Economic value added (EVA)

Economic value added is similar to residual income(RI) but it is considered superior to residual income because it uses the approach to determine the profit figure which are difficult to be manipulated by division managers. It does not penalize or reward managers for the expenses or revenues over which they have no control. EVA is determined by deducting the notional cost of investment (Capital employed X cost of capital%) from the profit after tax figure (Adjusted).

To calculate the profit figure, it eliminates the non-cash expenses like depreciation, amortization and provisions to reflect the profit near to cash flow. It also eliminates expense incurred with a view to improvement in business, so it also encourages managers to pursue long term growth. Interest expense is also eliminated even if it involves cash flows, the reason is that interest expense are taken into account when deciding the cost of capital for EVA just like RI. Unlike other performance measures, EVA uses tax expense to reach profit for the period used in the calculation and Accounting depreciation is replaced by tax or economic depreciation. In this way, managers are encourage to take decision which are tax effective for the business.

Revenue are recognized at market price for both external and internal transfers. Management accounts needs to be adjusted if internal or external transfers are not at market price. So it reduces the problem associated with transfer pricing by recognizing the revenue to the seller and cost to the buyer at market price. It can lead to goal congruence by encouraging the behavior required by the business.

Capital employed is also adjusted for the items used to compute adjust profit figure. Any expense eliminated should be adjusted back to their respective line item in the Statement of Financial Position (SFP). Ex, Depreciation is added back to non-current assets, Amortization is added back to intangible non-current assets and provision are added back to liabilities (long or short term). Research expenditure expensed in the profit & loss is now capitalized in the Statement of Financial Position (SFP). All items should be adjusted in the way as EVA is used since ever.

Advantage of EVA is that it reduces shortcomings of RI. As mentioned above, it promotes liquidity (Another important aspect of divisional performance), growth and tax effectiveness. It also reduces the problems associated with transfer pricing.

Limitations of EVA is that financial data available from financial statements needs to be adjusted which can be difficult and time consuming. Rationale of some adjustments difficult to justify because it violates the IFRS, such as Accounting depreciation is replaced by economic depreciation.