wall street's contribution to management accounting: the stern stewart eva®financial...

Management Accounting Research, 1998, 9, 421 -444 Article No. mg980089

Wall Street’s contribution to management accounting: the Stern Stewart EVA@ financial management system

John O’Hanlon” and Ken Peasnell”

EVA@ is a variant of residual income marketed by Stern Stewart & Co., a New York consulting firm, with the purpose of promoting value-maximizing behaviour in corporate managers. This paper reviews the EVA system in the light of this purpose. First, it outlines the rationale for the use of residual income in ‘value-based management’, highlighting the potential shortcomings of residual income as a single-period performance indicator. Second, it considers the adjustments to GAAP-based accounting advocated by Stern Stewart in order to produce a more economically meaningful version of residual income (EVA) which might serve as an effective indicator of single-period performance. Third, it examines the Stern Stewart approach to the setting of EVA benchmarks. Finally, it reviews the logic behind the use of the ‘bonus bank‘ to separate the award of EVA-based bonuses from the payment of such bonuses. 0 1998 Academic Press

Key words: EVA@; residual income; performance measurement

1. Introduction

I n recent years, a New York consulting firm, Stern Stewart L+ Co., has provided a notable contribution to the professional literature o n corporate financial management (Stewart, 1991; Stern et al., 1995). Stern Stewart’s system is designed to provide a single, value-based measure which can b e used in evaluating business strategies, valuing acquisitions and capital projects, setting managerial performance targets, measuring performance and paying bonuses. Stern Stewart argues that the system provides a unified financial framework encompassing financial accounting, management accounting and business valuation. They have labelled their performance measure ‘Economic Value Added’ and have trademarked it as EVA@.

EVA appears to have passed its initial market test with flying colours. Many leading American and British companies now use EVA or similar products marketed by other consulting firms (see McTaggart et al., 1994; Copeland et al., 1996).

* Department of Accounting and Finance, Management School, Lancaster University, Lancaster LA1 4YX, UK.

Accepted 5 September 1998.

1044-5005/98/040421+24 $30.00/0 0 1998 Academic Press

422 J. O’Hanlon and K. Peasnell

Numerous articles have appeared in the business press on the subject. In short, the term EVA has now entered the language of corporate management. What is not yet clear is whether EVA is a ‘9-day wonder’, doomed to disappear from business consciousness as quickly as it appeared, or will prove to be a lasting and valuable addition to the practice of management. The sceptic might argue that, since it merely involves deducting a capital charge from accounting profit, EVA is little different from residual income, a measure long known to management accountants. The sceptic might also observe that, although residual income entered the mainstream accounting literature in the 1960s through David Solomons’ path-breaking 1965 book on the control of divisionalized enterprises, it has not since figured prominently in practice (Drury, 1997). It is too soon to determine whether using EVA to reward senior executives results in managers taking shareholder value enhancing decisions, although the initial results are generally encouraging (Wallace, 1997).

The purpose of this paper is to examine EVA’s properties as a tool for monitoring and rewarding managers of business units. Stern Stewart’s output apart, the literature in this area consists largely of descriptions and applications of EVA and empirical tests of how closely it correlates with share prices and returns compared to competitor performance metrics. Little attention has previously been given to EVA’s foundations or to assessing the methods Stern Stewart uses in applying it in real-world management settings. We attempt to fill this gap.

The paper is organized as follows. Section 2 outlines the rationale for the use of residual income measures in ‘value-based management’, highlighting the potential shortcomings of residual income as a single-period performance indicator. Section 3 considers the adjustments to GAAP-based accounting advocated by Stern Stewart to produce a more economically meaningful version of residual income (EVA). The Stern Stewart approach to setting EVA benchmarks is considered in Section 4. Section 5 examines the logic behind their use of a bonus bank system to separate the award of EVA-based bonuses from the payment of such accrued bonuses. Our concluding remarks are presented in Section 6.

2. Residual income as a tool for value-based management

EVA is a tool for re-engineering corporations with a view to maximizing shareholder value. Stern Stewart is highly critical of the way in which different financial measures are commonly used for different financial management purposes (including the valuation of acquisitions, the measurement of performance and the paying of bonuses), involving inconsistent standards, goals and terminology. This may result in investment and operating decisions being taken on different grounds, with neither being effectively linked to the reward systems of the business. They are sceptical of approaches which entail using multiple indicators of performance, like the ‘balanced scorecard’ (Kaplan and Norton, 1996)) when setting strategic goals for managers. For Stern Stewart, the key test of all management actions is whether or not they contribute to the creation of owners’ wealth. They view modern developments such as the increased use of executive stock options and leveraged buyouts as useful devices for turning managers into entrepreneurs. However, they recognize that there are limited possibilities for directly motivating divisional managers with stock options. This alone may explain the continued use of traditional accounting measures

Wall Street’s Contribution to Management Accounting 423

for assessing the performance of divisional executives, while rewards for group managers have increasingly consisted of stock options. A problem with this conjunc- tion of value-based measures for senior management and accounting-based measures for divisional managers is that the different measures may encourage conflicting patterns of behaviour at different levels in the organization.

The task Stern Stewart addresses is that of adapting accounting-based measures of performance such that they are systematically related to economic value. We review below how residual income creates such a link, before considering the rationale for EVA.

The formal link between economic value and residual income It has long been recognized that economic value ultimately depends on future cash flows. This does not mean, however, that periodic free cash flow is a satisfactory measure of operating performance. Negative free cash flow could result from a high level of investment in profitable projects, the recent record of cellular telephone companies providing a striking example (Amir and Lev, 1996). EVA is marketed by Stern Stewart as an accounting-based performance measure which yields the same discounted present values as free cash flow, thereby retaining the focus of accounting profit on the matching of costs and revenues without losing value-relevance. It has long been known that the present value of a stream of future cash flows can be re-written as current book value plus the present value of future residual incomes (Preinreich, 1938; Edwards and Bell, 1961; Peasnell, 1982). As a result of the analytical work of Ohlson (1989, 1995) and Feltham and Ohlson (1995, 1996)) this approach has acquired increased credibility and is now playing a significant part in capital markets-based financial accounting research. Stern Stewart neither offers a formal proof of the residual income-based valuation relationship nor directs the reader to one.’ Since this relationship is crucial to the case for EVA, its main features are set out below.

The necessary and sufficient condition for the value equivalence of accounting and cash flow measures is that period t accounting profit is computed on a ‘comprehen- sive income’ (or ‘clean surplus’) basis, such as to contain all changes in book value during period t (transactions with owners excepted):’

where P, is the accounting profit for period t , C, is the cash paid to (net of contributions by) owners for period t and A , is the accounting book value of net assets at time t . This definition is sufficiently general to encompass both the proprietary concept of profit, where profit is viewed from the equity shareholders’ perspective, and the entity concept of profit, which is adopted by Stern S t e ~ a r t . ~ If

‘Stern Stewart identifies Miller and Modigliani (1961) as the source for this idea (O’Byrne, 1996). ’For ease of exposition, the analysis is in discrete terms where cash flows are assumed to occur at the end of each period. 3Strictly speaking, the aim is not to maximize shareholder value but to maximize the value of all of the financial claims on the business. Stern Stewart justifies its entity approach on the grounds that performance measures applied to investment and operating activities should be ‘... purged of the effects of financial leverage ...’ (Stewart, 1991, p. 87). Stern Stewart’s EVA valuation procedure is, in fact, a residual income version of the Modigliani and Miller (1963) valuation framework, in which the operating cash flows of the entity, net of tax, are capitalized at the entity’s weighted average cost of capital.


an entity perspective is adopted, net assets is equal to equity shareholders’ funds plus debt; if a proprietary perspective is adopted, net assets is equal to equity shareholders’ funds. The definition is also sufficiently general to deal with the accounting for businesses at any level of aggregation, be it the whole group, a division or even a branch.

Residual income for period t, denoted X,, is defined as accounting profit for period t minus a capital charge based on the net assets employed during the period:

k being the (assumed constant) cost of ~ a p i t a l . ~ Armed with these definitions, it is a straightforward matter to show that the expression for the economic value of the entity (denoted V,) in terms of present value of all future cash flows to owners,

C/ t+ r v,= c 7 = 1 ( 1 + k l r

can be re-written in terms of current book value plus the present value of all expected future residual incomes. Again, this definition of value can be applied at any level of aggregation. Substitution of equations ( 1 ) and ( 2 ) into (3a) gives:

Provided that A , + J ( l + k ) r + 0 as T+ 0, then all book value terms other than the first disappear and equation (3b) collapses to:

* t + r V,=A,+ c 7= 1 ( 1 + k ) r

These expressions are general enough to deal with the finite-life case where a business is liquidated at time t + T, as long as the liquidating cash flow to owners is included as the final dividend (Peasnell, 1982).

It is important to recognize that equation (3c) holds for any accounting procedures that obey the clean surplus relationship. Accounting conservatism simply alters the relative magnitudes of the two terms on the right hand side of equation (3c): conservative accounting at time t will drive down book value at time t but will drive up subsequent residual incomes. We return to this later, when addressing the adjustments Stern Stewart makes to GAAP in measuring managerial performance.

Stern Stewart’s approach entails adjusting conventional accounting measures of

4The residual income relationship is not dependent upon the cost of capital being constant. This assumption is made to simplify the presentation. A more general treatment would allow for time-varying cost of capital (Peasnell, 1982).


book value and profit in ways outlined in the next section and re-labelling the resultant residual income concept as EVA. Expression (3c) then becomes:

7=m EVA,,.

7= 1 (1 + k ) r V,=A,+ c

where A , is now Stern Stewart’s adjusted book value. Expression (3d) provides the theoretical foundation for Stern Stewart’s EVA financial management system.

The crucial difference between economic value and book value is in the timing of recognition of gains and losses. The excess of economic value over book value is commonly referred to as the entity’s unrecorded goodwill. Expression (3d) provides a formal statement to the effect that unrecorded goodwill is the present value of future EVAs. For Stern Stewart, a business is successful to the degree that it creates economic value in excess of the value of the capital invested. They treat the market as the final arbiter of business success, so the creation of economic value by business units must ultimately result in higher market values for the equity and debt claims on the business as a whole. Stern Stewart describes the excess of market value over invested capital as ‘Market Value Added’ (MVA):

7=m EVA,,.

7= 1 (1 + k ) r MVA,=V, -A,= c (4)

Thus, business success is defined in terms of the present value of future EVAs. We address later the question of how positive EVAs can arise, other than by chance, in a competitive economy.

A difficulty with this definition of success is that book value reflects two related things. First, it measures the amounts the owners have invested or re-invested in the business (paid-in capital and retained earnings) and, as such, constitutes a benchmark for assessing future achievements. Second, it accumulates the achievements of years gone by, as recognized in past EVAs and not yet returned to the owners. The larger are the gains recognized in the past, the higher is A , and, therefore, the lower is MVA,. In short, the recognition of past gains creates a burden, as far as passing the MVA test in the present and future is concerned. Only at the beginning of the business’ life is equation (4) an unambiguous measure of performance, since at that time there has been no imperfect measurement of past achievements to muddy the picture. An alternative, not mentioned by Stern Stewart, would be to exclude retained earnings from the investment base and to replace it by accumulated interest charged on the funds (net of dividends) provided by investor^.^

Further insight into the relationship described in equation (3d) can be obtained by noting that profit for period t can be written as the product of the return on assets (ROA) for period t and the amount of capital invested in the business (A, - and that, therefore, EVA can be written in terms of the ‘spread’ between profitability (ROA) and the cost of capital ( k ) :

EVA , = P, - kA,- = (ROA , - k ) A,- (5)

5For a related idea, see the distinction drawn by Anthony (1983, Ch. 4) between entity equity and shareholder equity.


where ROA, = P,/A,- Because EVA can be incorporated within a formal valuation model and can be decomposed into terms that include Profitability, it provides a theoretically appealing focus for the task of expressing ‘value-drivers’ in terms of accounting numbers. For example, a Dupont-type decomposition of profitability (into asset turnover, return on sales, etc.) can feed directly into an EVA-based valuation model.

More generally, the decomposition of EVA in equation (5) into its profitability (ROA,) and scale (A, - components highlights shortcomings of conventional accounting-based performance measures and the advantages of the residual income approach. Defining performance in terms of profitability has long been known to result in under-investment since maximizing ROA (or, alternatively, the ‘spread’ between ROA and k ) may involve rejecting positive net present value (NPV) projects that dilute ROA.6 Defining performance in terms of the absolute amount of profit can have the opposite effect of encouraging over-investment (acceptance of negative NPV projects) due to failure to take proper account of profitability. By combining spread and scale factors within EVA, as in equation (5)) one class of problem created by the use of accounting performance measures can be overcome. This argument underlay the case made for residual income as a divisional performance measure over 30 years ago (Solomons, 1965).

The problem with residual income as a single-period perfomance indicator Early criticisms of residual income were of two sorts. First, charging interest on fixed investment is not likely to enhance the quality of production decisions since investment outlays are sunk costs. Moreover, in the presence of capital rationing, pushing major investment decisions down the organizational hierarchy can result in loss of value through the neglect of interactions (Amey, 1969). Stern Stewart tackles this criticism of residual income head on, arguing that many modern companies have grown too large to be managed centrally. They propose empowering managers in a way that turns them into quasi-owners, with investment decisions being deliberately passed down the hierarchy. Thus, charging interest on sunk costs is seen to be a positive feature of residual income. Owners cannot escape the cost of earlier capital commitments, and so managers must not be allowed to either. This appears to be an important attraction of EVA to Stern Stewart’s clients (Stern and Chew, 1998, pp.

A second, long-standing criticism of reward systems based on the residual income of a single period is that they can result in myopic behaviour (Flower, 197 1). There is a danger that the failure of the accounting system to reflect economic reality (including the non-recognition of certain important assets) might cause the business to be run without proper regard to the long-term. Whilst this deficiency is encountered with other accounting-based performance measures, the case for EVA is diminished if it is similarly plagued. Much of Stern Stewart’s effort has been devoted to addressing this problem.

We now consider this issue. The problem can be articulated formally by re-writing

490-5 14).

6This is the criticism usually levelled at the internal rate of return (IRR); this is not surprising since the IRR can be expressed (Peasnell, 1982) as a weighted average of lifetime ROAs. Indeed, when ROA is constant it is equal to the IRR.


equation (3c) as an expression for the observed excess of the periodic change in entity value over that required by the owners (which we term ‘excess money return’):

where k V,- an expectations operator. This can be re-written as follows:

is the periodic change in entity value required by the owners and E,[.] is

V,- V,- , + C,- k V , - , =A, -A, - , + C,- k V , - , + GW,- GW,-, (6)

where GW, denotes unrecorded goodwill at time t = ( V , - A,), being the present value of expected future residual income at time t. Since, from equations (1) and (a),

A , -A,- + c, = P, = x, + kA,-

(6) can be expressed more informatively as:

with AGW, denoting GW, - GW,- ,. In equation (7)) the excess money return has been broken down into two terms. The first term on the right-hand side of equation (7) is the residual income for period t, which can be thought of as the excess money return on the book value component of economic value; the second term represents the excess money return on unrecorded goodwill.

It is clear from equation (7) that the owners’ excess gain during period t is not, in general, equal to that period’s residual income. A sufficient condition for single-period residual income to equal single-period excess money return is that book value be equal to economic value ( A , = V,), or equivalently that unrecorded goodwill be zero (GW, = 0), throughout. The ‘obvious’ answer to this problem is to adjust the accounting book value of the entity such that it is always equal to the entity’s economic value. Indeed, one influential contributor to the Shareholder Value literature has advocated disregarding conventional accounting measures in the assessment of managerial performance and using regularly revised present values and compar- isons of actual with planned cash flows instead (Rappaport, 1986). The most commonly voiced objection to substituting entity present value for book value is the subjectivity involved. A more subtle objection was raised by Bromwich (1973) a quarter-century ago. He pointed out that the use of present value entailed the performance measure being struck after the drawing up of future investment plans, which typically arise as outputs of the performance measurement process rather than as inputs to it.

Another way of addressing the problem is to consider the possibility of cancelling valuation errors. Close inspection of equation (7) reveals that it is not necessary to set book value equal to economic value in order for residual income to provide an unbiased measure of excess money return. A weaker sufficient condition is that unrecorded goodwill must grow at a rate equal to the cost of capital: AGW,/GW,- = k . This would be unlikely if unrecorded goodwill were attributable purely to any


advantages (including monopoly power) that the business enjoys in the market place, since these might be expected to diminish rather than grow with the passage of time. In practice, economic factors of this sort will be tangled up with measurement errors arising from accounting conservatism. Accounting recognition and measurement practices are likely to ensure that residual income will only provide a crude one-period indicator of excess money return.

It is helpful to note at this juncture two studies, Biddle et al. (1997) and Bacidore et al. (1997)) which address the question of the association between single-period EVA and shareholder wealth creation in the USA.7 In both studies, the measure of wealth creation is abnormal shareholder return, obtained by dividing the excess money return to shareholders by the opening market value of shareholders’ funds; the EVA measures were obtained from the ‘Stern Stewart Performance 1000’ database (Stern Stewart & Co., 1997). Biddle et al. (1997) report that conventionally measured reported earnings are generally more closely associated with abnormal shareholder return than is EVA. Bacidore et al. (1997) compare EVA with a new measure of their own, which they call ‘refined economic value added (REVA)’. Their objection to EVA is that it fails to reflect the opportunity cost to the owners (who have the option of selling their ownership claims in the financial markets) of the unrecorded goodwill component of value. REVA addresses this complaint by subtracting from periodic profit a capital charge based on the opening market value of the entity. Bacidore et al. (1997) find that abnormal shareholder returns are more strongly associated with REVA than with EVA.8

Detailed consideration of the research designs employed in these studies is beyond the scope of this paper.’ However, as a means of conveying the flavour of the issues that have to be addressed in such work, we make two observations regarding the Bacidore et al. (1 997) analysis. First, REVA is a hybrid measure, whereby changes in goodwill are ‘recorded’ for the purpose of arriving at the capital charge but are left out of the determination of profit. REVA therefore violates the clean surplus definition of residual income that we have shown to be the very basis of the long-run linkage between residual income and economic value. Whilst Stern Stewart intro- duces many variations from GAAP when determining EVA, care is taken to ensure that the clean surplus ‘tidiness’ condition is not violated. Second, because the required return on the opening market value of shareholders’ funds is subtracted both in the abnormal shareholder return and in the REVA measure, the dice are loaded against EVA relative to REVA.

A fundamental issue in designing a single-period accounting measure of economic performance is how far to push the accrual process along the cash-value spectrum, the end points of which can be described as follows:

‘Cash accounting’ (no accruals): the only flows that are recognized by the accounting system are cash flows. The only asset shown on the entity’s balance sheet is its holding of cash and cash equivalents. Since this can be assumed to

7See also Stark and Thomas (1998) in the current issue for evidence on the value-relevance of residual income in the UK. ‘Wu (1998) suggests that, where both residual income and stock return contribute to a manager’s compensation package, the manager might wish, for diversification reasons, to take actions that decrease the association between the two measures. ’For Stern Stewart’s views on the Biddle et al. (1997) study, see O’Byrne (1997~).


yield its required return (Feltham and Ohlson, 1995)) residual income is always equal to operating cash flow (net of investment outlays). ‘Economic value accounting’ (full accruals): the entity’s accounting book value is always equal to the entity’s economic value and the entity’s accounting profit is always equal to the entity’s economic income. Actual residual income is always equal to the ‘excess money return’ earned on the entity’s economic value. Expected future residual income is always zero.

Neither extreme is attractive in itself as the basis for a single-period performance measure. Conventional financial accounting is the outcome of complex regulatory and market processes whereby issues of relevance are balanced against the concern for reliability. The resultant package of GAAP accruals falls part-way between the ‘cash accounting’ and ‘economic value accounting’ extremes and is intended to be applicable to businesses in general. In contrast, Stern Stewart’s approach is in the tradition of management accounting, in that their judgements on these matters are focused on specific (rather than general-purpose) decision and control needs and are enterprise-contingent by design. No general solution is possible.

The Stern Stewart system encompasses a number of approaches to address the problems involved in using single-period residual income to measure performance:

a series of radical adjustments to GAAP in determining EVA; the use of non-zero EVA benchmarks, where appropriate; and ‘bonus banks’ separating the award and payment of bonuses.

These procedures are discussed in the remainder of the paper.

3. EVA-tailored GAAP

Stern Stewart has identified over 120 aspects of conventional GAAP which require adjustment in arriving at EVA. They point out, however, that typically only about ten of these adjustments are needed for any one company (Stern et al., 1995, p. 4 1). The main adjustments are discussed in a number of publications (e.g. Stewart, 199 1, Ch. 2-4; Stern et al., 1995). The following commentary stands back from the detail, in order to try to make sense of the logic driving the adjustments.

Much of Stern Stewart’s ‘tailoring’ of GAAP has the effect of shifting accounting closer to ‘economic value’ accounting, as described in Section 2. However, it would be incorrect to suggest that their ideal accounting is economic value accounting. Stern Stewart’s adjustments are intended to ensure that book capital reflects the full cost of investments in operating assets, but not the unrealized economic value of future pay-offs from those assets: primarily on the grounds of cost effectiveness, they support the continued use of historical costs in preference to current costs (Stewart, 1994, p. 78). Furthermore, in their desire to limit managerial opportunities to engage in inter-period allocation of EVA, Stern Stewart advocates some adjustments which have the effect of taking accounting back towards ‘cash accounting’.

Stern Stewart’s tailoring of GAAP is intended to produce a performance measure that will encourage managers to behave like owners. Their procedures have three purposes:


to undo accounting conservatism; to discourage earnings management; and to immunize performance measurement against past accounting ‘errors’.

The ways in which their adjustments are intended to achieve these three objectives are examined below.

Accounting conservatism Stern Stewart attributes the conservative bias in accounting to accountants being ‘... the unwitting slaves of the bankers’ (Stewart, 1991, p. 29). Many of their proposed adjustments are intended to remove accounting conservatism. We illustrate their approach by considering four of these adjustments, three of which move accounting further away from cash accounting and one of which pushes it back towards cash accounting.

First, Stern Stewart advocates the capitalization of all intangible investments in such things as goodwill, research and development (R& D) and marketing (Stewart, 1991, pp. 114-116). The objective is straightforward: to discourage one source of myopic behaviour of managers, by treating investment in intangibles in the same manner as investment in tangible assets. While this would have the incidental effect of moving the book value of the business closer to its economic value, that is not Stern Stewart’s objective; indeed, tangible and intangible assets alike would be shown at depreciated historical cost. The intention is to avoid penalizing managers at the time of the investment decision, without going so far as to credit the value of future (undelivered) performance to the managers at that time.

How would Stern Stewart view British practice concerning the treatment of intangibles? We conjecture that they would deplore the pre-FRS 10 (Accounting Standards Board, 1997) practice of charging purchased goodwill directly to equity reserves. Doing so weakens accountability by absolving managers from the need to earn a return on such investment, through violation of the clean surplus requirement of EVA given in equation (1). This creates incentives for managers to grow through acquisition rather than developing their own organizations, particularly when this is exacerbated by investment in ‘home grown’ goodwill being expensed as incurred. Likewise, Stern Stewart would doubtless criticize the distinction drawn in SSAP 13 (Accounting Standards Committee, 1989) between development expenditure, which is allowed to be capitalized in specific circumstances, and expenditure on basic research, which is not. The effect of the distinction is to create a bias against long-term investment. For Stern Stewart, the concern about the uncertainty of the pay-offs, which underlay the distinction drawn in SSAP 13, is not itself grounds for failing to recognize an investment (Stewart, 199 1, p. 1 16). Furthermore, while they would applaud the capitalizing of outlays on the building of brands, we doubt they would support recording such assets at valuation (Barwise et al., 1989): to do so would credit managers with anticipated future performance.

Our second example concerns Stern Stewart’s views on ‘full cost’ versus ‘successful efforts’ methods of accounting for oil and gas exploration expenditures. They argue that the costs of unsuccessful exploration represent part of the true cost of discovering productive fields and that such costs should therefore be capitalized rather than expensed (Stewart, 1991, p. 30). The effect of Stern Stewart’s recommendation is, again, to move EVA further away from cash accounting. The logic here, though, is

Wall Street’s Contribution to Management Accounting 43 1

dictated by considerations of business strategy: oil and gas exploration is a portfolio business and should be accounted for as such, if the scale of investment is not to be under-stated. Current practice can make managers unduly risk averse.

Our third example concerns the possibility that EVA might discourage managers from investing in assets which will not immediately generate profits. Such assets will initially reduce EVA because of the associated capital charge penalty in the periods prior to revenues coming on stream. Stern Stewart’s solution to this ‘strategic investment’ problem is to eliminate the charge, by capitalizing interest equal to the periodic capital charge during this non-earning period (Stewart, 199 1, p. 1 16). Although managers are not charged with capital costs during non-earning periods, they do not escape the capital charge entirely: it eventually comes through in later periods, and at a higher level due to the earlier capitalization of interest having increased the investment base on which the charge is levied.” Again, the effect is to move EVA further away from cash accounting. The benefit is that single-period EVA becomes a better (but still imperfect) measure of performance. The adjustment stops short of economic value accounting, since the manager is not credited with the anticipated benefits associated with the strategic investment. The focus is still on delivered performance, albeit with better matching.

Our fourth example deals with the recognition of liabilities. Stern Stewart is opposed to deferred tax accounting for two main reasons. First, accounting for deferred tax liabilities can give rise to conservatism, since deferred tax balances may be expected to be ‘paid’ so far in the future as to have a present value close to zero. Second, such accounting reduces managers’ incentives to engage in efficient tax planning. In this case, the general effect of the Stern Stewart approach is to move the accounting towards a cash basis.

Conservatism is a pervasive feature of accounting. Stern Stewart acknowledges that it may be appropriate for some purposes, but argues that it has undesirable consequences in the context of performance measurement. A counter-argument can be made. There is a school of thought (e.g. Ijiri, 1975) that argues that accounting conservatism partly derives from its role in performance measurement: conservatism is a necessary counter-balance to the optimism of the ‘steward’.

Earnings management Some of Stern Stewart’s adjustments are intended to remove (or at least to minimize) the opportunities open to management to smooth accounting profits. Their principal targets are general provisions for bad debts, warranties and inventory obsolescence (Stewart, 1991, p. 117). They propose instead that the costs associated with these items should ordinarily be recognized on a cash basis. The objective is to retain specific provisions and eliminate those in the nature of a permanent provision that is growing along with the rest of the business.

Are such provisions used to manage earnings? Evidence on the likelihood of such behaviour is difficult to obtain, but McNichols and Wilson (1988) find that companies tend to increase the discretionary component of the provision for bad debts when their reported income is either very high or very low. More generally, there is evidence that accounting accrual procedures are exploited to manage accounting

The same idea has been mooted by others (e.g. Anthony, 1983; Grinyer, 1985). For further analysis of 10

the various rationales that have been offered for capitalization of interest, see Peasnell (1993).


performance measures when these are employed in executive bonus schemes (e.g. Healy, 1985; Gaver et al., 1995; Holthausen et al., 1995) but it is not clear that the provisions targeted by Stern Stewart are the culprits.” Whether the elimination of general provisions would simply lead managers to look elsewhere to manage earnings remains to be seen. Research on earnings management has scarcely begun.”

Many proposals have been made over the years for abandoning depreciation accounting, because of its alleged inherent arbitrariness (e.g. Thomas, 1969, 1974) and, hence, vulnerability to the exercise of managerial discretion. Stern Stewart opposes the arbitrary amortization of goodwill for the same reason, proposing instead that it should be carried in the EVA balance sheet at full amount (Stewart, 1991, p. 114). However, they are not opposed to depreciation as such. In the case of identifiable intangibles like R& D and marketing costs, Stern Stewart recommends that they be capitalized and amortized over the lives of successful new products. They make the point that depreciation is an economic cost, in the sense that an asset would have to be leased if it were not owned, and recommend that more than the customary level of attention should be given to making depreciation charges responsive to wear-and-tear and obsolescence. The common thread in Stern Stewart’s position on the subject is their opposition to the use of arbitrary depreciation formulae. We return to the issue of depreciation in a subsequent sub-section.

Past accounting ‘errors’ Stern Stewart has a procedure for preventing past accounting measurement ‘errors’ from distorting managers’ divestment decisions. If an asset is in the books at an amount which differs from its economic value ~ as is ordinarily the case (except by coincidence) under historical cost accounting ~ a manager might be discouraged from making the economically correct retention/divestment decision. Stern Stewart therefore recommends that no gains or losses should be booked on retirement of a non-trading asset. This can be achieved simply by subtracting the sale proceeds from the net book value of aggregate fixed assets (Stewart, 1991, pp. 141-146). In effect, they are treating the sale proceeds as being equal to the book value of the asset that is being retired. Thus, the procedure is equivalent to one in which the asset is ‘re-valued’ to exit value at the time of disposal. This treatment has the attractive property of causing the sale proceeds to be the sole determinant of the effect of the asset sale on subsequent capital charges. This, in turn, forces managers to recognize that a decision to keep an asset is equivalent to a decision to invest the available sale proceeds in that asset.

This is a crude way of dealing with the opportunity cost dimension of past investment decisions. As explained in the article by Bromwich and Walker (1998) in this issue, the opportunity cost of retaining an asset in the business is the interest forgone on the disposal proceeds. To do the job properly, assets should be recorded at exit value, not historical cost, throughout (Peasnell, 1981). However, apart from the possibly non-trivial bookkeeping costs, marking to market in this way might have dysfunctional behavioural consequences, in that large write-downs might have to be made for infrequently traded fixed assets early in the life of new investments. The

For survey evidence of divisional managers’ views on this issue in a non-EVA setting, see Merchant

For a useful review of the difficulties involved, see Schipper (1989).

11

(i989).


Stern Stewart approach may thus be thought of as a cheap and pragmatic com- promise. But it leaves loose ends. Their treatment implies either that there is a simultaneous adjustment to the book value of the remaining assets or that a ‘dangling’ asset or liability has to be created: it is unclear how such dangling items should be depreciated.

This treatment of gains and losses on disposals is arguably Stern Stewart’s most radical departure from GAAP. It should not be mistaken for the practice of simply taking such items directly to reserves, thereby excluding them from profit. That approach violates the clean surplus requirement underpinning the residual income- based valuation relationship in equation (3c). For Stern Stewart, the focus is on the entity’s total ‘invested capital’ and not on the corresponding component assets. This is a radical departure from GAAP. Their mindset is that of a management accountant, not that of an auditor or financial accountant.

Why might the accounting adjustments fail to solve the problem? Stern Stewart’s approach is to work with the grain of conventional accounting practice. Their ‘tailoring’ of GAAP is intended to discourage managers from game playing and behaving myopically. As with all accounting models, trade-offs have to be made in terms of relevance and reliability, and it is not entirely clear what income construct underpins the EVA system.

T o our knowledge, the only place in Stern Stewart’s published output in which the underlying income construct is explicitly addressed is in a footnote to Stewart (1994, p. 80, footnote 3). Here, it is stated that ‘... EVA is intended to be an annuitized measure of the NPV to be realized over the life of the project or company ...’ This statement appears within the context of a discussion of choice of depreciation methods and of the advantages of the ‘sinking fund method’, by which we think they mean the more commonly known ‘annuity depreciation method’.13 It is important to note that the annuity depreciation method is ordinarily understood to be one that produces (together with interest on the asset’s reducing net book value) a constant annual charge. Annuity depreciation will therefore only yield a stream of constant EVAs (i.e. ‘annuitized NPV’) if the periodic net cash flows associated with the asset are themselves constant. If cash flows change through time, EVA can only be made constant by the application of ‘plug’ depreciation rates which may have to be negative in certain periods (i.e. assets may sometimes have to be re-valued upwards). This is a problem that the ‘annuitized NPV’ conception of EVA shares with economic income. An alternative would be to use the Earned Economic Income (EEI) ‘matching’ approach proposed by Grinyer (1 985). Here, accounting depreciation is computed such that book value is a constant proportion of economic value throughout the life

The sinking fund depreciation method is now rarely encountered in practice but, historically, was commonly used in utilities, nationalized industries and property companies (Merrett and Sykes, 1963, p. 39). It involves charging profit and crediting accumulated depreciation with an annual amount equal to an annual cash deposit placed in an investment account. These cash deposits plus interest accumulate, by the end of the asset’s life, to an amount equal to the cost of the asset. The rationale is that the investment account should provide funds for replacement of the asset at the end of its life. Obviously, the depreciation charged to the profit and loss account over the asset’s life will sum to less than the original cost of the asset, but the shortfall is made good by crediting to the accumulated depreciation account the interest earned on the investment account. For details, see Carter (1933, pp. 654-6591. It can be easily demonstrated that the depreciation schedule arrived at by the annuity method is identical to the schedule of interest and depreciation credited to the accumulated depreciation account under the sinking fund method.

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of the asset and residual incomes are proportional to the cash flows. Rogerson (1 997) has shown that a residual income measure identical to EEI has useful incentive properties of the type sought by Stern Stewart and discussed by Bromwich and Walker (1 998).

There are drawbacks to both of the above EVA concepts. Consider the following ‘effort’ story. A manager intends to work hard in years 1 and 3 and to take it easy in year 2. Under the ‘annuitized NPV’ system, performance will be incorrectly reported as being the same in all three periods but will be shown correctly as variable under EEI. Now consider a situation where the manager applies equal effort in all 3 years but the nature of the project is such that benefits accrue unevenly over the 3 years. Under the annuitized NPV system, performance will be reported correctly as being the same in all 3 years but will be incorrectly shown as variable under EEI.

The various Stern Stewart accounting adjustments summarized in the previous three sub-sections are essentially ad hoc in character. It is unclear whether they fit together in a manner consistent with one of the potential EVA income concepts discussed in previous paragraphs (i.e. constant EVA or EEI) or, indeed, with any other ‘ideal’ EVA concept of income (such as one assigning a larger role to current v a l ~ e s ) . ’ ~ Even after the ‘tailoring’ process, positive EVA will not necessarily signal superior managerial performance, nor will negative EVA necessarily indicate that value has been destroyed.

What constitutes superior managerial performance in any particular period is a complex matter, not easily captured by a single-period accounting measure. Stern Stewart deserves credit for persevering in the face of this fundamental indeterminacy and for trying to adjust the accounting for obvious biases and arbitrariness. However, Stern Stewart implicitly acknowledges that, even after the implementation of their adjustments, various systematic biases may remain. We discuss in Section 4 below how they tackle these biases by setting a non-zero EVA benchmark. They also acknowledge that opportunities will probably remain for managers to engage in short-term inter-period profit allocation, even when allowance is made for choice of an appropriate non-zero EVA benchmark. We discuss in Section 5 how Stern Stewart addresses this problem by requiring that EVA-based bonuses that are awarded have to pass through a ‘bonus bank’ before being paid out.

4. Setting the EVA benchmark

Despite Stern Stewart’s tailoring of GAAP, biases are likely to remain. These arise from the way in which accountants record business transactions. When assets are purchased, the investment is shown at cost and positive NPV is not recorded. If events go according to plan, the NPV is reported piecemeal by the accounting system and results in a stream of positive EVAs. If the business operates in a monopolistic or non-competitive market setting, even second-rate managers should be capable of generating positive EVAs. Equally problematic, failure to capitalize all of the costs incurred in generating future positive NPV opportunities will result in a stream of positive future EVAs, even where the business is just earning normal economic returns (O’Hanlon, 1997). While Stern Stewart deals with the more obvious and

For example, see Bell and Peasnell (1997). 14


measurable failures of GAAP to capitalize intangible investments, many business expenditures involve the ‘purchase’ of benefits which are not wholly related to the projects or activities with which they are directly associated. A prime example is the benefit of ‘learning by doing’, the costs of which are buried in day-to-day operating costs and expensed as such. It is also possible that the book value of the assets committed to a business may exceed the economic value of the business. This can happen in both cyclical and ‘rust bowl’ industries, if depreciation schedules are not adjusted to reflect falls in the value of assets; in this case, it is expected that future EVA will be negative. Consequently, the EVA benchmark for where superior performance begins may have to be set above or below zero, as economic circumstances and accounting imperfections dictate.

Stern Stewart dubs this the ‘unequal endowments’ problem (Stern et al., 1995, p. 43). In some businesses, past windfalls and prior (expensed) investment in competitive advantage will have made it easy for the current management team to generate positive EVAs in the future; in other businesses, the achievement by the current management team of even a zero EVA might represent a resounding success.15 Given that ‘zero EVA’ may well be an inappropriate benchmark, the question arises of how EVA benchmarks are to be set.

This question brings us to a problem familiar to management accountants. Whilst it may be desirable, for motivational purposes, to set budgets through a process of bargaining and negotiation, such negotiations can easily become a venue for ‘game- playing’ on the part of the budgetees, particularly when compensation is tied to budgets. Stern Stewart advocates that budgets should be divorced from bonuses and that the latter should be driven by pre-determined formulae rather than by negotiation (Stewart, 1991, pp. 242-248). For Stern Stewart, budgeting is a management technique for planning and control of operations, not a device for motivating profit centre managers. Preferably, EVA-based bonuses should be based on benchmarks (or a benchmark formula) objectively determined at the outset (Stern et al., 1995, p. 44)) when a long-term compensation contract is negotiated. Stern Stewart has developed regression-based models for implementing such an approach (O’Byme, 1997b).

The obvious starting point for considering the selection of an appropriate EVA benchmark is provided by equations (3d) and (4). MVA is the sum of the present values of all of the future EVAs expected by the capital market. Stephen O’Byrne, the previous head of Stern Stewart’s executive compensation advisory practice and the author of a number of papers which address this issue (O’Byrne, 1996, 1997b), has proposed that the expected EVAs impounded in MVA should be used as the basis for setting future EVA benchmarks. The conversion of current MVA into a set of future EVA benchmarks requires some assumption as to the time path that the (non-zero) expected future EVAs will follow. O’Byrne reviews two possible approaches. One simple approach is to assume that current MVA is the present value of EVAs expected to be earned over a finite ‘competitive advantage period’. O’Byrne points out that this approach, whilst convenient, is difficult to justify by reference to the observed patterns of EVA and MVA in going concern companies: MVA does not normally disappear within a short horizon. Consequently, O’Byrne proposes an

It is pertinent, here, to recall Stern Stewart’s concern that book values should not be treated as though 15

they were economic values. A business with negative MVA should not necessarily be wound up.


alternative approach which assumes that non-zero EVA will persist indefinitely, or at least well beyond any feasible forecast horizon (O’Byrne, 1996, 1997b).

Recent Stern Stewart literature refers to EVA benchmarks in terms of ‘expected EVA improvement’ [see, for example, O’Byrne (1997b, pp. 24-27)]. This approach can be justified in two ways. First, if the adjustments to the accounting basis fail to remove the bias in EVA as a measure of the entity’s abnormal economic performance, then a focus on changes in EVA may do the trick. Second, the modelling of EVA improvements as a constant proportion of a growing capital base (O’Byrne, 1997b, p. 25)) which is consistent with assuming that the market-to-book ratio will remain approximately constant in the future, means that the manager is judged against a benchmark of permanent gains. Any new investment is assumed to yield positive gains of the same order of magnitude as past ones.

We now present a simple example intended to convey the spirit of the market-based approach to the setting of EVA benchmarks. Suppose EVA is expected to take the form of a geometrically increasing perpetuity. Further suppose that both the market value of the entity and the book value of the entity are expected to increase at the same rate as EVA. The market-to-book ratio is therefore expected to remain constant. In such a setting, equation (3d) can be written as:

V,=A,+ EVA,, 1 = A , + A , ( M - 1) k - g

where g(g < k) is the expected constant growth rate (in profit, EVA, book value, market value and goodwill) and M is the (assumed constant) market-to-book ratio. From equation (8)) the expectation at time t of EVA,, expressed as a proportion of A , (the expected EVA rate), is as follows:16

E,[ Ev2:+1] = ( M - l ) ( k - g ) .

In this example, the expected EVA rate is a positive function of the proportional market-to-book premium and a positive function of the excess of the cost of capital over the growth rate. Other things being equal, EVA at time t + 1 of less than ( M - 1)( k - g) A , would represent unsatisfactory performance, in that it would be accompanied (sooner or later) by a fall in market v a 1 ~ e . l ~

The approach exemplified above involves setting EVA benchmarks by reference to market expectations of future EVA. Whilst this is likely to be preferable to the naive use of a benchmark EVA of zero, it leads to a difficult question which EVA practitioners have to grapple with: to what degree should market expectations of

Note that such scaling of EVA by book value is an approach used by Stern Stewart in empirical analysis of EVA data. See O’Byrne (1996, p. 118; 19976, p. lo), and Stern Stewart & Co. (1997, p. 8) for details.

O’Byrne (19976, pp. 24-27) provides a detailed example of how EVA benchmarks might be used as part of the ‘calibration’ of an EVA-based bonus system. The market’s expectations regarding a company’s future EVAs are inferred from, inter-alia, the company’s market value. The manager’s ‘target bonus’ figure, derived from peer company compensation practices, is then used, together with an estimate of the shortfall in periodic EVA which would reduce the periodic shareholder return to zero, to arrive at a bonus rate. This rate is then applied to (positive and negative) deviations from expected (benchmark) EVA to arrive at the manager’s bonus. The bonus so calculated is then fed into the bonus bank, outlined in Section 5.

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future EVA be allowed to drive EVA benchmarks? For example, suppose the high reputation of a managerial team gives rise to market expectations of high future EVA. If these market expectations are impounded in the benchmark EVA at the outset, then the managers will not be rewarded for eventually achieving the expected high EVA. This is not a fanciful example: similar concerns were voiced by Carm Adi- mando, the CFO of Pitney Bowes and a committed supporter of EVA, at a ‘Stern Stewart EVA Roundtable’ (Stern and Chew, 1998, pp. 499-500).

The task of setting benchmarks which reward managers for their efforts and not for their ‘endowments’ is a difficult one. An approach which might achieve this would entail setting EVA benchmarks on a ‘deprival value’ basis. A manager’s EVA benchmark could be set by reference to an estimate of what the market value of the business would be if that manager were to be replaced by one of average quality. All of this highlights the potential benefits from Stern Stewart’s efforts to ‘improve’ the underlying accounting, as reviewed in Section 3 above. If the accounting adjustments succeed in making ‘zero EVA’ into an appropriate demarcation line between what constitutes ‘superior’ and ‘inferior’ Performance, there will be no need to read the market’s mind about future EVAs.

5. The bonus bank concept

In this section, we review the reasons for Stern Stewart’s recommendation that EVA-based bonus awards be passed through a bonus bank before being paid out. We also outline the main features of the Stern Stewart bonus bank system. Their system is at odds with the practices employed by many companies, so we start by presenting a stylized picture of conventional bonus schemes.

The option-like nature of conventional bonus schemes Many conventional bonus schemes are reputed to have the characteristics represented in Figure 1 (Holthausen et al., 1995, pp. 34-35). Below a lower bound of entity performance (denoted L), no bonus is awarded. Once the performance level L is achieved, bonus starts to be awarded by reference to the extent to which entity performance exceeds L.” Additional bonus is awarded in respect of performance up to the level U, beyond which point additional performance attracts no additional bonus. In the situation depicted in Fig. 1, the position of the manager is not that of a quasi-owner: a quasi-owner would be exposed to changes in entity performance over the entire range.” Here the manager is a quasi-holder of a portfolio of options on the entity’s performance. The manager effectively holds a long call option, with exercise price L, and a short call option, with exercise price U, on the entity’s performance. The fact that the manager is an option holder creates problems. The bonus system provides no incentive to increase effort when doing so will result in performance exceeding U. Likewise, there is no incentive to apply effort (beyond that necessary to avoid dismissal) if the outcome will still fall short of L.

In some cases, a target bonus may be awarded if L is achieved and then additional bonus is awarded by reference to the extent to which entity performance exceeds L.

Shareholders are protected by limited liability; so if all equity value is destroyed, the exposure passes to the creditors. Stern Stewart takes an entity perspective to avoid such ‘financing distortions’ when defining operational measures of performance.

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Basis for award of managerial bonus

L U

Entity performance

Figure 1. Relationship between entity performance and bonus basis in standard bonus schemes. Notes: L denotes the performance level below which no bonus is paid; and U denotes the performance level above which no additional is paid. In some bonus schemes, L may take the form of a target that, if achieved, generates a bonus for target achievement. The bonus is then increased in line with performance over the range from L to U.

The reasons for the existence of the option-like relationship between performance and bonus payments, often found in practice, can be summarized as follows. At the top end of the scale, if managers knew that there were no limits to the bonus to be paid on the strength of a single period’s results, they would have strong incentives to engage in behaviour aimed at accelerating the recognition of income. This could entail accounting manipulation and/or the taking of investment decisions aimed at improving current reported performance at the cost of future losses. Income accelerating choices might be attractive purely on ‘time value of money’ grounds but might also be contemplated by managers planning to leave their posts before their chickens come home to roost. At the bottom end of the scale, there are legal and labour market limits to how much money can be taken away from managers in response to poor performance.

Why does an EVA system need a bonus bank? T o some extent, EVA deals with the problem of the inter-period manipulation of accounting numbers and, hence, of bonuses. Although the inter-period re-allocation of profits changes the present value of those profits (and of related bonuses), such re-allocation of profits does not change the present value of EVAs. This can be seen from equation (3c): the ‘time value of money’ benefit that is achieved by bringing profits forward into the current period is exactly cancelled by the increased capital charge levied against the EVAs of future periods. If bonuses are directly linked to EVA, they too are value-invariant with respect to inter-period profit manipulation. However, this value-invariance will break down if bonuses do not reflect fully all impacts, both current and future, of a manipulation. If managers’ future bonuses are lower-bounded at zero, or if managers could leave before the future negative EVA consequence of current positive EVA feeds through into future bonuses, then the value-invariance property is lost. Managers may therefore still have incentives to accelerate the recognition of accounting income under an EVA system.

An additional problem arises as a result of the leveraging effect of the capital


charge. Because EVA is the difference between profit and a capital charge, expected EVA will be substantially lower than expected profit. The bonus rates attaching to profits under an EVA-based scheme may thus have to be higher than under a profit-based scheme. This may render EVA-based bonuses more sensitive to profit manipulation than are profit-based bonuses. Consider the temptation to boost current EVA, at the expense of future EVA, by reducing current maintenance expenditures. If managers can avoid the personal consequences of such acts, either by pocketing the gains and leaving (contract horizon considerations) or as a result of option-like lower bounds on future bonus awards, the higher bonus rate required under an EVA-based system might actually increase managers’ incentives to engage in income-accelerating activity.

Outline of the bonus bank system Stern Stewart introduced the device of the bonus bank to address the potential problem of managers engaging in EVA accelerating activity. Use of a bonus bank separates the bonus award from the bonus payment. Under the bonus bank system, a manager’s EVA-based bonus for the period is added to that manager’s bonus bank. The opening balance for the period on this bonus bank will comprise the excess of bonuses awarded in previous periods over bonuses paid in those previous periods. The bonus paid will be based on the updated bonus bank balance, consisting of the opening balance plus the award for the year. All sorts of variations are possible, a simple one being the payment of a proportion, typically one third, of the balance (if positive) on the bonus bank (Stewart, 1991, p. 237).” No bonus is paid if the bonus bank balance is negative. The remaining balance, positive or negative, is then carried forward to the following period.

A bonus bank system allows a company to award a manager a high bonus in respect of a single period’s high reported performance knowing that, if subsequent events show the ‘performance’ to have been illusory, much of the bonus award will be eliminated before it is paid out. By subjecting bonus awards to modification in the light of subsequent reported performance, the bonus bank system reduces incentives for managers to try to look good in the short term and move on to another job before problems become evident. It has the additional virtue of providing ‘golden handcuffs’ for genuinely high performing managers. Furthermore, because negative EVA-based bonuses can be charged against the bonus bank balance, the company can ‘fine’ a manager if poor performance follows high reported performance, without the need to confiscate the manager’s basic salary.”

Standard bonus systems tend to make managers into the holders of a portfolio of options on the company’s performance. In contrast, systems based on a bonus bank allow bonuses to be awarded over a wide range of performance outcomes, removing much of the option-like nature of traditional bonus plans, and enable managers to be

Another idea of Stern Stewart’s is to relate the actual bonus payment to a pre-determined target bonus payment. For example, the payment can be set equal to 100 percent of the bonus bank balance, up to the amount of the target bonus payment, plus one third of the bank balance in excess of the target bonus (O’Byrne, 19976, p. 26). This moves the system back towards conventional budgeting practice, albeit without exposing the company to gaming by the managers.

The basic salary represents the minimum earnings of a manager under any bonus system where negative bonus payments are prohibited. It should not be confused with the concept of ‘reservation wage’ used in principal-agent models. The agent’s reservation wage is the minimum expected earnings and includes a probability-weighted bonus element.

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exposed to the differing outcomes which owners face. Stern Stewart acknowledges that managers may have to be compensated by a higher valued package because of the increased risk under this system (O’Byrne, 1997b, pp. 30-31).22

Stern Stewart does not appear to recommend that interest be accrued on balances held in the bonus bank. The effect of not accruing interest on bonus bank balances is to cause the present value of bonuses paid to become dependent upon the policy regarding the pay-out of bonuses from the bonus bank. This appears to be a second-order problem. A potentially serious problem would arise if the non-accrual of interest had the effect of making the present value of bonus payments subject to the effects of accounting manipulation. However, the value-invariance property of EVA ensures that this is not the case, although the period by period pattern of bonuses will be affected.

In some respects, the bonus bank can be viewed as Stern Stewart’s last line of defence, intended to mop up remaining problems that have not been adequately dealt with by: (i) the residual income-based valuation relationship which underpins EVA; (ii) the accounting adjustments; and (iii) the non-zero EVA benchmark. What evidence is there to suggest that the bonus bank concept is likely to be useful? Healy (1 985) and Holthausen et al. (1 995) found that managers tend to manipulate income downward when their bonuses are at their maximum. The evidence at the other end of the spectrum is mixed: unlike Healy (1985)) Holthausen et al. (1995) found no evidence of managers manipulating income downward when they are beneath the lower bound necessary to receive any bonus. Detecting earnings manipulation is a difficult task and any statistical tests are likely to be of low power; given this, the fact that researchers have uncovered some evidence of earnings manipulation suggests that it might be pervasive. Indeed, it is likely to become even more of a problem if pay is made more sensitive to performance, as Stern Stewart proposes. The bonus bank concept is a potentially useful way of addressing the problem.

6. Concluding remarks

Our review of the Stern Stewart EVA financial management system has had to be selective. EVA is intended to provide the basis for a variety of tasks, including financial planning, valuation, restructuring decisions and mergers and acquisitions planning. We have concentrated on Stern Stewart’s approach to measuring and rewarding managers in charge of business profit centres. This topic is at the very heart of business management, and has engaged the attention of management accountants for a very long time.

The novelty in Stern Stewart’s publications on EVA and executive compensation lays in the way in which they combine ideas from finance and accounting to provide a framework within which managers will run businesses as though they owned them. Balanced scorecards, stakeholder models, quality management and learning companies are only useful as means of bringing about value creation, which is Stern Stewart’s ultimate criterion for judging entrepreneurial performance. Their EVA variant of residual income provides the basis for this criterion to be applied in

See Jensen and Murphy (1990) for evidence concerning the low pay-performance sensitivity of traditio- 22

nal CEO reward systems and arguments for exposing CEOs to greater performance-related risk.


practice, and in a way that can be applied at both the company and profit centre levels of analysis.

A key feature of the Stern Stewart approach is the emphasis on empowering managers by allowing them to run their divisions as separate business enterprise^.'^ A key issue is whether EVA is an appropriate tool for this purpose in all circumstances. Kaplan and Norton (1996, pp. 49-50) point out that, when the division is a mature business such that the parent company wants to ‘harvest’ past investments and discourage new investment, performance might be better measured in terms of free cash flow generation rather than in terms of EVA. At the other end of the spectrum, a sole focus on EVA might lead a division with good growth prospects to under-invest because of the dent to the EVAs of early years caused by the capital charge being at its maximum when revenues are lowest. The ‘strategic investment’ concept is Stern Stewart’s way of dealing with this problem, but the question has to be asked whether the problem is more pervasive than they envisage (Bromwich and Walker, 1998).

Little independent research has been carried out into the practical consequences of using EVA as the basis for rewarding managers. There is some evidence that managers paid on the basis of EVA are more selective in their investment decisions, use existing capital more intensively and return free cash flow to shareholders (Wallace, 1997). These are actions consistent with the strong rate of return discipline associated with residual income. What has not yet been properly established is whether there has been any mitigation of the under-investment problem traditionally associated with strong reliance on short-run accounting measures. Independent in-depth field studies of the experiences of companies that have implemented EVA would complement what is currently being learned by other means about the usefulness of EVA.

The relationship between economic value, book value and future EVAs provides a basis for many of the claims that are made in support of EVA. These claims are various. EVA is claimed to induce managers to take decisions aimed at maximizing owners’ wealth; it is claimed that its adoption causes the share price of the adopting company to rise; and it is claimed that EVA is more closely related to share price than is conventionally measured accounting earnings. For the management accountant, the first of these claims is of most interest and has been the focus of this article. If the second claim is true, it will be so because the market believes the first! The third claim is different in character. It is necessarily true that the present value of expected fu tu re EVAs, together with current book value, is related to current market value; but it is an open question whether current EVA is more closely correlated with share price than are current reported earnings numbers. Moreover, it is not necessarily the case that a good managerial performance measure should outperform conventional earnings in this regard.

As Stern Stewart readily acknowledges, EVA is merely a special case of a measure that has been around for a very long time. We have used the framework that links EVA to economic value as a basis for examining the nature and purpose of the

Stern Stewart even goes so far, where possible and appropriate, as to recommend that divisions issue part of their shares on the stock market and grant the managers share options. The transaction costs theory of the firm (Coase, 1937; Williamson, 1985) suggests that there must be some economies of scale or scope to explain why the division belongs to the parent in the first place. Stern Stewart is well aware that there are likely to be serious disadvantages in proceeding too far down the spin-off path; the skill is in re-making the company from within (Stewart, 1991, Ch. 14).

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adjustments that Stern Stewart advocates should be made to conventional accounting profit in arriving at EVA. Stern Stewart appears to have devised the accounting adjustments, in an essentially ad hoc fashion, on the basis of consulting experiences, and the adjustments do not seem to be clearly underpinned by any formally expressed theory of income measurement. We have tried to categorize the adjustments in terms of three concerns which have been expressed in Stern Stewart’s writings, namely unwinding accounting conservatism, elimination of opportunities for earnings management and immunization of decisions from past accounting errors. The lack of recourse to a formal framework is not surprising in the light of the formidable obstacles in the way of collapsing performance measurement into a robust, single-period accounting measure. We seek to show how Stern Stewart’s ideas on EVA benchmark setting and bonus banks are intended to make good the deficiencies in EVA.

Joel Stern and Bennett Stewart are financial economists and do not claim to be accountants. Their ideas on accounting are striking and are advanced with great vigour, but are not entirely novel. What is new is the way in which they use accounting as a device for linking incentive systems to a model of shareholder value creation. Their ideas on how best to adjust and use accounting numbers to serve specific management ends are sufficiently thoughtful and arresting to warrant being included amongst the more significant contributions of recent years to management accounting. EVA has passed the initial market test of attracting the interest of the business community. Time will tell whether it lives up to its early promise.

Acknowledgements: Helpful comments were provided by Philip Bell, Gary Biddle, Michael Bromwich, Greg Milano, Stephen O’Byrne, Peter Pope, Bob Scapens and an anonymous reviewer.

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