Accounting Profit vs. Economic Profit. the Necessity of a Management Performance System to Boost Organization’s Performance

Accurate information is a critical input in a decision making process that targets real value creation for shareholders. The objective of this paper is the analysis of two articles of Stern Steward Research, namely â€Å"Accounting is Broken. Here’s How to fix it. A Radical Manifiesto† and â€Å"The capitalism Manifesto. The Transformation of the Corporation – Employee Capitalism –â€Å". Both papers propose a roadmap to fix the conventional accounting shortness through the use of Value Based Management (VBM) as a real and effective management system of value creation and measurement.Economic Value Added (EVA) plays the main role in this management approach, as a very effective performance metric in the alignment of the organization with its ultimate goal of shareholder’s value creation. VIEW OF THE READING In the first paper â€Å"Accounting is Broken. Here’s How to fix it. A Radical Manifiesto†, the accounting related aspects of EV A are discussed, providing a comparison between accounting earnings and economic earnings. Weaknesses of accounting standards are exposed here.The authors suggest a serie of radical reforms for the conventional accounting in order to align conventional with economic accounting in order to provide managers with the information that really matters and avoid mispreactices to deceive shareholders. The paper proposes EVA as a rock solid measure that provides a very clear picture of the organization’s performance. According to the paper accountants should start using economic profit (EVA) to better reflect the economic reality of the organization.Economic earnings underpin the decision making process, clarifying the economic objectives and setting up a target for value creation. The paper highlights the capability of EVA measure to fix some weaknesses of the accounting earnings perspective and proposes some reforms: †¢Cost of equity must be brought into the light of day as a k ey element for the economic profit. Shareholders need and deserve to be compensated for the risk they are taking by investing in a company. †¢Operating decision must be separated from investment and financing decision to avoid manipulation. Intangible assets should be capitalized as investments aimed at the creation of economic profit. †¢Stock options have to be expensed and depreciation and amortization must be better measured. The second paper â€Å"The capitalism Manifesto. The Transformation of the Corporation – Employee Capitalism –â€Å" analyzes the role of EVA measure as a metric of the total organizational productivity and the role it plays or can play in a pay-per-performance incentive plan to align the interest of the owners with the interest of the employees to enhance organization performance.Empowerment and accountability are seen as the basis to boost employee’s performance and the basis to set up incentive programes to stick the gains . The paper presents a deep analysis on the implementation of effective business management and incentive systems down to the shop floor in the European Union. Some examples are presented to explain the potential role of EVA in the implementation of a European policy for incentive plans. According to the paper, executives and frontline employees can or should unify their efforts within the EVA proven management system, to maximize value creation within the organization.The authors propose that decision making process at all levels should be implemented within a management framework where short- and long term incentive plans will be linked to results in form of value creation. Incentive plans should also be linked to cash and equity to guarantee the sustainability of the organization. If the employees can invest in the organization, they will start acting like owners taking right decisions and fostering sustainable growth. MY POINT OF VIEW Both papers assume a shareholder’s va lue perspective: the first and foremost purpose of a Corporation is to maximize shareholder value.This perspective should be brought in balance with the stakeholder’s perspective. Profitability has to be combined with responsibility. According to S. David Young and Stephen F. O’Byrne (2000), the economic pressures that organizations are facing nowadays induce managers, in some cases, to use bad practices in order to deceive shareholders by inflated earnings or not sustainable growth. EVA alone cannot solve this issue. A very clear management system has to be set up with guidelines and accountability for executives. Corporations cannot become economic machines.Responsibility for stakeholders (employees, society, environment, customers) has to play a central role as well. Economic earnings should be the main target, but corporations should be able to provide the needed environment to create the expected value based on ownership, clear economic and financial information, moral recognition, personal growth, empowerment and training. The first paper is a very interesting approach to EVA and to accounting practices. It sheds light on the issue that accounting is not what is used to be and cannot account anymore for what it has to account.Accounting standards lack the ability to control and guide executive behavior. On the other hand, the paper tends to fully disqualify accounting. Conventional accounting has played and will play its role in the society. It is hard to say that accounting is completely responsible for all bad practices and mismanagement cases (Enron, Worldcom, etc). Accounting has its weak points and these weaknesses have been used by irrational managers to inflate value in the shareholder’s eyes. The question is if we are talking about a symptom or about a root cause.We cannot solve the problem working on the symptoms. The root causes have to be found and addressed. In the current competitive environment, managers are struggling with the value creation process. Fierce competition and growing expectations of the shareholders is a killing combination to push managers in the bad path. It is not rare then that some of them make use of bad practices in order to boost value on the short-term, but putting in serious dangerous the future of the organization.In such situation is fair to say that accounting cannot account anymore for what really counts. Accounting standards allow these bad practices. A superior management system is in need. S. David Young and Stephen F. O’Byrne (2000) states that EVA can actually boost productivity and is able to match the interests of shareholders and stakeholders. Decision making process must be decentralized and roll down to the floor. In my experience, executives lack the ability to empower employees.Maybe it is the fear to lose power or that they don’t trust the subordinates. In any case they are missing the possibility to stimulate and motivate employees and the m ost important they are failing to use the advantage of impacting decision making by the ‘time and place’ factors. I think one of the reasons can be that they lack a measure like EVA that can set up the targets for the whole organization, allowing the cascading of the decision making process, improving the performance of the organization through more motivated employees and ownership boosting.EVA can be used at all levels within the organization, stimulating the decision making and risk taking attitude of the employees, since EVA will bring transparency and direction to the objectives to be met to create true value. In this case owners don’t have to worry about the earning sharing and they can start seeing employees as partner with the same objectives and motivations. Nowadays the intellectual capital of a corporation is one of the strongest competitive edges they can create. Employee’s satisfaction must be one of the goals within the organization to make i t sustainable.Employee’s satisfaction cannot be based only on cash or equity. People need a trusty environment where they can interact and reach high productivity levels, based not only on economic incentives, but on total ownership, supported by an increasing role in the decision making process, contributing to the value creation process and ensuring a sustainable growth of the organization. If one takes a closer look at EVA methodology to demonstrate that EVA is not as simple as supporters tell. EVA is a performance measure capable of reliably indicating the intrinsic value of all companies in all times.As a performance metric, EVA remains in control of the corporation and should impact Market Value Added (MVA) on the long term creating true value for the shareholders. With EVA managers have a more effective tool to support their decision making process. The entire metric was developed based on the following three ideas : 1. Cash flows are the best indicators of performance . The accounting distortions must therefore be â€Å"fixed†. Accrual based accounting should be transformed into cash-flow accounting. 2. Some expenses are really investments and should be capitalized on the balance sheet.True investments must therefore be recognized as means to create future cash flow. 3. Equity capital is expensive (or, at the very least, not free). This expense must therefore be accounted for. Investment is an economic decision and opportunity cost should be taken into account. To calculate EVA, two sets of information’s are needed, namely the Net Operating Profit After Taxes (NOPAT) and the Weighted Average Cost of Capital (WACC). NOPAT is first calculated based on the Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).Some adjustments are needed here to account for the correct operating profit of the corporation. Important here is to understand that operating and financing decisions must be evaluated separately. NOPAT provides a very clear picture of the organization operating performance, excluding potential manipulation through financing decisions. On the other hand, WACC is the average of the costs of the financing sources, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.WACC demands a very clear policy from the organization about its financial structure (debt and equity relationship) to calculate the cost of the capital. This is a fundament to avoid bad practices, manipulations, abuse of leverage technique through cheaper debts and ineffective decision making process. A very strong and reliable financing structure is needed in order to not compromise the future of the organization and to provide a very solid platform for the economic growth, by choosing projects with a really economic impact on the bottom line. Generally speaking, EVA has a big drawback.As we could se e above, EVA is very far from being a simple metric. The point here is that the implementation of value-added measures such as EVA into a company is a costly and time consuming process . Substantial costs and time are justified only if benefits of optimizing the company’s strategy for value creation can be achieved. A transition to value-added measurements requires serious commitment of the board of directors and senior management to use these measures to manage the business. Every individual in the company must buy into the plan to make it successful.Extensive training and communication effort directed to everyone in the company is also required. EVA may be a complex concept and may not be something the average person/employee/manager/investor is going to understand without big efforts. When it comes to the organizational change required to implement something like EVA, you need to get people on board and it could be a very difficult task and therefore a major obstacle for i ts adoption. EVA should not be viewed as the answer to all things either. It doesn’t solve business problems, which is the manager’s responsibility.In conjunction with MVA, it does provide a meaningful target to pursue for both internally and externally oriented decisions. Managers remain the leaders within the corporations and the one who has to drive the value creation process. Generally speaking, shareholders must be provided with clear data on the corporation performance and on the decision making process. They need and deserve a return on their investment, but it should not be forgotten that their investment decisions involve risk and they must be compensated for this.The cost of the capital should be incorporated. Value creation should be calculated as the difference between NOPAT and capital and its cost. Accounting earnings don’t mean value creation. A Corporation can report net profits that don’t actually mean value creation from the shareholderà ¢â‚¬â„¢s viewpoint. To accomplish this, managers need clear and strong performance metrics able to stretch the corporation to achieve clear performance targets properly aligned with the ultimate goal of creating value. EVA is a metric upon which the whole organization can be build.In the current high competitive market, Value Based Management is a competitive advantage. It aligns the organizations with the expectations of the shareholders, facilitating the decision making process, avoiding accounting manipulation, targeting the ultimate goal of value creation, providing a very unambiguous metric such as EVA to guide the organization through the value creation process and ensuring the long term economic growth of the organization based on clear and transparent management practices.CONCLUSIONS Both papers offer a very clear perspective of the advantages of using EVA. Value Based Management provides Senior Management Teams with a clear benefit since it is able to close the gap between accounting earnings and economic earnings, driving the value within the organization. With EVA, the corporations possesses a metric that drives value and supports the incentive plans to motivate employees and make them to act like owners.Effective implementation could be an issue due to the complexity of the concept, but EVA is nowadays the most effective management approach connecting shareholders and stakeholders to accomplish the ultimate economic goal of the corporation, the value creation. EVA creates a very transparent environment providing more qualitative data to the shareholders about the organization’s performance and the use of the resources. It also provides a more qualitative decision making process in order to satisfy shareholder’s expectations.