Changes incorporated in financial accounts while implementing EVA

question 5.

Enlist and explain the changes which are to be incorporated in the Financial Accounts of a company while implementing EVA.

1. Meaning of EVA and Need for Changes

Economic Value Added (EVA) is a measure of economic profit.

EVA = NOPAT – (Capital Employed × Cost of Capital)

where

• NOPAT = Net Operating Profit After Tax (economic profit from operations),
• Capital Employed = funds invested in business operations,
• Cost of Capital = minimum return expected by investors (owners + lenders). Changes incorporated in financial accounts while implementing EVA

Traditional financial accounts are prepared under accounting rules (historical cost, legal form etc.). For EVA we need economic reality of profit and capital. Therefore, several adjustments / changes are made in the financial accounts.

These changes can be grouped as:

1. Changes in Profit figure (to get NOPAT)
2. Changes in Capital Employed
3. Other presentation and disclosure changes

2. Changes in Profit – From Accounting Profit to NOPAT

(1) Elimination of Non-Operating Items

• Remove incomes and expenses which are not related to normal operations, e.g.
  • Profit or loss on sale of fixed assets,
  • Dividend income from investments,
  • Extraordinary gains or losses, donations etc. Changes incorporated in financial accounts while implementing EVA
• EVA is based only on operating performance, so these items are excluded from profit.

(2) Adjusting Interest and Tax

• Profit and Loss Account shows interest as expense and calculates profit after interest and tax (PAT).
• For EVA we require profit available to all providers of capital (equity + debt).
• Therefore:
  • Add back Interest (after tax) to PAT to arrive at NOPAT.
  • Use actual tax relating to operating profit only (ignore tax effect of non-operating items). Changes incorporated in financial accounts while implementing EVA

(3) Capitalisation of Certain Revenue Expenses

Some expenses treated as revenue in financial accounts actually give benefit for many years. For EVA they are treated as capital investments and amortised over useful life.

Examples:

• Heavy advertising and brand-building expenditure
• Research and development (R&D) expenses
• Major employee training and development expenses. Changes incorporated in financial accounts while implementing EVA

Adjustment:

• Add back such expenses to profit (after tax) and create corresponding asset in capital employed, then charge only economic amortisation each year.

(4) Adjustment of Depreciation

• Accounting depreciation is based on historical cost and legal rules.
• For EVA we use economic depreciation (depreciation based on current replacement cost and useful life). Changes incorporated in financial accounts while implementing EVA

Adjustment:

• Add back accounting depreciation and deduct economic depreciation to obtain NOPAT.

(5) Treatment of Provisions and Reserves

• Many provisions (general provisions, contingency reserves) are created by appropriating profit, not true expenses.
• For EVA, only expected operating losses are recognised as expense.

Adjustment:

• Add back excess or purely discretionary provisions and reserves to profit.
• Retain only necessary provisions relating to operations (e.g. specific bad debt provision). Changes incorporated in financial accounts while implementing EVA

(6) Operating Leases

• Under traditional accounts, operating lease rentals are charged as expense.
• In EVA, long-term operating leases are treated similar to financing.

Adjustment:

• Add back annual lease rental (after tax) to profit,
• Recognise a lease asset and corresponding lease liability in capital employed and charge economic depreciation + finance cost instead.

(7) Deferred Tax and Extraordinary Items

• Deferred tax adjustments are accounting entries; they do not represent current cash tax related to operations.
• Extraordinary items (e.g. loss by earthquake, major one-time restructuring) are separated.

Adjustment:

• Remove deferred tax charge/credit from profit while computing NOPAT.
• Exclude extraordinary items from NOPAT and treat them separately.

3. Changes in Capital Employed

To compute the capital charge (Capital × Cost of Capital) we must adjust the Balance Sheet figures from accounting view to economic capital.

(1) Use of Net Operating Assets Only

• Exclude non-operating investments, surplus cash, and assets not used in operations.
• Capital Employed should include only assets engaged in core business operations.

(2) Capitalisation of Intangible and Deferred Costs

• As mentioned earlier, R&D, advertising, training etc. are capitalised.
• Their unamortised balance is added to capital employed as an asset. Changes incorporated in financial accounts while implementing EVA

(3) Adjustment for Revaluation Reserves

• If fixed assets have been revalued, revaluation reserve may distort capital.
• EVA aims at consistent valuation (often replacement cost).

Adjustment:

• Either restate assets at appropriate economic value or eliminate unrealistic revaluation reserves to avoid inflated capital base.

(4) Treatment of Goodwill

• Purchased goodwill shown in the Balance Sheet may not represent current economic value.
• Self-generated goodwill is generally not recorded.

Adjustment (depending on policy):

• Either write off goodwill against reserves (not include in capital employed),
  or
• Include only that goodwill which truly represents economic value. Changes incorporated in financial accounts while implementing EVA

(5) Conversion of Short-Term Financing

• Interest-bearing short-term borrowings which finance fixed assets or permanent working capital are added to capital employed.
• Spontaneous liabilities like trade creditors are normally excluded from capital employed. Changes incorporated in financial accounts while implementing EVA

4. Presentation and Disclosure Changes

While implementing EVA, the company usually:

1. Prepares a reconciled statement showing movement from accounting profit to NOPAT with all adjustments clearly listed.
2. Shows a reconciliation of capital employed from Balance Sheet figures to EVA capital.
3. Discloses cost of capital (WACC), EVA for the year, and comparison with previous years.

This improves transparency and helps shareholders understand the true economic performance of the company.

Conclusion

Implementing EVA requires several changes in traditional financial accounts:

• Profit is converted into Net Operating Profit After Tax by excluding non-operating items, adjusting interest, depreciation, provisions, leases and special expenses.
• Balance Sheet figures are modified to derive economic capital employed, by including only operating assets and capitalising certain intangible/deferred costs. Changes incorporated in financial accounts while implementing EVA

These changes ensure that EVA reflects true economic profit, showing whether the company is really creating value over and above the cost of capital for its shareholders.

If you would like to know the syllabus of Mcom-l Contemporary Accounting, you must visit the official website of Gndu.

👉 Important questions of Contemporary Accounting

1. Influence of other disciplines on Accounting
2. Methods of evaluating Human Resources
3. Importance of Accounting for price level changes
4. Issues involved in corporate Reporting