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Abstract:
Economic Value Added (EVA) has attracted considerable attention as an alternative to traditional accounting earnings for use in both valuation and incentive compensation. With a host of consultants now marketing related metrics, numerous claims have been made - most based on anecdotal evidence or in-house studies. This paper summarizes independent evidence regarding EVA's alleged advantages. We begin by reviewing the theory that links the underlying concept of residual income to shareholder value. Second, we discuss how Stern Stewart modifies residual income to produce its proprietary EVA metric and show how median EVA compares with residual income, net income and operating cash flows over the period 1988-97. Third, we examine the claim that EVA is more closely associated with stock returns and firm value than is net income. The evidence indicates that EVA does not dominate net income in associations with stock returns and firm values. Fourth, we examine a second claim that compensation plans based on residual income motivate managers to take actions consistent with increasing shareholder value. Here, the independent evidence suggests that managers do respond to residual income-based incentives. Finally, we discuss how a metric such as EVA can be useful for internal incentive purposes even if it conveys little news to market participants regarding the firm's valuation.

Abstract:
Accountants and economists have claimed that residual income has attributes superior to reported accounting earnings. In recent years, Stern Stewart & Co. has successfully marketed a variant of residual income ("economic value added"; or EVA?) to U.S. and international corporations. The purpose of this paper is to 1) empirically test assertions that EVA is more highly associated with stock market returns and firm values than are earnings and cash from operations, and 2) evaluate which components of EVA, if any, are contributing to its association with stock returns.

We first compare the relative information content of residual income and EVA versus two currently mandated performance measures, earnings and cash from operations. Results for the full sample suggest that, while each measure is individually significant, earnings is more highly associated with market-adjusted returns than is residual income, EVA, or cash from operations. Next, we conduct incremental information content tests on components of EVA (e.g., cash from operations, operating accruals, capital charge, and accounting "adjustments";). Results suggest that cash from operations and accruals are of primary importance while EVA components are statistically significant only in some samples. Finally, we conduct sensitivity analyses by repeating our tests using: a) subsets of firms categorized into "firm-types" by Stern Stewart; b) positive and negative values of each independent variable to allow the regression coefficients to differ; c) subsets of firms that report using EVA for internal business decisions; and d) five-year return intervals. Considered together, these results do not support claims that EVA dominates earnings in relative information content, and suggest rather that earnings generally outperforms EVA.

Abstract:
This study tests assertions that Economic Value Added (EVA) is more highly associated with stock returns and firm values than accrual earnings, and evaluates which components of EVA, if any, contribute to these associations. Relative information content tests reveal earnings to be more highly associated with returns and firm values than EVA, residual income, or cash flow from operations. Incremental tests suggest that EVA components add only marginally to information content beyond earnings. Considered together, these results do not support claims that EVA dominates earnings in relative information content, and suggest rather that earnings generally outperforms EVA.

Value-relevance, relative information content, incremental information content, firm market value, economic value added, EVA, residual income, economic profits, earnings, cash from operations, charge for capital.

Abstract:
Economic reasoning suggests that capital follows profitability. This study introduces into residual income valuation "capital follows profitability" investment dynamics whereby capital investments are guided by the profitability of underlying investment opportunities. These investment dynamics predict convex versus linear relations between future and current residual income, with slope and convexity dependent on investment opportunity. We test these predictions against the linear information dynamics (LID) proposed by Ohlson (1995) and Feltham and Ohlson (1996), with supportive results. These findings point the way to further development of links between firm value and the economics of value creation.

Abstract:
Economic reasoning suggests that capital follows profitability. This study introduces into residual income valuation "capital follows profitability" investment dynamics whereby capital investments are guided by the profitability of underlying investment opportunities. These investment dynamics predict convex versus linear relations between future and current residual income, with slope and convexity dependent on investment opportunity. We test these predictions against the linear information dynamics (LID) proposed by Ohlson (1995) and Feltham and Ohlson (1996), with supportive results. These findings point the way to further development of links between firm value and the economics of value creation.

Residual Income, Valuation, Linear Information Dynamics, Investment Dynamics, Non-linear Residual Income Dynamics

Abstract:
Prior evidence that higher quality financial reporting improves capital investment efficiency leaves unaddressed whether it reduces over- or under-investment. This study provides evidence of both in documenting a conditional negative (positive) association between financial reporting quality and investment for firms operating in settings more prone to over-investment (under-investment). Firms with higher financial reporting quality also are found to deviate less from predicted investment levels and show less sensitivity to macroeconomic conditions. These results suggest that one mechanism linking reporting quality and investment efficiency is a reduction of frictions such as moral hazard and adverse selection that hamper efficient investment.

Financial Reporting Quality, Investment Efficiency, Accounting Quality, Adverse Selection, Moral Hazard

Abstract:
This study examines how accounting quality relates to firm-level capital investment efficiency. Our first hypothesis is that higher quality accounting enhances investment efficiency by reducing information asymmetry between managers and outside suppliers of capital. Our second hypothesis is that this effect should be stronger in economies where financing is largely provided through arm's-length transactions compared with countries where creditors supply more capital. Our results are consistent with these hypotheses both across and within countries. They are robust to alternative econometric specifications, different measures of accounting quality and investment-cash flow sensitivity, and numerous control variables.

investment, accounting quality

Abstract:
Prior evidence that higher quality financial reporting improves capital investment efficiency leaves unaddressed whether it reduces over- or under-investment. This study provides evidence of both in documenting a conditional negative (positive) association between financial reporting quality and investment for firms operating in settings more prone to over-investment (under-investment). Firms with higher financial reporting quality also are found to deviate less from predicted investment levels and show less sensitivity to macroeconomic conditions. These results suggest that one mechanism linking reporting quality and investment efficiency is a reduction of frictions such as moral hazard and adverse selection that hamper efficient investment.

Financial Reporting Quality, Investment Efficiency, Accounting Quality, Adverse Selection, Moral Hazard

Abstract:
This study distinguishes between incremental and relative information content. Incremental comparisons ask whether one accounting measure provides information content beyond that provided by another, and apply when one measure is viewed as given and an assessment is desired regarding the incremental contribution of another (e.g., a supplemental disclosure). Relative comparisons ask which measure has greater information content, and apply when making mutually exclusive choices among alternatives, or when rankings by information content are desired (e.g., when comparing alternative disclosures). Questions of both incremental and relative information content arise frequently in accounting. However, few previous studies have examined questions of relative information content. Possible explanations include unfamiliarity with the relative versus incremental distinction, and the additional statistical complexity involved in testing for relative information content. First, we examine analytically the relation between incremental and relative information content, demonstrating that they address different research questions and that different tests for statistical significance are required. Second, we identify accounting research contexts in which questions of relative and incremental information content arise. Third, we propose a new regression-based test for relative information content. This test applies to both returns and valuation studies, generalizes to any number of predictor variables, and can be used in conjunction with White's (1980) adjustment for heteroskedasticity. Fourth, we illustrate tests for relative and incremental information content in a familiar research setting that compares the information contents of net income, cash flows, and net sales in 40 industries.