wall street_s contribution to management accounting.pdf

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

Wall Streets contribution to managementaccounting: the Stern Stewart EVA@financial management systemJohn OHanlon and Ken Peasnell

EVA@ is a variant of residual incom e m arketed by Stern Stewart Co., a New Yorkconsulting firm, with the purpose of promoting value-maximizing behaviour incorporate managers. T hi s 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 manage-ment, highlighting the potential shortcomings of residual income as a single-periodperformance indicator. Seco nd, it considers the adjustments to GA AP-based account-ing advocated by Stern Stew art in o rder to prod uce a m ore economically meaningfulversion of residual income (EVA) which might serve as an effective indicator ofsingle-period performance. Third, it examines the Stern Stewart approach to thesetting of EVA benchmarks. Finally, it reviews the logic behind the use of the bonusbank to separate the award of EVA-based bonuses from the payment of suchbonuses. 998 Academic PressKey words: EVA@; esidual income; performance measurement

1 IntroductionI n r e c e n t ye a rs , a N e w Yo r k c o n s u l ti n g f i rm , Stern Stewart L Co., h a s p r o v i d e d an o ta b l e c o n t r i b u t io n t o t h e p r o f e ss io n al li t er a tur e o n c o r p o r a t e f in a n ci a l ma n a g e m e n t( S t e wa r t , 1 9 9 1 ; S t e r n et al., 1995) . S t e r n S tewar t s sys tem i s des igned to p rov ide as in g l e , v a lu e - b a s e d me a s u r e wh ic h c a n b e u s e d i n e v a lu a t i n g b u s in e s s s t r a t e g i e s ,va lu ing acqu is i t ions and cap i ta l p ro jec t s , se t t ing manager ia l pe r fo rmance ta rge ts ,m e a s u r i n g p e r f o r m a n c e a n d p a y i n g b o n u s e s . S t e r n S t e w a r t a r g u e s t h a t t h e s y s t e mp r o v id e s a u n i f ie d f i n a n c i al f r a m e w o r k e n c o m p a s s in g f in a n c i al a c c o u n tin g , m a n a g e -m e n t a c c o u n t i n g a n d b u s i n e s s v a lu a ti o n. T h e y h a v e l ab e ll ed t h e ir p e r f o r m a n c em e a s u r e E c o n o m i c V a l ue A d d e d a n d h a v e t ra d e m a r k e d i t a s E V A @ .EVA a p p e a r s t o h a v e p a s s e d i t s i n i t i a l ma r k e t t e s t w i th f l y in g c o lo u r s . M a n yl ea d in g A m e r i c a n a n d B r it is h c o m p a n i e s n o w u s e E V A o r s i m il ar p r o d u c t s m a r k e t e db y o t h e r c o n s u l t i n g f ir m s ( se e M c T a g g a r t et al., 1 9 9 4 ; C o p e l a n d et al., 1996) .

Department of Accounting and Finance, Management School, Lancaster University, Lancaster LA14YX, UK.Accepted 5 September 1998.

1044-5005/98/040421+24 30.00/0 998 Academic Press


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422 J OHanlon and K PeasnellNumerous articles have appeared in the business press on the subject. In short, theterm EVA has now entered the language of corporate management. What is not yetclear is whether EVA is a 9-day wonder, doomed to disappear from businessconsciousness as quickly as it appeared, or will prove to be a lasting and valuableaddition to the practice of management. The sceptic might argue that, since it merelyinvolves deducting a capital charge from accounting profit, EVA is little differentfrom residual income, a measure long known to management accountants. Thesceptic might also observe that, although residual income entered the mainstreamaccounting literature in the 1960s through David Solomons path-breaking 1965book on the control of divisionalized enterprises, it has not since figured prominentlyin practice (Drury, 1997). It is too soon to determine whether using EVA to rewardsenior 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 EVAs properties as a tool for monitoringand rewarding managers of business units. Stern Stewarts output apart, the literaturein this area consists largely of descriptions and applications of EVA and empiricaltests of how closely it correlates with share prices and returns compared to competitorperformance metrics. Little attention has previously been given to EVAs foundationsor to assessing the methods Stern Stewart uses in applying it in real-world manage-ment settings. We attempt to fill this gap.

The paper is organized as follows. Section 2 outlines the rationale for the use ofresidual income measures in value-based management, highlighting the potentialshortcomings of residual income as a single-period performance indicator. Section 3considers the adjustments to GAAP-based accounting advocated by Stern Stewart toproduce a more economically meaningful version of residual income (EVA). TheStern 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 theaward of EVA-based bonuses from the payment of such accrued bonuses. Ourconcluding remarks are presented in Section 6.

2 Residual income as a tool for value-based managementEVA is a tool for re-engineering corporations with a view to maximizing shareholdervalue. Stern Stewart is highly critical of the way in which different financial measuresare commonly used for different financial management purposes (including thevaluation of acquisitions, the measurement of performance and the paying of bonuses),involving inconsistent standards, goals and terminology. This may result in invest-ment and operating decisions being taken on different grounds, with neither beingeffectively linked to the reward systems of the business. They are sceptical ofapproaches which entail using multiple indicators of performance, like the balancedscorecard (Kaplan and Norton, 1996)) when setting strategic goals for managers. ForStern Stewart, the key test of all management actions is whether or not theycontribute to the creation of owners wealth. They view modern developments suchas the increased use of executive stock options and leveraged buyouts as usefuldevices for turning managers into entrepreneurs. However, they recognize that thereare limited possibilities for directly motivating divisional managers with stock op-tions. This alone may explain the continued use of traditional accounting measures


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Wall Streets Contribution to Management Accounting 423for assessing the performance of divisional executives, while rewards for groupmanagers have increasingly consisted of stock options. A problem with this conjunc-tion of value-based measures for senior management and accounting-based measuresfor divisional managers is that the different measures may encourage conflictingpatterns of behaviour at different levels in the organization.

The task Stern Stewart addresses is that of adapting accounting-based measures ofperformance such that they are systematically related to economic value. We reviewbelow how residual income creates such a link, before considering the rationale forEVA.Th e for ma l link between economic valu e an d residual incomeIt has long been recognized that economic value ultimately depends on future cashflows. This does not mean, however, that periodic free cash flow is a satisfactorymeasure of operating performance. Negative free cash flow could result from a highlevel of investment in profitable projects, the recent record of cellular telephonecompanies providing a striking example (Amir and Lev, 1996). EVA is marketed byStern Stewart as an accounting-based performance measure which yields the samediscounted present values as free cash flow, thereby retaining the focus of accountingprofit on the matching of costs and revenues without losing value-relevance. It haslong been known that the present value of a stream of future cash flows can bere-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 theanalytical work of Ohlson (1989, 1995) and Feltham and Ohlson (1995, 1996)) thisapproach has acquired increased credibility and is now playing a significant part incapital markets-based financial accounting research. Stern Stewart neither offers aformal proof of the residual income-based valuation relationship nor directs thereader to one. Since this relationship is crucial to the case for EVA, its main featuresare set out below.

The necessary and sufficient condition for the value equivalence of accounting andcash 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 valueduring period t (transactions with owners excepted):

where P, is the accounting profit for period t , C, is the cash paid to (net ofcontributions by) owners for period t and A , is the accounting book value of netassets at time t . This definition is sufficiently general to encompass both theproprietary concept of profit, where profit is viewed from the equity shareholdersperspective, and the entity concept of profit, which is adopted by Stern S t e ~ a r t . ~fStern Stewart identifies Miller and Modigliani (1961) as the source for this idea (OByrne, 1996).For ease of exposition, the analysis is in discrete terms where cash flows are assumed to occur at the endof each period.3Strictly speaking, the aim is not to maximize shareholder value but to maximize the value of all of thefinancial claims on the business. Stern Stewart justifies its entity approach on the grounds that perfor-mance measures applied to investment and operating activities should be ... purged of the effects offinancial leverage... (Stewart, 1991, p. 87). Stern Stewarts EVA valuation procedure is, in fact, a residualincome version of the Modigliani and Miller (1963) valuation framework, in which the operating cashflows of the entity, net of tax, are capitalized at the entitys weighted average cost of capital.


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424 J OHanlon and K Peasnellan entity perspective is adopted, net assets is equal to equity shareholders funds plusdebt; if a proprietary perspective is adopted, net assets is equal to equity shareholdersfunds. The definition is also sufficiently general to deal with the accounting forbusinesses at any level of aggregation, be it the whole group, a division or even abranch.

Residual income for period t , denoted X,, is defined as accounting profit forperiod 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 . ~rmed with these definitions, it is astraightforward matter to show that the expression for the economic value of theentity (denoted V,) n terms of present value of all future cash flows to owners,

C / t +v = c7 = 1 1 + k l rcan be re-written in terms of current book value plus the present value of all expectedfuture residual incomes. Again, this definition of value can be applied at any level ofaggregation. 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 thefirst disappear and equation (3b) collapses to:

* t +V,=A,+ c= 1 1 k ) rThese expressions are general enough to deal with the finite-life case where a businessis liquidated at time t T, as long as the liquidating cash flow to owners is includedas the final dividend (Peasnell, 1 9 8 2 ) .

It is important to recognize that equation (3c) holds for any accounting proceduresthat obey the clean surplus relationship. Accounting conservatism simply alters therelative 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 driveup subsequent residual incomes. We return to this later, when addressing theadjustments S tern Stewart makes to GAAP in measuring managerial performance.

Stern Stewarts approach entails adjusting conventional accounting measures of

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


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Wall Streets Contribution to Management Accounting 425book value and profit in ways outlined in the next section and re-labelling theresultant residual income concept as EVA. Expression (3c) then becomes:

7=m EVA,,.= 1 (1 k ) r

V,=A,+ cwhere A , is now Stern Stewarts adjusted book value. Expression (3d) provides thetheoretical foundation for Stern Stewarts EVA financial management system.

The crucial difference between economic value and book value is in the timing ofrecognition of gains and losses. The excess of economic value over book value iscommonly referred to as the entitys unrecorded goodwill. Expression (3d) provides aformal statement to the effect that unrecorded goodwill is the present value of futureEVAs. For Stern Stewart, a business is successful to the degree that it createseconomic value in excess of the value of the capital invested. They treat the market asthe final arbiter of business success, so the creation of economic value by businessunits must ultimately result in higher market values for the equity and debt claims onthe business as a whole. Stern Stewart describes the excess of market value overinvested capital as Market Value Added (MVA):

7=m EVA,,.= 1 (1 k ) rM V A , = V , - A , = c (4)

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

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

Further insight into the relationship described in equation (3d) can be obtained bynoting 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 , - andthat, therefore, EVA can be written in terms of the spread between profitability(ROA) and the cost of capital k ) :

EVA , P, kA - ( RO A , )A,- 5)5For a related idea, see the distinction drawn by Anthony (1983, Ch. 4) between entity equity andshareholder equity.


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426 J OHanlon and K Peasnellwhere ROA, P,/A,- Because EVA can be incorporated within a formal valuationmodel and can be decomposed into terms that include Profitability, it provides atheoretically appealing focus for the task of expressing value-drivers in terms ofaccounting numbers. For example, a Dupont-type decomposition of profitability(into asset turnover, return on sales, etc.) can feed directly into an EVA-basedvaluation model.

More generally, the decomposition of EVA in equation 5) into its profitability(ROA,) and scale A , - components highlights shortcomings of conventional ac-counting-based performance measures and the advantages of the residual incomeapproach. Defining performance in terms of profitability has long been known toresult in under-investment since maximizing ROA (or, alternatively, the spreadbetween ROA and k ) may involve rejecting positive net present value (NPV) projectsthat dilute ROA.6 Defining performance in terms of the absolute amount of profitcan have the opposite effect of encouraging over-investment (acceptance of negativeNPV projects) due to failure to take proper account of profitability. By combiningspread and scale factors within EVA, as in equation 5)) one class of problem createdby the use of accounting performance measures can be overcome. This argumentunderlay the case made for residual income as a divisional performance measure over30 years ago (Solomons, 1965).T he problem w ith residual income as a single-period pe rf om an ce indicatorEarly criticisms of residual income were of two sorts. First, charging interest on fixedinvestment is not likely to enhance the quality of production decisions since invest-ment outlays are sunk costs. Moreover, in the presence of capital rationing, pushingmajor investment decisions down the organizational hierarchy can result in loss ofvalue through the neglect of interactions (Amey, 1969). Stern Stewart tackles thiscriticism of residual income head on, arguing that many modern companies havegrown too large to be managed centrally. They propose empowering managers in away that turns them into quasi-owners, with investment decisions being deliberatelypassed down the hierarchy. Thus, charging interest on sunk costs is seen to be apositive feature of residual income. Owners cannot escape the cost of earlier capitalcommitments, and so managers must not be allowed to either. This appears to be animportant attraction of EVA to Stern Stewarts clients (Stern and Chew, 1998, pp.

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

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

490-5 14).

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


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Wall Streets Contribution to Management Accounting 427equation 3c)as an expression for the observed excess of the periodic change in entityvalue 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,[.] s

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 presentvalue 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 hasbeen 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 moneyreturn on the book value component of economic value; the second term representsthe excess money return on unrecorded goodwill.

It is clear from equation (7) that the owners excess gain during period t is not, ingeneral, equal to that periods residual income. A sufficient condition for single-periodresidual income to equal single-period excess money return is that book value beequal to economic value A , V,),or equivalently that unrecorded goodwill be zeroGW, 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 entityseconomic value. Indeed, one influential contributor to the Shareholder Value litera-ture has advocated disregarding conventional accounting measures in the assessmentof managerial performance and using regularly revised present values and compar-isons of actual with planned cash flows instead (Rappaport, 1986). The mostcommonly voiced objection to substituting entity present value for book value is thesubjectivity involved. A more subtle objection was raised by Bromwich (1973) aquarter-century ago. He pointed out that the use of present value entailed theperformance measure being struck after the drawing up of future investment plans,which typically arise as outputs of the performance measurement process rather thanas inputs to it.

Another way of addressing the problem is to consider the possibility of cancellingvaluation errors. Close inspection of equation (7) reveals that it is not necessary to setbook value equal to economic value in order for residual income to provide anunbiased measure of excess money return. A weaker sufficient condition is thatunrecorded 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


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428 J OHanlon and K Peasnelladvantages (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 errorsarising from accounting conservatism. Accounting recognition and measurementpractices are likely to ensure that residual income will only provide a crude one-periodindicator of excess money return.

It is helpful to note at this juncture two studies, Biddle et al. (1997) and Bacidoreet al. (1997)) which address the question of the association between single-periodEVA and shareholder wealth creation in the USA.7 In both studies, the measure ofwealth creation is abnormal shareholder return, obtained by dividing the excessmoney return to shareholders by the opening market value of shareholders funds; theEVA measures were obtained from the Stern Stewart Performance 1000 database(Stern Stewart Co., 1997). Biddle et al. (1997) report that conventionally mea-sured reported earnings are generally more closely associated with abnormal share-holder return than is EVA. Bacidore et al. (1997) compare EVA with a new measureof their own, which they call refined economic value added (REVA). Their objec-tion to EVA is that it fails to reflect the opportunity cost to the owners (who have theoption of selling their ownership claims in the financial markets) of the unrecordedgoodwill component of value. REVA addresses this complaint by subtracting fromperiodic profit a capital charge based on the opening market value of the entity.Bacidore et al. (1997) find that abnormal shareholder returns are more stronglyassociated with REVA than with EVA.8

Detailed consideration of the research designs employed in these studies is beyondthe scope of this paper. However, as a means of conveying the flavour of the issuesthat have to be addressed in such work, we make two observations regarding theBacidore et al. (1 997) analysis. First, REVA is a hybrid measure, whereby changes ingoodwill are recorded for the purpose of arriving at the capital charge but are leftout of the determination of profit. REVA therefore violates the clean surplus defini-tion of residual income that we have shown to be the very basis of the long-runlinkage between residual income and economic value. Whilst Stern Stewart intro-duces many variations from GAAP when determining EVA, care is taken to ensurethat the clean surplus tidiness condition is not violated. Second, because therequired return on the opening market value of shareholders funds is subtracted bothin the abnormal shareholder return and in the REVA measure, the dice are loadedagainst EVA relative to REVA.

A fundamental issue in designing a single-period accounting measure of economicperformance 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 theaccounting system are cash flows. The only asset shown on the entitys balancesheet 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 residualincome in the UK.Wu (1998) suggests that, where both residual income and stock return contribute to a managerscompensation package, the manager might wish, for diversification reasons, to take actions that decreasethe association between the two measures.For Stern Stewarts views on the Biddle et al. (1997) study, see OByrne (199 7~ ) .


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Wall Streets Contribution to Management Accounting 429yield its required return (Feltham and Ohlson, 1995)) residual income is alwaysequal to operating cash flow (net of investment outlays).Economic value accounting (full accruals): the entitys accounting book value isalways equal to the entitys economic value and the entitys accounting profit isalways equal to the entitys economic income. Actual residual income is alwaysequal to the excess money return earned on the entitys economic value.Expected future residual income is always zero.

Neither extreme is attractive in itself as the basis for a single-period performancemeasure. Conventional financial accounting is the outcome of complex regulatoryand market processes whereby issues of relevance are balanced against the concernfor reliability. The resultant package of GAAP accruals falls part-way between thecash accounting and economic value accounting extremes and is intended to beapplicable to businesses in general. In contrast, Stern Stewarts approach is in thetradition of management accounting, in that their judgements on these matters arefocused on specific (rather than general-purpose) decision and control needs and areenterprise-contingent by design. No general solution is possible.

The Stern Stewart system encompasses a number of approaches to address theproblems 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; andbonus banks separating the award and payment of bonuses.

These procedures are discussed in the remainder of the paper.

3. EVA-tailored GAAPStern Stewart has identified over 120 aspects of conventional GAAP which requireadjustment in arriving at EVA. They point out, however, that typically only about tenof these adjustments are needed for any one company (Stern et al., 1995, p. 4 1). Themain 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, inorder to try to make sense of the logic driving the adjustments.

Much of Stern Stewarts tailoring of GAAP has the effect of shifting accountingcloser to economic value accounting, as described in Section 2. However, it wouldbe incorrect to suggest that their ideal accounting is economic value accounting.Stern Stewarts adjustments are intended to ensure that book capital reflects the fullcost of investments in operating assets, but not the unrealized economic value offuture pay-offs from those assets: primarily on the grounds of cost effectiveness, theysupport the continued use of historical costs in preference to current costs (Stewart,1994, p. 78). Furthermore, in their desire to limit managerial opportunities to engagein inter-period allocation of EVA, Stern Stewart advocates some adjustments whichhave the effect of taking accounting back towards cash accounting.

Stern Stewarts tailoring of GAAP is intended to produce a performance measurethat will encourage managers to behave like owners. Their procedures have threepurposes:


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430 J OHanlon and K Peasnellto undo accounting conservatism;to discourage earnings management; andto immunize performance measurement against past accounting errors.

The ways in which their adjustments are intended to achieve these three objectivesare examined below.Acc oun ting conservatismStern Stewart attributes the conservative bias in accounting to accountants being... the unwitting slaves of the bankers (Stewart, 1991, p. 29). Many of theirproposed adjustments are intended to remove accounting conservatism. We illustratetheir approach by considering four of these adjustments, three of which moveaccounting further away from cash accounting and one of which pushes it backtowards cash accounting.

First, Stern Stewart advocates the capitalization of all intangible investments insuch things as goodwill, research and development (R& D) and marketing (Stewart,1991, pp. 114-116). The objective is straightforward: to discourage one source ofmyopic behaviour of managers, by treating investment in intangibles in the samemanner as investment in tangible assets. While this would have the incidental effectof moving the book value of the business closer to its economic value, that is notStern Stewarts objective; indeed, tangible and intangible assets alike would be shownat depreciated historical cost. The intention is to avoid penalizing managers at thetime 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 ofintangibles? We conjecture that they would deplore the pre-FRS 10 (AccountingStandards Board, 1997) practice of charging purchased goodwill directly to equityreserves. Doing so weakens accountability by absolving managers from the need toearn a return on such investment, through violation of the clean surplus requirementof EVA given in equation (1). This creates incentives for managers to grow throughacquisition rather than developing their own organizations, particularly when this isexacerbated 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, whichis allowed to be capitalized in specific circumstances, and expenditure on basicresearch, which is not. The effect of the distinction is to create a bias againstlong-term investment. For Stern Stewart, the concern about the uncertainty of thepay-offs, which underlay the distinction drawn in SSAP 13, is not itself grounds forfailing to recognize an investment (Stewart, 199 1, p. 1 16). Furthermore, while theywould applaud the capitalizing of outlays on the building of brands, we doubt theywould support recording such assets at valuation (Barwise et al., 1989): to do sowould credit managers with anticipated future performance.

Our second example concerns Stern Stewarts views on full cost versus successfulefforts methods of accounting for oil and gas exploration expenditures. They arguethat the costs of unsuccessful exploration represent part of the true cost of discoveringproductive fields and that such costs should therefore be capitalized rather thanexpensed (Stewart, 1991, p. 30). The effect of Stern Stewarts recommendation is,again, to move EVA further away from cash accounting. The logic here, though, is


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Wall Streets Contribution to Management Accounting 431dictated by considerations of business strategy: oil and gas exploration is a portfoliobusiness and should be accounted for as such, if the scale of investment is not to beunder-stated. Current practice can make managers unduly risk averse.

Our third example concerns the possibility that EVA might discourage managersfrom investing in assets which will not immediately generate profits. Such assets willinitially reduce EVA because of the associated capital charge penalty in the periodsprior to revenues coming on stream. Stern Stewarts solution to this strategicinvestment problem is to eliminate the charge, by capitalizing interest equal to theperiodic 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 laterperiods, and at a higher level due to the earlier capitalization of interest havingincreased the investment base on which the charge is levied. Again, the effect is tomove EVA further away from cash accounting. The benefit is that single-period EVAbecomes a better (but still imperfect) measure of performance. Th e adjustment stopsshort of economic value accounting, since the manager is not credited with theanticipated benefits associated with the strategic investment. The focus is still ondelivered performance, albeit with better matching.

Our fourth example deals with the recognition of liabilities. Stern Stewart isopposed to deferred tax accounting for two main reasons. First, accounting fordeferred tax liabilities can give rise to conservatism, since deferred tax balances maybe 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 taxplanning. In this case, the general effect of the Stern Stewart approach is to move theaccounting towards a cash basis.

Conservatism is a pervasive feature of accounting. Stern Stewart acknowledges thatit may be appropriate for some purposes, but argues that it has undesirable conse-quences in the context of performance measurement. A counter-argument can bemade. There is a school of thought (e.g. Ijiri, 1975) that argues that accountingconservatism partly derives from its role in performance measurement: conservatismis a necessary counter-balance to the optimism of the steward.Earnings managementSome of Stern Stewarts adjustments are intended to remove (or at least to minimize)the opportunities open to management to smooth accounting profits. Their principaltargets are general provisions for bad debts, warranties and inventory obsolescence(Stewart, 1991, p. 117). They propose instead that the costs associated with theseitems should ordinarily be recognized on a cash basis. The objective is to retainspecific provisions and eliminate those in the nature of a permanent provision that isgrowing along with the rest of the business.

Are such provisions used to manage earnings? Evidence on the likelihood of suchbehaviour is difficult to obtain, but McNichols and Wilson (1988) find that compa-nies tend to increase the discretionary component of the provision for bad debts whentheir reported income is either very high or very low. More generally, there isevidence 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 of0the various rationales that have been offered for capitalization of interest, see Peasnell (1993).


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432 J OHanlon and K Peasnellperformance 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 theprovisions targeted by Stern Stewart are the culprits. Whether the elimination ofgeneral provisions would simply lead managers to look elsewhere to manage earningsremains to be seen. Research on earnings management has scarcely begun.

Many proposals have been made over the years for abandoning depreciationaccounting, because of its alleged inherent arbitrariness (e.g. Thomas, 1969, 1974)and, hence, vulnerability to the exercise of managerial discretion. Stern Stewartopposes the arbitrary amortization of goodwill for the same reason, proposing insteadthat 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 ofidentifiable intangibles like R& D and marketing costs, Stern Stewart recommendsthat they be capitalized and amortized over the lives of successful new products. Theymake the point that depreciation is an economic cost, in the sense that an asset wouldhave to be leased if it were not owned, and recommend that more than the customarylevel of attention should be given to making depreciation charges responsive towear-and-tear and obsolescence. The common thread in Stern Stewarts position onthe subject is their opposition to the use of arbitrary depreciation formulae. Wereturn to the issue of depreciation in a subsequent sub-section.Past accounting errorsStern Stewart has a procedure for preventing past accounting measurement errorsfrom distorting managers divestment decisions. If an asset is in the books at anamount which differs from its economic value ~ as is ordinarily the case (except bycoincidence) under historical cost accounting ~ a manager might be discouragedfrom making the economically correct retention/divestment decision. Stern Stewarttherefore recommends that no gains or losses should be booked on retirement of anon-trading asset. This can be achieved simply by subtracting the sale proceeds fromthe 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 isbeing retired. Thus, the procedure is equivalent to one in which the asset isre-valued to exit value at the time of disposal. This treatment has the attractiveproperty of causing the sale proceeds to be the sole determinant of the effect of theasset sale on subsequent capital charges. This, in turn, forces managers to recognizethat a decision to keep an asset is equivalent to a decision to invest the available saleproceeds in that asset.

This is a crude way of dealing with the opportunity cost dimension of pastinvestment decisions. As explained in the article by Bromwich and Walker (1998) inthis issue, the opportunity cost of retaining an asset in the business is the interestforgone on the disposal proceeds. To do the job properly, assets should be recordedat exit value, not historical cost, throughout (Peasnell, 1981). However, apart fromthe possibly non-trivial bookkeeping costs, marking to market in this way might havedysfunctional behavioural consequences, in that large write-downs might have to bemade 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 MerchantFor a useful review of the difficulties involved, see Schipper (1989).

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Wall Streets Contribution to Management Accounting 433Stern 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 asimultaneous adjustment to the book value of the remaining assets or that adangling asset or liability has to be created: it is unclear how such dangling itemsshould be depreciated.

This treatment of gains and losses on disposals is arguably Stern Stewarts mostradical departure from GAAP. It should not be mistaken for the practice of simplytaking such items directly to reserves, thereby excluding them from profit. Thatapproach violates the clean surplus requirement underpinning the residual income-based valuation relationship in equation (3c). For Stern Stewart, the focus is on theentitys total invested capital and not on the corresponding component assets. Thisis a radical departure from GAAP. Their mindset is that of a management accoun-tant, not that of an auditor or financial accountant.Whymig ht the accounting adjustm ents fa il to solve the problem?Stern Stewarts approach is to work with the grain of conventional accountingpractice. Their tailoring of GAAP is intended to discourage managers from gameplaying and behaving myopically. As with all accounting models, trade-offs have tobe made in terms of relevance and reliability, and it is not entirely clear what incomeconstruct underpins the EVA system.

T o our knowledge, the only place in Stern Stewarts published output in which theunderlying 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 annuitizedmeasure of the NPV to be realized over the life of the project or company ... Thisstatement appears within the context of a discussion of choice of depreciationmethods and of the advantages of the sinking fund method, by which we think theymean the more commonly known annuity depreciation method.13 It is important tonote that the annuity depreciation method is ordinarily understood to be one thatproduces (together with interest on the assets reducing net book value) a constantannual charge. Annuity depreciation will therefore only yield a stream of constantEVAs (i.e. annuitized NPV) if the periodic net cash flows associated with the assetare themselves constant. If cash flows change through time, EVA can only be madeconstant by the application of plug depreciation rates which may have to be negativein certain periods (i.e. assets may sometimes have to be re-valued upwards). This is aproblem that the annuitized NPV conception of EVA shares with economic income.An alternative would be to use the Earned Economic Income (EEI) matchingapproach proposed by Grinyer (1 985). Here, accounting depreciation is computedsuch 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, wascommonly 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 anannual cash deposit placed in an investment account. These cash deposits plus interest accumulate, by theend of the assets life, to an amount equal to the cost of the asset. The rationale is that the investmentaccount should provide funds for replacement of the asset at the end of its life. Obviously, the depreciationcharged to the profit and loss account over the assets 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 onthe investment account. For details, see Carter (1933, pp. 654-6591. It can be easily demonstrated thatthe depreciation schedule arrived at by the annuity method is identical to the schedule of interest anddepreciation credited to the accumulated depreciation account under the sinking fund method.

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Wall Streets Contribution to Management Accounting 435measurable failures of GAAP to capitalize intangible investments, many businessexpenditures involve the purchase of benefits which are not wholly related to theprojects or activities with which they are directly associated. A prime example is thebenefit of learning by doing, the costs of which are buried in day-to-day operatingcosts and expensed as such. It is also possible that the book value of the assetscommitted to a business may exceed the economic value of the business. This canhappen in both cyclical and rust bowl industries, if depreciation schedules are notadjusted to reflect falls in the value of assets; in this case, it is expected that futureEVA will be negative. Consequently, the EVA benchmark for where superior perfor-mance begins may have to be set above or below zero, as economic circumstancesand 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 competi-tive advantage will have made it easy for the current management team to generatepositive EVAs in the future; in other businesses, the achievement by the currentmanagement team of even a zero EVA might represent a resounding success.15Giventhat zero EVA may well be an inappropriate benchmark, the question arises of howEVA benchmarks are to be set.

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

The obvious starting point for considering the selection of an appropriate EVAbenchmark is provided by equations (3d) and (4). MVA is the sum of the presentvalues of all of the future EVAs expected by the capital market. Stephen OByrne, theprevious head of Stern Stewarts executive compensation advisory practice and theauthor of a number of papers which address this issue (OByrne, 1996, 1997b), hasproposed that the expected EVAs impounded in MVA should be used as the basis forsetting future EVA benchmarks. The conversion of current MVA into a set of futureEVA benchmarks requires some assumption as to the time path that the (non-zero)expected future EVAs will follow. OByrne reviews two possible approaches. Onesimple approach is to assume that current MVA is the present value of EVAsexpected to be earned over a finite competitive advantage period. OByrne pointsout that this approach, whilst convenient, is difficult to justify by reference to theobserved patterns of EVA and MVA in going concern companies: MVA does notnormally disappear within a short horizon. Consequently, OByrne proposes an

It is pertinent, here, to recall Stern Stewarts concern that book values should not be treated as though5they were economic values. A business with negative MVA should not necessarily be wound up.


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436 J OHanlon and K Peasnellalternative approach which assumes that non-zero EVA will persist indefinitely, or atleast well beyond any feasible forecast horizon (OByrne, 1 9 9 6 , 1 9 9 7 b ) .

Recent Stern Stewart literature refers to EVA benchmarks in terms of expectedEVA improvement [see, for example, OByrne ( 1 9 9 7 b , pp. 24-27)]. This approachcan be justified in two ways. First, if the adjustments to the accounting basis fail toremove the bias in EVA as a measure of the entitys abnormal economic perfor-mance, then a focus on changes in EVA may do the trick. Second, the modelling ofEVA improvements as a constant proportion of a growing capital base (OByrne,1 9 9 7 b , p. 25)) which is consistent with assuming that the market-to-book ratio willremain approximately constant in the future, means that the manager is judgedagainst a benchmark of permanent gains. Any new investment is assumed to yieldpositive gains of the same order of magnitude as past ones.

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

V, =A, + EVA,, 1 = A , + A , M - 1 )k - gwhere 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 ofA , 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 proportionalmarket-to-book premium and a positive function of the excess of the cost of capitalover 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 beaccompanied (sooner or later) by a fall in market v a 1 ~ e . l ~

The approach exemplified above involves setting EVA benchmarks by reference tomarket expectations of future EVA. Whilst this is likely to be preferable to the naiveuse of a benchmark EVA of zero, it leads to a difficult question which EVApractitioners 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 analysisof EVA data. See OByrne (1996, p. 118; 19976, p. lo), and Stern Stewart Co. (1997, p. 8) for details.OByrne (19976, pp. 24-27) provides a detailed example of how EVA benchmarks might be used as par t

of the calibration of an EVA-based bonus system. The markets expectations regarding a companysfuture EVAs are inferred from, inter-alia, the companys market value. The managers target bonusfigure, derived from peer company compensation practices, is then used, together with an estimate of theshortfall in periodic EVA which would reduce the periodic shareholder return to zero, t o arrive at a bonusrate. This rate is then applied to (positive and negative) deviations from expected (benchmark) EVA toarrive at the managers bonus. T he bonus so calculated is then fed into the bonus bank, outlined in Section5.

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Wall Streets Contribution to Management Accounting 437future EVA be allowed to drive EVA benchmarks? For example, suppose the highreputation 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 highEVA. 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 SternStewart EVA Roundtable (Stern and Chew, 1998, pp. 499-500).

The task of setting benchmarks which reward managers for their efforts and not fortheir endowments is a difficult one. An approach which might achieve this wouldentail setting EVA benchmarks on a deprival value basis. A managers EVAbenchmark could be set by reference to an estimate of what the market value of thebusiness would be if that manager were to be replaced by one of average quality. Allof this highlights the potential benefits from Stern Stewarts efforts to improve theunderlying accounting, as reviewed in Section 3 above. If the accounting adjustmentssucceed in making zero EVA into an appropriate demarcation line between whatconstitutes superior and inferior Performance, there will be no need to read themarkets mind about future EVAs.

5 The bonus bank conceptIn this section, we review the reasons for Stern Stewarts recommendation thatEVA-based bonus awards be passed through a bonus bank before being paid out. Wealso outline the main features of the Stern Stewart bonus bank system. Their systemis at odds with the practices employed by many companies, so we start by presentinga stylized picture of conventional bonus schemes.T he option-like nature of conventional bonus schemesMany conventional bonus schemes are reputed to have the characteristics representedin Figure 1 (Holthausen et al., 1995, pp. 34-35). Below a lower bound of entityperformance (denoted L), no bonus is awarded. Once the performance level L isachieved, bonus starts to be awarded by reference to the extent to which entityperformance exceeds L. Additional bonus is awarded in respect of performance upto the level U, beyond which point additional performance attracts no additionalbonus. In the situation depicted in Fig. 1, the position of the manager is not that of aquasi-owner: a quasi-owner would be exposed to changes in entity performance overthe entire range. Here the manager is a quasi-holder of a portfolio of options on theentitys performance. The manager effectively holds a long call option, with exerciseprice L, and a short call option, with exercise price U, on the entitys performance.The fact that the manager is an option holder creates problems. The bonus systemprovides no incentive to increase effort when doing so will result in performanceexceeding U. Likewise, there is no incentive to apply effort (beyond that necessary toavoid 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 byreference 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 tothe creditors. Stern Stewart takes an entity perspective to avoid such financing distortions when definingoperational measures of performance.

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438 J OHanlon and K Peasnell

Basis for awardofmanagerialbonus

Lntity performance

Figure 1 Relationship between entity performance and bonus basis in standard bonus schemes. Notes: Ldenotes the performance level below which no bonus is paid; and U denotes the performance level abovewhich 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 therange from L to U.

The reasons for the existence of the option-like relationship between performanceand bonus payments, often found in practice, can be summarized as follows. At thetop end of the scale, if managers knew that there were no limits to the bonus to bepaid on the strength of a single periods results, they would have strong incentives toengage in behaviour aimed at accelerating the recognition of income. This couldentail accounting manipulation and/or the taking of investment decisions aimed atimproving current reported performance at the cost of future losses. Income acceler-ating choices might be attractive purely on time value of money grounds but mightalso be contemplated by managers planning to leave their posts before their chickenscome home to roost. At the bottom end of the scale, there are legal and labourmarket limits to how much money can be taken away from managers in response topoor performance.Whydoes a n EVA system need a bonus bank?T o some extent, EVA deals with the problem of the inter-period manipulation ofaccounting numbers and, hence, of bonuses. Although the inter-period re-allocationof profits changes the present value of those profits (and of related bonuses), suchre-allocation of profits does not change the present value of EVAs. This can be seenfrom equation (3c): the time value of money benefit that is achieved by bringingprofits forward into the current period is exactly cancelled by the increased capitalcharge levied against the EVAs of future periods. If bonuses are directly linked toEVA, 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 allimpacts, both current and future, of a manipulation. If managers future bonuses arelower-bounded at zero, or if managers could leave before the future negative EVAconsequence of current positive EVA feeds through into future bonuses, then thevalue-invariance property is lost. Managers may therefore still have incentives toaccelerate the recognition of accounting income under an EVA system.

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


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Wall Streets Contribution to Management Accounting 439charge. Because EVA is the difference between profit and a capital charge, expectedEVA will be substantially lower than expected profit. The bonus rates attaching toprofits under an EVA-based scheme may thus have to be higher than under aprofit-based scheme. This may render EVA-based bonuses more sensitive to profitmanipulation than are profit-based bonuses. Consider the temptation to boostcurrent EVA, at the expense of future EVA, by reducing current maintenanceexpenditures. If managers can avoid the personal consequences of such acts, either bypocketing the gains and leaving (contract horizon considerations) or as a result ofoption-like lower bounds on future bonus awards, the higher bonus rate requiredunder an EVA-based system might actually increase managers incentives to engagein income-accelerating activity.Outl ine of the bonus bank systemStern Stewart introduced the device of the bonus bank to address the potentialproblem of managers engaging in EVA accelerating activity. Use of a bonus bankseparates the bonus award from the bonus paym en t . Under the bonus bank system, amanagers EVA-based bonus for the period is added to that managers bonus bank.The opening balance for the period on this bonus bank will comprise the excess ofbonuses 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 theopening balance plus the award for the year. All sorts of variations are possible, asimple one being the payment of a proportion, typically one third, of the balance (ifpositive) on the bonus bank (Stewart, 1991, p. 237). No bonus is paid if the bonusbank balance is negative. The remaining balance, positive or negative, is then carriedforward to the following period.

A bonus bank system allows a company to award a manager a high bonus inrespect of a single periods high reported performance knowing that, if subsequentevents show the performance to have been illusory, much of the bonus award will beeliminated before it is paid out. By subjecting bonus awards to modification in thelight of subsequent reported performance, the bonus bank system reduces incentivesfor managers to try to look good in the short term and move on to another job beforeproblems become evident. It has the additional virtue of providing golden handcuffsfor genuinely high performing managers. Furthermore, because negative EVA-basedbonuses can be charged against the bonus bank balance, the company can fine amanager if poor performance follows high reported performance, without the need toconfiscate the managers basic salary.

Standard bonus systems tend to make managers into the holders of a portfolio ofoptions on the companys performance. In contrast, systems based on a bonus bankallow bonuses to be awarded over a wide range of performance outcomes, removingmuch of the option-like nature of traditional bonus plans, and enable managers to be

Another idea of Stern Stewarts is to relate the actual bonus payment to a pre-determined target bonuspayment. For example, the payment can be set equal to 100 percent of the bonus bank balance, up to theamount of the target bonus payment, plus one third of the bank balance in excess of the target bonus(OByrne, 19976, p. 26). This moves the system back towards conventional budgeting practice, albeitwithout exposing the company to gaming by the managers.

Th e basic salary represents the minimum earnings of a manager under any bonus system where negativebonus payments are prohibited. It should not be confused with the concept of reservation wage used inprincipal-agent models. T he agents reservation wage is the minimum expected earnings and includes aprobability-weighted bonus element.

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440 J OHanlon and K Peasnellexposed to the differing outcomes which owners face. Stern Stewart acknowledgesthat managers may have to be compensated by a higher valued package because ofthe increased risk under this system (OByrne, 1997b, pp. 30-31).22

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

In some respects, the bonus bank can be viewed as Stern Stewarts last line ofdefence, intended to mop up remaining problems that have not been adequatelydealt with by: (i) the residual income-based valuation relationship which underpinsEVA; (ii) the accounting adjustments; and (iii) the non-zero EVA benchmark. Whatevidence 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 incomedownward when their bonuses are at their maximum. The evidence at the other endof the spectrum is mixed: unlike Healy (1985)) Holthausen et al. (1995) found noevidence of managers manipulating income downward when they are beneath thelower bound necessary to receive any bonus. Detecting earnings manipulation is adifficult task and any statistical tests are likely to be of low power; given this, the factthat researchers have uncovered some evidence of earnings manipulation suggeststhat it might be pervasive. Indeed, it is likely to become even more of a problem ifpay is made more sensitive to performance, as Stern Stewart proposes. The bonusbank 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 beselective. EVA is intended to provide the basis for a variety of tasks, includingfinancial planning, valuation, restructuring decisions and mergers and acquisitionsplanning. We have concentrated on Stern Stewarts approach to measuring andrewarding managers in charge of business profit centres. This topic is at the veryheart of business management, and has engaged the attention of managementaccountants for a very long time.

The novelty in Stern Stewarts publications on EVA and executive compensationlays in the way in which they combine ideas from finance and accounting to provide aframework within which managers will run businesses as though they owned them.Balanced scorecards, stakeholder models, quality management and learning compa-nies are only useful as means of bringing about value creation, which is SternStewarts ultimate criterion for judging entrepreneurial performance. Their EVAvariant 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-2nal CE O reward systems and arguments for exposing CEOs t o greater performance-related risk.


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Wall Streets Contribution to Management Accounting 441practice, and in a way that can be applied at both the company and profit centrelevels of analysis.

A key feature of the Stern Stewart approach is the emphasis on empoweringmanagers by allowing them to run their divisions as separate business enterprise^. ^ Akey issue is whether EVA is an appropriate tool for this purpose in all circumstances.Kaplan and Nor ton (1996, pp. 49-50) point out that, when the division is a maturebusiness such that the parent company wants to harvest past investments anddiscourage new investment, performance might be better measured in terms of freecash flow generation rather than in terms of EVA. At the other end of the spectrum, asole focus on EVA might lead a division with good growth prospects to under-investbecause of the dent to the EVAs of early years caused by the capital charge being atits maximum when revenues are lowest. The strategic investment concept is SternStewarts way of dealing with this problem, but the question has to be asked whetherthe problem is more pervasive than they envisage (Bromwich and Walker, 1998).

Little independent research has been carried out into the practical consequences ofusing EVA as the basis for rewarding managers. There is some evidence thatmanagers 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 disciplineassociated with residual income. What has not yet been properly established iswhether there has been any mitigation of the under-investment problem traditionallyassociated with strong reliance on short-run accounting measures. Independentin-depth field studies of the experiences of companies that have implemented EVAwould complement what is currently being learned by other means about theusefulness of EVA.

The relationship between economic value, book value and future EVAs provides abasis for many of the claims that are made in support of EVA. These claims arevarious. EVA is claimed to induce managers to take decisions aimed at maximizingowners wealth; it is claimed that its adoption causes the share price of the adoptingcompany to rise; and it is claimed that EVA is more closely related to share pricethan is conventionally measured accounting earnings. For the management accoun-tant, 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 Thethird claim is different in character. It is necessarily true that the present value ofexpected f u t u r e EVAs, together with current book value, is related to current marketvalue; but it is an open question whether current EVA is more closely correlated withshare price than are current reported earnings numbers. Moreover, it is not necessar-ily the case that a good managerial performance measure should outperform conven-tional earnings in this regard.

As Stern Stewart readily acknowledges, EVA is merely a special case of a measurethat has been around for a very long time. We have used the framework that linksEVA 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 partof their shares on the stock market and grant the managers share options. The transaction costs theory ofthe firm (Coase, 1937; Williamson, 1985) suggests that there must be some economies of scale or scope toexplain why the division belongs to the parent in the first place. Stern Stewart is well aware that there arelikely to be serious disadvantages in proceeding too far down the spin-off path; the skill is in re-making thecompany from within (Stewart, 1991, Ch. 14).

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442 J OHanlon and K Peasnelladjustments that Stern Stewart advocates should be made to conventional accountingprofit in arriving at EVA. Stern Stewart appears to have devised the accountingadjustments, in an essentially ad hoc fashion, on the basis of consulting experiences,and the adjustments do not seem to be clearly underpinned by any formallyexpressed theory of income measurement. We have tried to categorize the adjust-ments in terms of three concerns which have been expressed in Stern Stewartswritings, namely unwinding accounting conservatism, elimination of opportunitiesfor earnings management and immunization of decisions from past accountingerrors. Th e lack of recourse to a formal framework is no t surprising in the light of theformidable obstacles in the way of collapsing performance measurement into arobust, single-period accounting measure. We seek to show how Ste rn Stewarts ideason EVA benchmark setting and bonus banks are intended to make good thedeficiencies in EVA.

Joel Stern and Bennett Stewart are financial economists and do not claim to beaccountants. Their ideas on accounting are striking and are advanced with greatvigour, but are not entirely novel. What is new is the way in which they useaccounting as a device for linking incentive systems to a model of shareholder valuecreation. Their ideas on how best to adjust and use accounting numbers to servespecific management ends are sufficiently thoughtful and arresting to warrant beingincluded amongst the more significant contributions of recent years to managementaccounting. EVA has passed the initial market test of attracting the interest of thebusiness community. Time will tell whether it lives up to its early promise.Acknowledgements: Helpful comments were provided by Philip Bell, Gary Biddle, MichaelBromwich, Greg Milano, Stephen OByrne, Peter Pope, Bob Scapens and an anonymousreviewer.ReferencesAccounting Standards Board, 1997. Financial Reporting Standard No. 10: Goodwill and Intangi-Accounting Standards Committee, 1989. Statement of Standard Accounting Practice No. 13:Amey, L., 1969. The Eficiency of Business Enterprises, London, George Allen and Unwin.Amir, E. and Lev, B., 1996. Value-relevance of nonfinancial information: The wirelesscommunications industry, Journa l of Acco unting and Economics, August-December, 3-30.Anthony, R., 1983. Tel l I t Like I t W as , Homewood, Irwin.Bacidore, J., Boquist, J., Milbourn, T. and Thakor, A., 1997. The search for the best financialperformance measure, Financial Analy sts Journal, May/June, 11-20.Barwise, P., Higson, C., Likierman, A. and Marsh, P., 1989. Acconntingfor Brands, LondonBusiness School and the Institute of Chartered Accountants in England and Wales.Bell, P. and Peasnell, K., 1997. Another look at the deprival value approach to depreciation, inCooke, T. and Nobes, C. (eds.) Th e Development ofAcconn ting in a n International Con text: A

Festschnyt in honour of R.H. Parker, London, Routledge, pp. 122-148.Biddle, G., Bowen, R. and Wallace, J., 1997. Does EVA@ beat earnings? Evidence onassociations with stock returns and firm values, Journal of Accounting and Economics,forthcoming.Bromwich, M., 1973. Measurement of divisional performance: a comment and extension,Acco unting an d Business Research, Spring, 123-1 32.Bromwich, M. and Walker M., 1998. Residual income past and future, Management Acconnt-ing Research, this issue.Carter, R., 1933. Advanced Acconnts, London, Sir Isaac Pitman and Sons, Ltd.

ble Assets F R S 10).

Accounting fo r Research and Development S S A P 13).


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