Accounting is Broken - Investment Analysts Journal

Stern Stewart & Co.
Transparency is not just
about disclosing more
data or even principally
about that. It is chiefly
about giving investors a
clear window into how
managers make or
should make decisions
that are in their best
interests.
The first step in the
separation process is to
measure profit before
subtracting any financing
charges. The result
is known as net operating
profit after taxes, or
NOPAT for short.
Unlike book net
income, NOPAT is not
affected by transitory
shifts in capital structure
or interest rates.
The second step is to
subtract all financing
costs as re p resented by
the strategic, weighted
average cost of capital.
The result is a popular
method to measure economic
profit that is
called EVA, or economic
value added.
WACC is the blended
cost of all capital. It is
computed by weighting
the after-tax cost of
each capital component
by its representation in
an ideal capital structure
mix.
Regulators and other accounting authorities have a responsibly to relieve management of
this tension, and to conform GAAP accounting to the established principles and practices
of value-based management. What’s needed is a new accounting standard that unites financial
re p o rting with the capital budgeting techniques most companies now employ for internal
re s o u rce allocation decisions. Tr a n s p a rency is not just about disclosing more data or
even principally about that. It is chiefly about giving investors a clear window into how
managers make or should make decisions that are in their best intere s t s .
The recommended new accounting treatment is straightforw a rd. It is to put all of the operating
results on one side of the economic profit calculation and then to subtract all financing
costs on the other side:
Economic Profit = Operating Results - The Cost of All Capital
The first step in the separation process is to measure profit before subtracting any financing
charges. The result is known as net operating profit after taxes, or NOPAT for short (a
t e rm Joel Stern coined in the late 1960s following the seminal articles on corporate valuation
theory by Nobel Laureates Merton Miller and Franco Modiglianni).
N O PAT is a key measure of a company’s profit that accountants should disclose to investors.
Unlike book net income, NOPAT is not affected by transitory shifts in capital stru c t u re or
i n t e rest rates. It lets the sun shine through to reveal pure operating results. Dividing
N O PAT by the sum total of a firm ’s debt and equity capital provides a rate of re t u rn you
can take to the bank. It measures how productively management has managed capital
re g a rdless of how it has financed the capital. It is far more reliable than re t u rn on equity as
a basis to compare a company’s perf o rmance from one year to the next or across a group of
companies within the same year, because financing diff e rences are purg e d .
Having removed financing costs from NOPAT, the second step is to subtract all financing
costs as re p resented by the strategic, weighted average cost of capital. The result is a popular
method to measure economic profit that is called EVA 6 , or economic value added:
Economic Profit = NOPAT - The Cost of Debt and Equity
E VA = NOPAT - (WACC% x $Total Capital)
WACC is the blended cost of all capital. It is computed by weighting the after-tax cost of
each capital component by its re p resentation in an ideal capital stru c t u re mix. Finance staff s
c a refully select their target capital stru c t u re blends by balancing the benefit of using cheap
debt financing against their need to pre s e rve financing flexibility and withstand downturn s
with an equity cushion. Depending on the company, the ideal target capital stru c t u re mix
usually runs in a range from about 20% debt and 80% equity for rapid growth high-tech
f i rms to about 60% debt and 40% equity for mature, cash surplus generating ones. The
t a rget capital stru c t u re is also one that management should be committed to attaining on
average and over time.
Once a firm ’s target capital stru c t u re is set, its weighted average cost of capital can be determined.
To illustrate, recall the former example company that was employing $1 billion in
equity capital. Suppose that the firm ’s management has established and is now maintaining
its capital stru c t u re target consisting of two-thirds equity and one-third debt. If so, its $1
billion in equity capital is currently augmented by $500 million in debt for a total capital
base of $1.5 billion.
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In a comprehensive EVA accounting system all financing costs should be backed out of NOPAT and impounded into the cost of
capital in order to clearly and totally separate operating and financing decisions. For instance, off-balance sheet lease commitments
should be discounted to a present value and included as part of debt capital for the purpose of measuring the overall cost of capital,
and the implied after-tax interest component of the annual rents should be added back to NOPAT. The debt and interest associated
with Special Purpose Entities in which the company holds more than a 50% economic interest (including any debt capital
that is secured by guarantees or derivative instruments) should also be brought into the firm ’s capital, cost of capital, and NOPAT
calculation. Out of sight should not become out of mind.
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