Page 79 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Management Control Systems

Notes the EVA. To overcome this, outlays on strategic investments are held back in suspense
account and thus, are kept out from capital charge for calculating EVA, till the time the
investment is expected to generate operating profits. In the meanwhile, capital charges
are added to the suspense account so that the balance in that account may reflect the full
opportunity cost (original investment plus capital charges thereon) of the investment.
3. Expense recognition: Companies incur substantial marketing costs to establish brands,
enter new markets, expand capital base, and gain market share. Under GAAP, they are
normally, treated as current period expenses though they are expected to generate benefits
over a long period of time. Under the EVA system, these outlays are capitalized and
appropriated over an appropriate period.

4. Depreciation: In GAAP, the straight line method of depreciation works reasonably well.
However, for significant amounts of long-lived assets, the use of straight-line method of
depreciation in calculating EVA can be a hindrance towards new investments, since under
the EVA system, the capital charge declines as the book value of the assets decreases on
account of depreciation. Hence, the managers are reluctant to replace 'cheap' old assets
with 'expensive' new assets. One method to eliminate this distortion may be to replace
straight line depreciation with sinking fund depreciation. Under the sinking fund method,
the annual depreciation is small initially, but rises over the life of the asset. It behaves like
the principle payment in a mortgage. If the sinking fund method of depreciation is used,
the sum of the depreciation charge and the EVA sinking fund method of depreciation is
used, the sum of the depreciation charge and the EVA capital charge remains constant over
time, exactly like the mortgage payment.
5. Restructuring Charges: Under GAAP, a restructuring charge is treated as a loss on an
investment that has turned bad. Such a charge leads to reduction in reported earnings and
hence managers tend to postpone restructuring. Under the EVA system, a restructuring
opportunity is welcomed as it facilitates a more productive deployment of capital. The
solution is, instead of treating as a loss consider as restructuring investment in the balance
sheet.
6. Taxes: Companies use an accelerated method of depreciation (like the written down value
method) for computing taxable profits for tax purposes and a slower method (straight line
method) for shareholder reporting purposes. Hence, the provision for income tax as per
GAAP earning statement (referred as book taxes) differs from the cash taxes a company
actually pays. The differences between book taxes and cash taxes go into a liability account
called deferred taxes which are presumably payable in future. The problem with this
accounting treatment is that most companies never pay their deferred taxes. Hence, from
economic point of view what matters is the tax the company pays now and not what it may
have to pay in future. So, for calculating NOPAT, only cash taxes must be deducted.
Correspondingly, deferred tax liability must be treated as quasi-equity and included as a
part of shareholders' funds.
7. Marketable Securities: Companies often hold marketable securities which do not represent
capital used for generating operating profit. The investment in them should be excluded
from the capital employed in the firm and the income from these investments should not
be included in NOPAT.

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