A Report On Concept Of Income
Economic Concept of income
| A relatively new group of economists called ”ecological economists” believe that continuing macro-economic expansion eventually leads to a decline in sustainable economic welfare. Ecological economists have therefore called for a halt to the high-growth policies being widely adopted by many governments. To support their belief, and to demonstrate how Fisherian income can serve as a useful guide to a nation’s macro-investment policy, a relatively simple formula for calculating Fisherian income is introduced and calculated for Australia for the period 1967–1997. The empirical evidence suggests that Australia may have surpassed its optimal or sufficient macro-economic scale in the mid-1970s. While, around this time, Australia began a transition to a lower rate of growth that arrested the steep decline in per capita Fisherian income, Australia had reverted back to a high-growth policy by the end of the study period. It chose not to continue the deceleration towards a steady-state economy. By 1997, per capita Fisherian income had increased to mid-1970s levels; however, the recent change in Australia’s macro-investment policy is likely to have a detrimental long-term impact on the sustainable economic welfare enjoyed by its citizens. |
Accounting concepts of income
This paper examines how conservative accounting affects the relation between accounting data and firm value. The analysis shows that conservative accounting can be characterized equivalently in terms of book value, earnings, or book rate of return. Furthermore, capitalized earnings generally provide a less biased estimate of equity value than book value does. In addition, firm growth affects the way earnings and book value are combined in valuation. A weighted average of book value and capitalized earnings, with the weight on earnings being an increasing and convex function of growth, yields an asymptotically unbiased estimate of equity value. When growth is positive, the weight on book value is negative.
Author Keywords: Capital markets; Conservative accounting; Equity valuation; Book rate of return; Residual income
JEL classification codes: M41; G12
How accounting gets more radical in measuring what really matters to investors
A corporate balance sheet, prepared according to generally accepted accounting principles, does a reasonable job informing about the physical assets and financial capital employed by a company. But when it comes to the increasingly important intangible assets of corporate enterprises, it provides next to no insight. Usual financial reporting reveal very little that’s meaningful to assess if a corporation is successful or not when it owns a considerable portion of intangible assets. And intangible assets such as the value of the relationship to the people or organizations a company sells to (customer value), the value of the relationship to organizations or individuals through which a company sells or is doing business with in general (business partner network value), the R&D pipeline of new leading edge products that will increase a company’s market share and will generate new revenue and free cash flow in the future (R&D pipeline or innovation capital), a highly skilled and talented work force which is committed to the company (human capital), leading edge business processes, organization structures and a corporate culture that help to convert individual knowledge and skills of employees into relationship value and innovation capital which the company owns when employees go home (structural capital), represent the major value drivers of today’s new economy and the basis for innovation, economic growth and wealth – both for companies and nations.
Under GAAP, expenditures made to increase brand awareness, to foster innovation, or to improve the productivity of employees cannot be capitalized. Instead, the logic goes, they must be expensed through the income statement, because the future benefits of such investments are so uncertain. The problem is, that corporate investments in tangible assets have stagnated while corporate value creation has surged at the same time. The S&P 500 index, reflecting the market value of the major U.S. corporations, surged between 135.76 at the end of 1980 to 1342.62 on November 20, 2000 – a ten fold increase. In the same period investments into tangible assets in the U.S. (as a percentage of corporate GDP) decreased from 14.1% in the 1980s to 12.6% in the 1990s (see Leonard Nakamura, “Intangibles: What put the New in the New Economy”, page 4). This suggest, that a large portion of the growth in corporate value over the past two decades has been created through investments into intangibles, for which financial reporting and accounting does not account for. It is the investments in R&D, in organizational innovation and organizational capital, in marketing and customer acquisition, that drive the performance of companies today.
If you look at the average return for financial, physical and intellectual assets, this becomes very clear:
Financial
Ten-year average return on U.S. Treasury bonds:4.5%
Physical
Average ROE for all companies with physical assets and inventories:7.0%
Intangible
Average expected return on equity for biotech and software industries:10.5%
This was the result of studies conducted by Baruch Lev, Professor of Accounting and Finance with the Stern School of Business at New York University. In a study for the chemical industry he found, that R&D investments of 83 companies over a span of 25 years returned 17% after tax, whereas capital spending earned just the cost of capital of 8%. So investments into intangible assets remain not only invisible through the traditional accounting approach, they are also the investments that yield the highest return ! So accountants and CFOs obviously need to do something about it to make this hidden value drivers more manageable and provide investors with more useful information.
Traditional accounting does not help to manage and to report on Intangible Assets
But unfortunately the value creation process of this type of investments is hard to grasp. We had long had a good idea of how to value manufacturing inventory or assess what a factory is worth. Today, the value of R&D invested in a software program, or the value of a user base of an Internet shopping site like Amazon.com is a lot harder to quantify. As intangible assets continue to grow in both size and scope, more and more people are questioning whether the true value – and the drivers of that value – is being reflected in a timely manner in accounting and in publicly available disclosure. Accounting’s fundamental purpose is to provide information that is useful in making rational investment, credit, and similar decision. In 1978 book value, as presented in the balance sheet of companies, was on average around 95% of the market value of companies in the US. Twenty years later, book value was just 28% of market value. So investors simply don’t value what accountants count.
How to change the actual and insufficient measurement, accounting and disclosure practice ?
In October 1999, former Chairman of the U.S. Securities and Exchange Commission (SEC), Arthur Levitt, asked Dean Jeffrey E. Garten of the Yale School of Management to form a task force of leaders from the business community, academia, the accounting profession, standard setting bodies, and corporate America to examine how the current business reporting framework can more effectively capture these momentous changes in the economy. On June 06, 2001 the task force presented its final report “Strengthening Financial Markets: Do Investors Have The Information They Need?”. In that report the task force made two recommendations for improvements:
1. Create a new framework for supplement reporting of intangible assets. It recommends that the SEC pull together the work that has already been done by academics, the accounting firms and projects sponsored by organizations such as the U.S. Financial Accounting Standards Board (FASB) in order to move forward with a framework for voluntary supplement reporting for intangible assets, operating performance measures and other information that would help investors to assess a company’s future performance. Such a framework of voluntary supplement reporting should complement existing GAAP-based financial statements by creating a common language for companies and investors to communicate about intangible assets and operating performance measures.
2. Create an environment that encourages innovation in disclosures. In addition to working to create a framework for disclosures about intangible assets and operating performance measures, the task force believes that the government should take as many actions as it can to create an environment that encourages innovative disclosures by reducing the risks associated with doing so. Many members of the tasks force felt, that the actual legal situation in the U.S. has discouraged companies from experimenting with supplement disclosures, despite already existing “safe harbour” provisions. The task force recommends to protect companies, who are willing to disclose more information, by new laws and/or new regulations from legal actions from shareholders. Companies should be permitted to provide more “soft” and speculative information as long as they warn investors that the information is speculative and provide explicit definitions about how such information is constructed. This could be done for example through a special marked section on a company’s investor relations website.
What is supplement accounting or reporting?
Some innovators, like the Swedish financial service company Skandia, already introduced a supplement report to its annual report 1998. Under the leadership of Leif Edvinsson, its former director of Intellectual Capital Management, Skandia has pioneered a new system for visualizing and developing intellectual, intangible and organizational business assets, which it used to manage the business internally but also to report to the public in the form a supplement report to its annual report
He developed the “Navigator”, a kind of Balanced Scorecard, to do that. The Navigator consists of five value-creating fields which present measure and key performance indicators for each area (see figure 1): The financial sector represents the stored past, the company’s achievements so far. The company’s people, customers, and processes are its very existence. Its innovation and development powers form the foundation, its future perspective, the new bottom line.
The Navigator provides, beside financial results, ratios and measures on the status of Skandia’s intangibles assets, such as number of customer contracts, which gives an indication of the value created for customers, such as number of contracts per employee, which gives an indication about effectiveness of processes and about organizational effectiveness at large. Another example is share of premiums from new launches (products), which gives an indication about the success of past product innovation (see the supplementary report of Skandia, the navigator, for 1998). This navigator at Skandia was the basis both for business planning and management as well as for outside reporting in form of a supplement report.
A new income statement and balance sheet
Another proposal for overhauling accounting and disclosure is, to change the structure and content of traditional financial statements such as the income statement, balance sheet, and cash flow statement.
The “old” income statement highlights the most important cost of the production orientated era: the costs of goods sold. When raw materials and direct labours made up most of a product’s cost, that was an important information for managers and investors. But today, intangible based businesses have very low variable costs or costs of goods sold, but high fixed costs or initial investments – for example into R&D or brand building. So costs of good sold is not that important any more.
Marketing costs and costs spend for R&D are much more important. And also profit is not a reliable indicator of performance any more. Often profit has become a subjective number that depends on when revenues and expenses are recognized. This is because the relationship between revenues and costs/expenses is not that tight anymore with intangible assets based business. You invest today into R&D to get some day in the future revenues out of that – hopefully.
So one proposal, which was often made in the last couple of years, was to change to cash based accounting. If you take the other topics mentioned above into account and remove interest expense (an financing activity – I come back to that), the format of the new income or operating statement could look like that:
Revenues
·
minus costs to serve customers
·
minus costs to produce products/services
·
minus costs to develop products/services
·
minus admin costs
Earnings before interest and taxes
minus taxes plus/minus non-cash adjustments
Cash Earnings
This change of the income statement should give readers an idea where a company spends money and it replaces manipulated “profit” with easy to verifiable cash money (you just have to look at the bank account). It focuses on the important tasks of companies today: taking care of customers (sales and marketing, shipping, service), producing things to sell (manufacturing or providing services, materials, equipment), and producing future offerings (research and development, knowledge creation). And it makes admin costs, a proxy for efficiency, visible and does not lump it into an item “sales, general, and administrative costs”.
The balance sheet is usually a snapshot of what resources (assets) a company controls and where it got the money to buy or built them (from shareholders/equity or through borrowings from third parties). In many industries today outsourcing of operations (and of the corresponding physical assets) has become usual. And some companies, like retailers, work with negative working capital. So today’s companies need less of physical assets or working capital to do their job. So it is not control of resources versus funding of these resources what has to be in the focus of today’s companies, but investments, mainly investments into the future, into intangible assets versus financing of these investments.
So the new balance sheet should not compare assets with liabilities and equity but investments with financings. On the investment side you will then find, beside working capital and fixed assets, intangible assets. And intangible assets like the R&D pipeline, the know-how of a work force, brand equity and a large customer base, relationships to business partners, are the real assets of knowledge-intensive companies. Therefore money spend on them should be treated and booked as investments. A balance sheet like this answers questions managers and investors need to ask: What are you really doing with the money you raise ? How are you investing into the future ?
And the task of the new cash flow statement is not any more to tell about a companies effectiveness in using financial resources (that does the new operating statement and balance sheet). Managers and investors need to know how much cash a business produces over and above what’s needed to operate it: free cash flow. So the new cash flow statement might take cash earnings (from operating statement), deduct from that investing activities (into working capital, fixed assets, and intangible assets), and get as a result free cash flow.
With that approach, companies will be better able to focus on the real concern of business under today’s condition and under the growing dominance of intangible assets: producing cash and creating value.
Get more radical: Calculate Knowledge-Capital Earnings (KCE)
Another approach, more from a macro perspective, is, to start with a company’s performance – company earnings – and then go inside and identify what assets produced the earnings. This is an approach proposed by Baruch Lev, who was mentioned already above:
Start with a company’s earnings, for example $500 million and then look at its balance sheet to see what it has in financial (for example $1 billion) and physical assets (another $2 billion). As it was outlined above, the average after-tax return of financial assets is about 4.5% and of tangible assets it is 7%. So $45 million and $140 million respectively of the total earnings can be credited to financial and tangible assets. So $315 million must have been produced by other assets. Baruch Lev calls that residual “knowledge-capital earnings” (KCE). He then calculates the knowledge capital itself by dividing the earnings by an expected rate of return on knowledge assets (10.5% – see above). So, to produce $315 million in earnings, that company would need $3 billion in intangible assets.
With Marc Bothwell, a vice president of Credit Suisse Asset Management, Baruch Lev has been investigating the implications of his work. They analysed and ranked for the third time leading American companies in 22 nonfinancial industries by knowledge capital through a so called Knowledge Capital Scorecard. The result was published in CFO Magazine in April, 2001. And it indicates clearly the value of incorporating knowledge capital into investment analysis. For example, the Scorecard shows that the market valuations of such New Economy stars as Dell Computer, Microsoft, and Intel, as well as knowledge-intensive companies in the pharmaceutical and biotech industries, have very little to do with the assets reflected on their balance sheets. Their stocks trade at huge multiples of book value (examples: Dell, 17.5; Pfizer, 18.2). But when knowledge capital is added to book value (a sum deemed comprehensive value by Baruch Lev), the ratio of market value to that comprehensive value becomes far more reasonable: Dell, 1.26; Pfizer, 1.90.
And Companies with a ratio of market value to comprehensive value significantly above 1 can be viewed as overvalued. Those with a ratio below 1 are probably undervalued. The negative correlation between this ratio and the subsequent stock returns of the 105 companies evaluated in the Scorecard was remarkably strong. Between the August 31, 2000, cutoff date for the Scorecard analysis and the end of last year, the average weighted return of 53 companies with a ratio of market value to comprehensive value below the median of 1.08 was 7 percent. For the 52 companies with a ratio above the median, the average return was -15.5 percent.
Companies with some of the highest ratios, such as Broadcom (8.5) and Siebel Systems (5.8), have since experienced some of the most severe slides in the stock market. Broadcom was down 80 percent since last August, and Siebel is down 60 percent compared with their stock value in April 2001. In contrast, companies trading at low multiples of comprehensive value fared far better. The shares of Rockwell International, for example, with a ratio of 0.62, and Georgia Pacific (0.35) were both up 15 percent over the same period.
Summary
As we have seen, there are serious reasons to reengineer the traditional accounting approach and how business information for management and investors is prepared. There are already different concepts and methodologies available – each with a different focus. The solution probably lies in a combination of these different approaches and of some other important aspects into a new comprehensive accounting, management and reporting system. The design of that new system will need the engagement of consultants, accounting professionals, academics and practitioners. And it will take some time. Therefore I will continue here and in my forthcoming “Intangible Assets oder die Kunst, Mehrwert zu schaffen: Erfolgreiche Unternehmensführung im Zeitalter des Intellectual Capital” (“Intangible Assets or the Art to Create Value: Successfull Enterprise Management in the Era of Intellectual Capitalism”) to present the actual status of discussion and the new evolving concepts.
More about about New Economy Economics and Management Best Practice in general, and about other related topics will be continued here in this new New Economy Analyst reports.
Interest cost
This Chapter does not set out to do more than refer to some salient points on <href=”#costs” target=”toc”>costs relevant to <href=”#proceedings” target=”toc”>proceedings in the Chancery Division. In particular it does not deal with the processes of detailed assessment or <href=”#appeal” target=”toc”>appeals in relation to such assessments.
A number of provisions in respect of <href=”#costs” target=”toc”>costs in the CPR and in the PD<href=”#top” target=”toc”>pdp-43, <href=”#top” target=”toc”>pdp-48. Supplementing <href=”#top” target=”toc”>Parts 43 to <href=”#top” target=”toc”>48 (<href=”#Costs” target=”toc”>Costs PD<href=”#top” target=”toc”>pdp-43) are likely to be relevant to Chancery <href=”#proceedings” target=”toc”>proceedings:
| (1) | Informing the client of costs orders: Solicitors have a duty to tell their clients, within 7 days, if an order for costs is made against them and they were not present at the hearing. Solicitors must also tell anyone else who has instructed them to act on the case or who is liable to pay their fees. They must inform these persons how the order came to be made (rule 44.2; Costs PD, paragraph 7.1). |
| (2) | Providing the court with estimates of costs: The court can order a party to file an estimate of costs and to serve it on the other parties. (Costs PD, paragraph 6.3). This is to assist the court in deciding what case management orders to make and also to inform other parties as to their potential liability for costs. In addition parties must file estimates of costs when they file their allocation questionnaire or any listing questionnaire (Costs PD, paragraph 6.4). |
| (3) | Summary assessment of costs: An outline of these provisions is given below. Their effect is that in the majority of contested hearings lasting no more than a day the court will decide, at the end of the hearing, not only who is to pay the costs but also how much those costs should be, and will order them to be paid, usually within 14 days. As a result the paying party will have to pay the costs at a much earlier stage than before. |
| (4) | Interim orders for costs: Where the court decides immediately who is to pay particular costs, but does not assess the costs summarily, for example after a trial lasting more than a day, so that the final amount of costs payable has to be fixed by a detailed assessment, the court may order the paying party to pay a sum or sums on account of the ultimate liability for costs. |
| (5) | Interest on costs: The court has power to award interest on costs from a date before the date of the order, so compensating the receiving party for the delay between incurring the costs and receiving a payment in respect of them from the paying party. |
Summary Assessment
The court will generally make a summary assessment of <href=”#costs” target=”toc”>costs whenever the hearing lasts for less than one day. The judge or Master who heard the application or other hearing (which will include a <href=”#trial” target=”toc”>trial, or the hearing of a <href=”#top” target=”toc”>Part 8 Claim, lasting less than a day) carries out the summary assessment. The court may decide not to assess <href=”#costs” target=”toc”>costs summarily either because it orders the <href=”#costs” target=”toc”>costs to be “costs in the case” or because it considers the case to be otherwise inappropriate for summary assessment, typically because substantial issues arise as to the amount of the <href=”#costs” target=”toc”>costs claimed. <href=”#Costs” target=”toc”>Costs payable to a party funded by the Legal Services <href=”#Commission” target=”toc”>Commission cannot be assessed summarily.
In order that the court can assess <href=”#costs” target=”toc”>costs summarily at the end of the hearing each party who intends to claim <href=”#costs” target=”toc”>costs must, no later than 24 hours before the time fixed for the hearing, serve on the <href=”#otherxparty” target=”toc”>other party, and file with the court, his or her statement of <href=”#costs” target=”toc”>costs. Paragraph <href=”#rh-pdp-13.5″ target=”toc”>13.5 of the <href=”#Costs” target=”toc”>Costs PD<href=”#top” target=”toc”>pdp-44 contains requirements about the information to be included in this statement, and the form of the statement. Failure by a party to file and serve his or her statement of <href=”#costs” target=”toc”>costs as required by paragraph <href=”#rh-pdp-13.5″ target=”toc”>13.5 of the <href=”#Costs” target=”toc”>Costs PD<href=”#top” target=”toc”>pdp-44 will be taken into account by the court in deciding what order to make about <href=”#costs” target=”toc”>costs and could result in a reduced assessment, in no order being made as to <href=”#costs” target=”toc”>costs, or in the party being penalised in respect ofthe <href=”#costs” target=”toc”>costs of any further hearing or detailed assessment hearing which may be required as a result of the party’s failure.
Where the <href=”#receivingxparty” target=”toc”>receiving party (the party to whom the <href=”#costs” target=”toc”>costs are to be paid) is funded by the Legal Services <href=”#Commission” target=”toc”>Commission the court cannot assess <href=”#costs” target=”toc”>costs summarily. It is not, however, prevented from assessing <href=”#costs” target=”toc”>costs summarily by the fact that the <href=”#payingxparty” target=”toc”>paying party (the party by whom the <href=”#costs” target=”toc”>costs are to be paid) is so funded. A summary assessment of <href=”#costs” target=”toc”>costs payable by a person funded by the Legal Services Commissionis not by itself a <href=”#determination” target=”toc”>determination of the amount of those <href=”#costs” target=”toc”>costs which the funded party is to pay (as to which see section 11 of the Access to Justice Act 1999 and regulation 10 of the Community Legal Services (<href=”#Costs” target=”toc”>Costs) <href=”#Regulations” target=”toc”>Regulations 2000). Ordinarily, where <href=”#costs” target=”toc”>costs are summarily assessed and ordered to be paid by a funded person the order will provide that thedetermination of any amount which the person who is or was in receipt of services funded by the Legal Services <href=”#Commission” target=”toc”>Commission is to pay shall be dealt with in accordance with regulation 10 of the <href=”#Regulations” target=”toc”>Regulations
The amount of <href=”#costs” target=”toc”>costs to be paid by one person to another can be determined on the standard basis or the indemnity basis. The basis to be used is determined when the court decides that a person should pay the <href=”#costs” target=”toc”>costs of another. The usual basis is the standard basis and this is the basis that will apply if the order does not specify the basis of assessment. <href=”#Costs” target=”toc”>Costs that are unreasonably incurred or are unreasonable in amount are not allowed on either basis.
On the standard basis the court only allows <href=”#costs” target=”toc”>costs which are proportionate to the matters in issue. If it has any doubt as to whether the <href=”#costs” target=”toc”>costs were reasonably incurred or reasonable and proportionate in amount, it resolves the doubt in favour of the <href=”#payingxparty” target=”toc”>paying party. The concept of proportionality will always require the court to consider whether the <href=”#costs” target=”toc”>costs which have been incurred were warranted having regard to the issues involved. A successful party who incurs <href=”#costs” target=”toc”>costs which are disproportionate to the issues involved and upon which he or she has succeeded will only recover an amount of <href=”#costs” target=”toc”>costs which the court considers to have been proportionate to those issues.
On the indemnity basis the court resolves any doubt it may have as to whether the <href=”#costs” target=”toc”>costs were reasonably incurred or were reasonable in amount in favour of the <href=”#receivingxparty” target=”toc”>receiving party.
The court must take into account all the circumstances, including the parties’ conduct and the other matters mentioned in <href=”#rh-cpr-44.5″ target=”toc”>rule 44.5. Indemnity <href=”#costs” target=”toc”>costs are not confined to cases of improper or reprehensible conduct. They will not, however, usually be awarded unless there has been conduct by the <href=”#payingxparty” target=”toc”>paying party which the court regards as unreasonable or unless the case falls within <href=”#rh-cpr-48.4″ target=”toc”>rule 48.
A party must normally pay <href=”#costs” target=”toc”>costs which are awarded against him or her and summarily assessed within 14 days of the assessment. But the court can extend that time (<href=”#rh-cpr-44.8″ target=”toc”>rules 44.8, <href=”#rh-cpr-3.1(a)” target=”toc”>3.1(a)). The court may therefore direct payment by instalments, or defer the liability to pay <href=”#costs” target=”toc”>costs until the end of the <href=”#proceedings” target=”toc”>proceedings so that the <href=”#costs” target=”toc”>costs can then be set against any <href=”#costs” target=”toc”>costs or judgment to which the <href=”#payingxparty” target=”toc”>paying party then becomes entitled.
If the parties have agreed the amount of <href=”#costs” target=”toc”>costs, they do not need to file a statement of the <href=”#costs” target=”toc”>costs, and summary assessment is unnecessary. If the parties to an application are able to agree an order by consent without the parties attending they should also agree a figure for <href=”#costs” target=”toc”>costs to be inserted in the order or agree that there should be no order as to <href=”#costs” target=”toc”>costs. If the <href=”#costs” target=”toc”>costs position cannot be agreed then the parties will have to attend on the appointment but unless good reason can be shown for the failure of the parties to deal with <href=”#costs” target=”toc”>costs as set out above no <href=”#costs” target=”toc”>costs will be allowed for that attendance.
The court finds it most unsatisfactory if parties agree the terms of a consent order but not the provision for <href=”#costs” target=”toc”>costs. Depending on the facts and circumstances, the court may not be able to decide on the question of <href=”#costs” target=”toc”>costs without hearing the application fully, but it is not likely to be consistent with the overriding objective to allow the necessary amount of court time to the dispute on <href=”#costs” target=”toc”>costs in such a case. The court may then have to decide the <href=”#costs” target=”toc”>costs issue on a broad brush approach, making an order against one party or the other only if it is clear, without spending too much time on it, that such an order would be appropriate, and otherwise making no order as to the <href=”#costs” target=”toc”>costs.
Conditional fee agreements
The court should be informed, on any application for the payment of <href=”#costs” target=”toc”>costs, if any party has entered into a <href=”#conditionalxfeexagreement” target=”toc”>conditional fee agreement. The court can then consider whether, in the light of that agreement, to stay the payment of any <href=”#costs” target=”toc”>costs which have been summarily assessed until the end of the action, or to decline to order the payment of <href=”#costs” target=”toc”>costs on account under <href=”#rh-cpr-44.3(8)” target=”toc”>rule 44.3(8).
Over the past decade, companies increasingly have been called on to create more value for their owners. Led by aggressive institutional shareholders like the California Public Employees Retirement System and fueled by widely published reports of overcompensated executives, shareholders are demanding that managers be given incentives to focus on corporate value creation. Consulting firms have responded with a host of new performance metrics. Some of the most popular are known as “economic value added,” “flow return on investment” and “economic profit.”
Whatever they’re called, they’re catching on fast. “The number of firms that have chosen to adopt value-based performance measures in recent years has shot up dramatically,” says Stefan Reichelstein, professor of accounting at the Graduate School of Business. “According to some estimates, around 200 of the Fortune 1000 firms are now using some value-based metric to measure the performance of their top-level managers.”
Economic value added has become so popular a concept that its acronym actually has been trademarked by consulting firm Stern Stewart & Co. Still, it’s not really new. “The concept of economic value added has been known for quite some time in the accounting literature as ‘residual income,'” Reichelstein says. “It’s really a very simple formula: accounting income, properly measured, less a capital charge for the assets used by that particular business or division.
“In contrast to ordinary accounting income, residual income is fundamentally compatible with present value considerations. That aspect in turn is critical in motivating managers to make long-term decisions that enhance the overall net present value of the firm.”
Which is all well and good. But the problem remains that managers may not be willing to engage in projects that increase value way down the line, value that isn’t measured — and therefore rewarded — now. “This is where the accounting rules come in,” Reichelstein says. “Good accounting rules allocate current and expected future cash flows so as to reflect value creation in the performance measure early on and consistently over time. That way, it is of less importance whether managers have shorter planning horizons than shareholders.”
Economic value added and similar formulas proposed in the “war of the metrics” all make adjustments to the accounting rules used for external financial reporting. But which of these adjustments is most effective in aligning the objectives of managers and shareholders remains a subject of lively debate.
In a paper that won the Best Paper Award at the Review of Accounting Studies conference at Cornell University last year, Reichelstein and Sunil Dutta, assistant professor of accounting at the Haas School of Business, University of California-Berkeley, analyze a model that compares the effectiveness of alternative performance metrics and accounting rules. The study, “Controlling Investment Decisions: Depreciation and Capital Charges,” focuses on capital investment decisions and the choice of depreciation method to account for these investments.
Dutta and Reichelstein establish that residual income, or economic value added, is indeed an efficient performance metric. When combined with particular depreciation schedules, residual income can align the objectives of shareholders and management consistently over time. In general, these depreciation schedules will differ from the common straight-line method used for external financial reporting purposes. The model analysis also shows how the capital charge rate used for performance evaluation purposes should vary with the riskiness of the investment project.
The authors believe their theoretical framework is useful for sorting out the many recommendations and prescriptions expressed in the growing field of value-based management. “Controlling Investment Decisions” analyzes one particular problem, capital investment decisions. But for other assets, such as receivables, inventory or multi-year construction contracts, similar issues arise.
“So once again the question is: To make the performance measure as effective as possible, how should the accounting be done?” says Reichelstein. He and Dutta broaden their inquiry in a related paper, “Stock Price, Earnings and Book Value in Managerial Performance Measures.”
“The setting in this paper is richer,” says Reichelstein, “in that you can base performance evaluation on both stock price and the accounting numbers. Stock price obviously is what shareholders ultimately care about. From a performance evaluation perspective, however, one drawback of stock price is that it aggregates all value-relevant information even though some factors are beyond the manager’s control. Accounting-based performance measures can mitigate that problem, and therefore you want both.” In this second paper, the authors identify the need for performance measures that are calculated as a properly weighted average of market value added and economic value added.
There is growing evidence that value-based management does deliver for shareholders. Reichelstein and his colleagues in academia predict that further analytical and empirical research will explain why and how. They believe that the interest in these metrics isn’t likely to lessen. After all, Reichelstein says, “People in the field realize the old adage that ‘whatever gets measured also gets delivered.'” SR
Comprehensive income
Comprehensive income is defined by the Financial Accounting Standards Board, or FASB,[1] as “the change in equity [net assets] of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.”
Comprehensive income is the sum of net income and other items that must bypass the income statement because they have not been realized, including items like an unrealized holding gain or loss from available for sale securities and foreign currency translation gains or losses. These items are not part of net income, yet are important enough to be included in comprehensive income, giving the user a bigger, more comprehensive picture of the organization as a whole.
Items included in comprehensive income, but not net income are reported under the accumulated other comprehensive income section of shareholder’s equity.
Economic
Comprehensive income (or earnings) [2] attempts to measure the sum total of all operating and financial events that have changed the value of an owner’s interest in a business. It is measured on a per-share basis to capture the effects of dilution and options. It cancels out the effects of Equity transactions for which the owner would be indifferent; issues of dividends; share buy-backs; share issues at market value.
It is calculated by reconciling the the book-value-per-share from the start of the period to the end of the period. This is conceptually the same as measuring a child’s growth by finding the difference between his height on each birthday. All other line items are calculated, and the equation solved for Comprehensive Earnings.
Shareholders’ Equity, beg. of period
– Dividends
+ Premium to book value received from new shares
(and vice versa)
+ Comprehensive Earnings (and vice versa)
——————————————
= Shareholders’ Equity, end of period
Income Taxes
Income tax expense is a substantial cost of business. Understanding accounting for income taxes is important to successful analysis of financial statements. The discussion here focuses on the accounting and analysis of periodic income tax expense and not on tax law.
Accounting for income tax
The accounting and reporting standards for income require both an assets and a liability approach. Specifically deferred taxes are determined separately for each tax-paying component in each tax jurisdiction. Determination includes the following procedures:
Identifying the types and amounts of temporary difference and the nature and amount of each type of operating loss and tax credit carryforward including the remaining length of the carryforward period.
Measuring total deferred tax liability for taxable temporary difference using the applicable tax rate.
Computing the total deferred tax asset for deductible temporary difference and the operating loss carryforwards using the applicable tax rate
Measuring deferred tax assets for each type of tax credit carryforward.
Reducing deferred tax assets by a valuation allowance if based on the weight of available evidence, it is more likely than not some portion or all deferred tax assets will not be realized
Permanent Income tax difference
Items are nontaxable for example, income on tax-exempt bonds and the life insurance proceeds on an employee.
Deduction are not allowed; for example penalties for filing certain returns, government fines and employee life insurance premiums.
Special deductions are granted: for example tax exclusion on dividend form unconsolidated subsidiaries or from other domestic corporation
The effective tax rate paid by a company on net income can vary from the statutory rate for many reasons including;
Basis of property differs for financial and tax accounting due to reorganization or combination.
Non- qualified and qualified stock option plans.
Special tax privileges, for example, in savings and loan associations, shipping lines or insurance companies.
Lower corporate income tax rate up to a certain level.
Tax credits, for example; research& development credits or foreign tax credit
Different tax rate on foreign income.
Tax expense that includes both state and local income taxes, net of federal tax benefit.
Tax loss carryorward benefits.
Temporary income tax differences
Unlike permanent differences, temporary differences are expected to affect taxable income at some future time/ that is, they are expected to reverse.
Income tax disclosures
Companies disclose the following components of the net deferred tax liability or net deferred tax assets as recognized on their balance sheets:
Total deferred tax liability
Total deferred tax assets.
Total valuation allowance recognized for deferred tax assets.
Additional disclosures are also available on the components of income tax expense for each year reported, including:
Current expense or benefit.
Deferred tax expense or benefit.
Investment tax credits.
Government grants
Benefit of operating loss carryforwards.
Tax expense resulting from allocating tax benefit to either contributed capital or goodwill deduction or another noncurrent intangible assets of an acquired entity.
Adjustment in the beginning of the year balance of the valuation allowance due to circumstances yielding a revised estimate of the realizability of the deferred tax asset in future period.
Adjustment in deferred tax liability or deferred tax assets due to changes in tax laws or rates or status of a company.
Analyzing income taxes
Our analysis must understand the relation between pre tax income and income tax expense. We should remember that procedures applied to loss carryforwards differ from those applied to carryback.tax loss carrybacks result in a tax refund in the loss year and recognized as an asset. A loss carryfoward results in deferred asset. This deferred tax assets is reduced by a valuation allowance to the extent” it is more likely than not” that all or part of it will not be realized by a reduction of taxes payable during the carryforward period.
Our analysis of components of deferred income tax expense can also yield insights. Through evaluation of components we can learn about capitalization of cost, early recognition of revenues and other discretionary accrual adjustment. We can also acquire information about expected future reduction in deferred income taxes.