EVA to boldly go.

In astronaut terms EVA means "extra vehicular activity." This was the term used to describe the lunar rover excursions during the Apollo missions to the moon. To finance professionals, EVA means economic value added and just like the moon explorations of the late 1960s and early 1970s, EVA has been hailed as a miracle. But what are the true benefits?

Some people bemoaned that the Apollo missions were a waste of money anti resources, yet the hidden benefits to mankind are immense (such as aiding the development of digital watches, new medicines and the calculator for example). Is EVA a serious contender that will benefit your company? Or are some people simply moonstruck?

Following is a perspective on the value of EVA and its application. Readers are invited to provide feedback on their own experiences with EVA.

The consulting firm of Stem Stewart published The Real Key to Creating Wealth (John Wiley & Sons, New York, 1998) which "celebrates a revolution in management known as economic value added (EVA)." Stern Stewart claims that:

1 EVA is the only true indicator of business and management performance;

2 EVA is "today's hottest financial idea and getting hotter";

3 EVA "allows all financial decisions to be modeled, monitored, evaluated, communicated, and compensated in terms of a single measure";

4 "EVA is the only reliable and unambiguous continuous-improvement metric";

5 EVA must be used to guide every decision;

6 EVA should be used as the "deciding factor in all business decisions."

EVA was also discussed in G. Bennet Stewart III's, The Quest for Value (Harper Collins, 1991). Must EVA be used as a single measure for every decision? Is it the one and only "true" indicator of business performance? What are the weaknesses of EVA and how should it be used, if at all? These weaknesses have not been discussed in Stern Stewart's two books on EVA.

The EVA equation

The formula for EVA is EVA = NOPAT - (weighted average cost of capital x capital). NOPAT is generally accepted accounting principles (GAAP) determined net income, plus or minus over 160 non-GAAP accounting adjustments. CAPITAL is GAAP determined assets, less short-term debt, plus or minus more than 160 non-GAAP accounting adjustments.

Any cost accounting text includes the formula for accounting residual income which is: residual income = net income (weighted average cost of capital x assets)

Since the definition of net income and assets can vary depending on the circumstances, EVA is a specific example of the many variations of residual income. Residual income was well known before the name EVA was invented. However, a 1978 survey on residual income shows that almost no companies were using it.

Weaknesses

There are at least seven severe weaknesses of EVA. First, EVA does not measure economic value or economic profit as stated by Stern Stewart. Although economic value and economic profit are conceptually sound, they have serious practical problems. Economic value of an organization is its expected future cash flows discounted at the cost of capital. Economic profit is the difference in the economic value at two points in time, adjusted for investment decisions.

EVA does not measure cash flow. Instead, EVA measures accounting accrual net income. Moreover, EVA measures past accounting net income rather than future cash flows.

Second, there are no consistent definitions of EVA, NOPAT, or capital. EVA does not measure cash flow from operations, which is easily defined, nor does it measure economic income. Capital is inconsistent with market value of assets and economic value of assets. To define NOPAT, GAAP net income would have to be first defined and then over 160 adjustments would have to be defined. To define capital, GAAP assets and short-term debt would have to be defined, and then more than 160 adjustments would also have to be defined. EVA is an accountant's idea of ecstasy, a hodge-podge of inconsistent accounting gobbledy-gook.

Third, EVA is too complex. Business people have enough trouble trying to understand GAAP, let alone over 160 accounting adjustments to GAAP. However, not all of the 160 adjustments have to be used according to Stern Stewart. Stern Stewart provides a list of seven tests that must be applied to each adjustment to see if it is warranted. EVA consultants will be happy to explain EVA, the 160 adjustments, and help your organization apply the seven tests to each of them.

EVA is inadequate as a single measure for any decision. EVA only measures short-term profitability. Other factors would include quality, time, and customer service. How does the product or service perform? When will the product or service be delivered to the customer? How long will it take to replace a worn-out part?

EVA only measures the short term. NOPAT is for one month, one quarter, or one year. Capital is measured at the historical cost of assets purchased one, 10, maybe 20 years ago. This purchase cost is a sunk cost and irrelevant for any decision.

If EVA is used to measure short-term profitability instead of return-on-investment, net operating income, or cash flow from operations, the long-term impact needs to be considered in any decision. Not only should the long term be considered, but also managers should be compensated on long-term factors. It would be a severe mistake to compensate managers only on EVA.

EVA is easy to manipulate. Here are a few of the many ways managers could increase EVA and hinder the organization:

1 EVA requires research and development expenditures to be capitalized. Managers could capitalize (record expenditures as assets rather than expenses or losses) expenditures that have no future value.

2 Managers could stop doing long-term planning and only work on the short run.

3 Managers could spend less time improving quality.

4 EVA allows restructuring charges to be capitalized. Managers could restructure when restructuring is not appropriate.

5 EVA allows managers to hold back expenditures in suspension (asset) accounts. Managers could therefore record as assets, expenditures that will provide no expected future benefit.

The 160 accounting adjustments give managers plenty of opportunity to manipulate. Managers will be able to make accounting judgments that will enhance their performance evaluation. How will this be stopped if EVA is used as a single performance measure? Will the manager's supervisor take the time to figure out which accounting adjustments should be reversed? Will hoards of internal auditors be sent in to stop the abuse?

EVA is inappropriate for capital budgeting decisions. The cash flows used in the net present value methods or internal rate of return are far superior to the hodgepodge of accounting rules used in EVA. EVA will cause projects to be accepted that should be rejected and will reject projects that should be accepted.

Recommendations The use of EVA should be modified with at least four considerations or recommendations. First, EVA should never be used by itself for any decision. Other factors besides short-term accounting profitability should be explicitly considered. For example, the impact on quality of the product or service, the time it takes to deliver the product or service, the service to the customers, and the image of the company should be considered. These factors are often important and may even override short-term accounting profitability

If EVA is used, it should not receive too much emphasis. A choice needs to be made among EVA, return on investment, cash flow from operations, and accounting net income. EVA may not be selected as the best measure of short-term profitability. It should be noted that the alleged benefits of EVA assume that no other measure of short-term profitability is available. Moreover, the alternative may be to use multiple performance measures rather than a single accounting measure of short-run profitability. If EVA is chosen as a single measure or as one measure in a group of measures, there is a serious danger that EVA will be overemphasized. Managers will find it easier to focus on a single measure and are often more comfortable emphasizing short-term profitability. Also, the impact of softer measures, such as quality, will be difficult to determine.

Moreover, if EVA is used, it must be used with a long-term compensation program. The compensation program will provide rewards to managers who emphasize the long nm and punish managers who over-emphasize short-term accounting profitability. Without a long-term compensation program, managers can increase EVA by seriously damaging the viability of the organization.

Note that a long-term compensation program should be used whether EVA is used or not. Also, the accounting adjustments can be used whether EVA is used or not. Therefore, neither of these factors provide a reason to select EVA over any other measure of short-term accounting profitability.

EVA should not be used for capital budgeting. The cash flow used in net present value and internal rate of return methods is conceptually superior to EVA and will more accurately evaluate capital budgeting projects.

EVA consultants will be glad to have your organization pay them to explain EVA, NOPAT, capital, the accounting adjustments, seven tests to determine which adjustments are necessary, a special EVA compensation program, and much more. Reading the sections of any cost accounting text on residual income versus return on investment, on capital budgeting, and on reward systems will be more informative.

There is no silver bullet or panacea for business success so there is no need to shoot yourself with a pretend silver bullet.

David E. Keys is an international professor of accountancy at Northern Illinois University ([e-mail]); Mumin Azamhuzjaev is project manager, Caterpillar Overseas S.A., Moscow; and James Mackey is professor of accountancy, California State University-Sacramento.