Corporate Governance , Accounting

Measuring Executive Accountability

Researchers establish that residual income, or economic value added, is indeed an efficient performance metric.

May 01, 2002

| by Janet Zich

Over the past decade, companies increasingly have been called on to create more value for their owners. Led by aggressive institutional shareholders like the California Public Employees Retirement System and fueled by widely published reports of overcompensated executives, shareholders are demanding that managers be given incentives to focus on corporate value creation. Consulting firms have responded with a host of new performance metrics. Some of the most popular are known as “economic value added,” “flow return on investment,” and “economic profit.”

Whatever they’re called, they’re catching on fast. “The number of firms that have chosen to adopt value-based performance measures in recent years has shot up dramatically,” says Stefan Reichelstein, professor of accounting at Stanford Graduate School of Business.” According to some estimates, around 200 of the Fortune 1000 firms are now using some value-based metric to measure the performance of their top-level managers.”

Economic value added has become so popular a concept that its acronym actually has been trademarked by consulting firm Stern Stewart & Co. Still, it’s not really new. “The concept of economic value added has been known for quite some time in the accounting literature as ‘residual income,’” Reichelstein says. “It’s really a very simple formula: accounting income, properly measured, less a capital charge for the assets used by that particular business or division.

“In contrast to ordinary accounting income, residual income is fundamentally compatible with present value considerations. That aspect in turn is critical in motivating managers to make long-term decisions that enhance the overall net present value of the firm.”

Which is all well and good. But the problem remains that managers may not be willing to engage in projects that increase value way down the line, value that isn’t measured—and therefore rewarded—now. “This is where the accounting rules come in,” Reichelstein says. “Good accounting rules allocate current and expected future cash flows so as to reflect value creation in the performance measure early on and consistently over time. That way, it is of less importance whether managers have shorter planning horizons than shareholders.”

Economic value added and similar formulas proposed in the “war of the metrics” all make adjustments to the accounting rules used for external financial reporting. But which of these adjustments is most effective in aligning the objectives of managers and shareholders remains a subject of lively debate.

In a paper that won the Best Paper Award at the Review of Accounting Studies conference at Cornell University last year, Reichelstein and Sunil Dutta, assistant professor of accounting at the Haas School of Business, University of California, Berkeley, analyze a model that compares the effectiveness of alternative performance metrics and accounting rules. The study, “Controlling Investment Decisions: Depreciation and Capital Charges,” focuses on capital investment decisions and the choice of depreciation method to account for these investments.

Dutta and Reichelstein establish that residual income, or economic value added, is indeed an efficient performance metric. When combined with particular depreciation schedules, residual income can align the objectives of shareholders and management consistently over time. In general, these depreciation schedules will differ from the common straight-line method used for external financial reporting purposes. The model analysis also shows how the capital charge rate used for performance evaluation purposes should vary with the riskiness of the investment project.

The authors believe their theoretical framework is useful for sorting out the many recommendations and prescriptions expressed in the growing field of value-based management. “Controlling Investment Decisions” analyzes one particular problem, capital investment decisions. But for other assets, such as receivables, inventory, or multi-year construction contracts, similar issues arise.

“So once again the question is: To make the performance measure as effective as possible, how should the accounting be done?” says Reichelstein. He and Dutta broaden their inquiry in a related paper, “Stock Price, Earnings, and Book Value in Managerial Performance Measures.”

“The setting in this paper is richer,” says Reichelstein, “in that you can base performance evaluation on both stock price and the accounting numbers. Stock price obviously is what shareholders ultimately care about. From a performance evaluation perspective, however, one drawback of stock price is that it aggregates all value-relevant information even though some factors are beyond the manager’s control. Accounting-based performance measures can mitigate that problem, and therefore you want both.” In this second paper, the authors identify the need for performance measures that are calculated as a properly weighted average of market value added and economic value added.

There is growing evidence that value-based management does deliver for shareholders. Reichelstein and his colleagues in academia predict that further analytical and empirical research will explain why and how. They believe that the interest in these metrics isn’t likely to lessen. After all, Reichelstein says, “People in the field realize the old adage that ‘whatever gets measured also gets delivered.’”

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