, p. 101) calls our attention to the fact
that these differentiated situations are compensated period after period, i.e.,
when the entire stock of material has been used up, the sum of the costs of
materials applied by the various years will be equal. However, this situation
only occurs if the company makes the purchases and sells them without the
intention of continuing to operate, or when it works with zero inventory.
Young and O’Byrne (2000, p. 227) observe that the
adoption of the LIFO method provokes two problems in the value creation
indicator:
1.
In an inflationary economy
inventories are substantially underestimated; consequently this also applies to
the net assets and invested capital;
2.
When the inventories are liquidated,
a situation that occurs when the inventories decrease from one year to the
next, the operating income and the value creation indicator are overestimated
as a result of the comparison between costs at historical prices and revenue at
current prices.
The authors inform that the organizations that adopt
this method present a stock reserve in the notes to their financial statements,
and that this reserve is calculated by the difference between the inventory
value and the current cost value.
This reserve is added to the invested capital, and its annual variations
are added to the operating income. Young (1999, p. 11) emphasizes that in
economies with low inflation, and relative stability in the prices of factors,
the benefit of the inventory adjustment is minimum.
Frezatti (2001, p. 57) adds another situation in which
adjustment is necessary. When the organization decides to change the inventory
movement criterion (e.g.: from FIFO to weighted average cost), not causing any
influence on the cash flow, but affecting income. In this situation, he
proposes the reversal of the allocation value of the change of criterion from
income, and the formation of the balance sheet amount that will form part of
the invested capital.
Allowance for guarantee, doubtful accounts and
contingency
FIPECAFI (1994, p. 118) observes that the provision
formed by the fiscal limits represents a healthy policy, but could produce
significant distortions through over or undervaluation, not acceptable by
accounting principles as they distort the financial statements and income of
the company, as well as the corresponding dividends.
Young and O’Byrne (2000, p. 225-226) inform that some
EVA proponents argue that the formation of reserves is subjective and can serve
as a manipulative tool to obscure the performance results of managers, besides
provoking the distancing of the economic result and cash flow. If this argument
is correct, the provision should be added to the operating income, and, to
complete the reversal of the effect on the balance sheet, add the provision,
net of the tax effect, to the invested capital.
Frezatti (2001, p. 57) adds that a careful analysis
should be carried out to discover to what extent the provision reflects
conditions normally observed at the company, since simply disregarding it does
not constitute a healthy practice. In his opinion, when provisions are over
dimensioned in relation to the perceived risk, they should be reversed from
income, having as a counter entry an account that affects the invested capital.
Type 3 Adjustments
The objective of type 3 adjustments is to expurgate
non-recurrent gains and losses, i.e., once identified, they should be
expurgated from income.
Non-recurrent gains and losses
Once identified, the occurrence of a single event,
whose repercussion on income only occurs at a specific moment in time, should
be expurgated from income, but evaluated and planned separately from recurrent
income. This is the opinion of Frezatti (2001, p. 58) in relation to
non-recurrent events, since in this manner there is a perception of what gives
rise to the company’s income under normal, routine conditions.
Young and O’Byrne (2000, p.206) present a different
approach to the topic. Using the oil exploration business as an example, the
authors inform that many accountants defend the approach of removing the
investments from the asset if an oil well results in a dry hole, without any
prospects of generating a future cash flow.
However, according to the authors, if the costs of
unproductive wells are written off as expenses, the project will appear to be
extremely profitable, much more than it really is, furnishing inconsistent
figures in the period. If the costs of dry wells are capitalized and amortized
over the period of duration of the oil reserve, one will obtain a better picture
of the performance of the project. In other words, the capitalization of the
cost of dry wells makes the accounting return from the project closer to the
economic return.
According to Young (1999, p. 4), by proceeding in this
fashion two important advantages stand out. Firstly, by maintaining the capital
invested in the balance sheet, it becomes a constant reminder of the manager’s
obligation to obtain sufficient gains to return all the capital funds used.
Secondly, the manager is left without the capacity to manage the recognition of
loss, and therefore, to modify the data that forms the basis for the
performance analysis.
According to Young and O’Byrne (2000, p. 209) the
practical effect of writing off unproductive investments at the organization,
maintaining the most promising investments in the balance sheet, is no
different from oil companies that enter the costs of their dry wells in income.
Some aspects to be emphasized
This chapter has explored an important and
controversial aspect: the adjustment of operating income and invested capital
to correct some deviations and distortions in the accounting figures based on
accounting principles. The logic and mechanics behind the adjustments were
discussed, and authors such as Young (1999) and Frezatti (2001, p. 67) concluded
that:
1.
The adjustments developed to migrate
from Accounting to the economic result arise from the need to analyze income
differently, based on the return obtained in relation to its capital cost,
allowing the organization to have the information contribute toward the
management of the organization’s value (Young 1999, p. 1);
2.
The tool sports a higher potential
for use in managerial accounting, since each organization can have different
characteristics, requiring different adjustments, in accordance with its
traits, size and profile of events (Young, 1999, p. 12);
3.
Adjustments contribute towards the
improvement of managers’ performance in decision-making (Young 1999, p. 12),
especially if the tool is used as a basis for the calculation of variable
remuneration;
4.
In spite of the equality between
income by the cash flow and the economic return, differences occur throughout
the period of analysis that could lead to a decision that is not the most
suitable, which can be more detrimental than decisions provoked by a difference
between the income presented by the cash flow and economic return.
CONCLUSION
Classical authors currently emphasize the importance
of value in the perspective of corporate management. Value management implies
Managerial Accounting structured in such a way as to focus on the creation of
value in different
business situations and levels of the organization. In this context, the
paper analyzed the interaction and conflict between the prescriptive approach,
which presents how information should be gathered and prepared, and the descriptive
approach, representing the status quo of companies in the country.
For this evaluation the adjustments suggested by users
of the EVA technique were used as a basis to determine which methods are used
the most often and their relation with the controller’s perception in
approximating accounting data to the company’s economic result.
The most important aspects perceived in the onsite
survey are:
1.
Controllers show concern with the
implementation of a consistent information structure that supports the decision-making
process, in the form of Managerial Accounting, increasing the odds of better
performance and perpetuation of the company;
2.
The most frequently used methods are
the same used in Financial Accounting: straight-line depreciation, allowance
for doubtful accounts and valuation of inventories by the mobile weighted
average. One of the explanations for this is that the adjustment cannot produce
more work than the return that it provides through gains in the more efficient
allocation of funds;
3.
The general perception of
controllers is that all the methods contribute to approximate the accounting
data to the economic result, with a minimum of 44% and a maximum of 95%
respondents that recognize its contribution, at different degrees of intensity.
The most frequently mentioned are: allowance for doubtful accounts, provision
for contingency and provision for guarantee, besides all the respective
adjustments;
4.
72% of regressions showed evidence
of a statistically significant relation, confirming that the controller’s perception
of contribution provided by the method in approximating the accounting and
economic data is directly related to the frequency of use of this method at the
company;
5.
The author calculated the
correlations between and among the variables, confirming the relation evidenced
in regressions. For the other variables that did not present a statistically
significant relation, the author observes a starting point for expounding on
the analysis of the topic, seeking the validation of other theories. In this
case, a qualitative survey with in-depth interviews is suggested.
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