ACC6003 Chapter 10 Notes

Holding managers accountable for ST profits of returns may induce managers to reduce or postpone investments that promise payoffs in future measurement periods, even when those investments have a positive NPV and meet other criteria to make them worthwhile. This is called ___.

investment myopia.

Fourth, accounting measures are understandable. Acc is a standard course in business school and managers have used the measure for so long they are well familiar with ____ & _____, at least at a ___ if not fully ____ level.

what they represent and how they can be influenced conceptual fully accounting-technical

At managerial levels, job responsibilities are both ___ and ____. In common jargon, managerial jobs are said to be ___ in nature. The list of measures used in practice to motivate and evaluate managerial performance island and can be classified into three broad categories: two of these categories include ____, expressed in either ___ or ____s, and the third category includes ______.

broad and varied multitasking summary financial measures of performance market (stock price) or accounting terms combinations of measures.

Managers can also boost current period profits and returns by destroying goodwill that has been ____. They can force employees to ____. But if the product is of lower quality, ___ may diminish and the costs of __ or ___ may increase and some employees may be __ or tempted to leave. This all can _____.

built up with customers, suppliers, employees, and so on work OT to finish production at the end of the measurement periodso that the product can be shipped and revenues can be booked customer satisfaction service repairs or customer returns demotivated ruin organizational culture.

Firms often employ a variety of stock based compensation plans, such as stock option and restricted stock plans, which link incentive payments to stock price. In this way, employees who are eligible for equity based compensation plans are rewarded for ___ as defined above or at least ___ - ______.

generation shareholder returns its most significant component - changes in value of common stock.

EVA may have better congruence characteristics and it exhibits the features of any ___ When using accounting-based ROI measures, managers evaluated by these measures should understand that when they "run down" their business by not investing in it or by not replacing their old assets, they will eventually hamper their ability to ___, thereby hurting the numerator in their ROI measure, assuming of course that they plan to be around long enough to worry about them. In that sense, ROI measures have a ___ mechanism built into them.

generic residual income measure. generate revenues from these assets self disciplining

It is possible however to improve the market measures to make them more ___ of performance such as by using ____. For example managers going to be held accountable for generating market returns greater than those of the overall market or greater than those of a chosen peer group of companies. When done well, and consistent with efficient contracting, RPE firms select peers that allow ___ and ____.

informative of controllable elements relative performance of valuations (RPE) effective removal of common risk and improve fairness of compensation

Authors of a report on pay at FTSE 100 companies by CFA UK, a society of investment professionals and Lancaster Business School (Haas, Liu, Young, Zhang). Relatively simplistic performance measures such as ___, ___ continue to dominate the measures against which executives' performance was benchmarked over the period (10 yrs in 2003 to 2013). Value based metrics that related __ to the _____ were rarely used. The report said the dangers of over-reliance on such measures of executives' performance were well documented and included: investment myopia, earnings manipulation, excessive risk taking and threats to organizational culture.

EPS, Total Shareholder Return performance to the cost of capital

But studies have documented positive effects of market based measures and associated incentives, such as stock options on, say, innovation which is an inherently ___, even when used at ___. There is no one size fits all approach and there are trade offs. But an exclusive reliance on market measures is likely __, even where the __ because market measures do have limitations. These limits can cause organizations to look for surrogate measures and the most important surrogates used are ___ like ____.

LT endeavor requiring appropriate risk taking lower, non-executive levels in the organization ineffective benefits are believed to exceed the drawbacks accounting measures profits and returns.

A company's stock price at any point in time can be a poor guide of ___, and thus, although an emphasis on shareholder value seems highly congruent conceptually, the ST changes in stock price as a proxy for it can cause problems. One problem is that even though relying on market measures should align managers' incentives with LT value of the firm, they will not always do this. Worse, they can create ___.

LT value adverse incentives

Over the years, a number of valuation anomalies - such as the ___ Effect and the ___ effect - have been documented although these tend to be ___ and ____ in duration. More significant for incentive purposes are some other, larger market imperfections and lags; these are particularly likely and more likely to be significant in markets where stocks are not as actively traded. For example, in developing countries, suggestions to rewards managers based on stock market valuation changes are met with skepticism. Because ___ and ___ as those in developed countries, managers can ____ and large investors can _____.

Monday January relatively small and temporary regulations in certain countries are not as well established not as well enforced slant their disclosures to affect valuations manipulate the markets.

One consulting firm, ____ recommends a measure called Economic Value Added (EVA) that combines several of the modifications to the standard accounting model in a _____. The generic EVA formula is EVA=______

Stern Stewart and Co, residual income-type measure. Modified Net Operating Profit After Tax - (modified Total Capital * Weighted Average Cost of Capital)

ROI is a common _____ that is commonly used in ____. _____ are comprised of multiple responsibility centers, the managers of which are held primarily accountable for ___ or ____. The divisionalized form of organization dates back to the 20s when it was introduced in the ___, but its use spread particularly quickly after ___ as one response to increased organizational size and complexity.

accounting performance measure large, divisionalized firms Divisionalized organizations profit or some form of accounting ROI DuPont Company WWII

Relying heavily on ROI measures in a results controls system can cause problems. 1) The numerator in the ROI measure is ___, thus it has all the limits of profit measures such as the tendency to create ___. 2) There's a tendency for the measures to induce ____. A narrow focus on ROI may lead division managers to make decisions that ______, that is, decisions that appear locally optimal (for the division) may not be globally optimal (for the firm). 3) ROI measures sometimes provide ___ because ____. This leads to ___ and ____.

accounting profit myopia sub optimization improve division ROI even though the decisions are not in the corporation's global use interest misleading signals about performance of investment centers (divisions) because they have difficulties in measuring the fixed asset portion of the denominator poor investment and performance evaluation decisions.

Divisionalization provides several advantages. Large, complex organizations are not able to control behaviors effectively with ___ or _____. The central administration cannot know everything. Even if it could, it'd take time for it to do this. decision making would be unnecessarily delayed, even if it were informed. When an organization is divisionalized, local managers become ___ and they are able to make ___. Because they control their own success, managers are more likely to be __ and ___. This decision making makes them more experiences making it easier for them to ___. Top management's time becomes available to focus on ____.

action-dominated control systems involving the direct guidance of a central manager or the enforcement of standard operating procedures by a central administration. experts in their products and markets informed decisions more quickly. motivated and entrepreneurial climb the ladder strategic decisions.

Because it _____, EVA should better reflect economic income than accounting profit in many settings. It should mitigate the investment myopia problem because it involves _____ managers might try to cut if they were pressured for profits (R&D, employee training). EVA also has all the advantages of a _____.

addresses some of the known weaknesses of account profit or return measures capitalization of the most important type of discretionary expenditures residual income-type measure.

The summary measures reflect the _____ (accounting profits aggregate both revenue and cost related decisions). The first category of summary measures contains market measures; that is, those that reflect ___. The second category includes accounting measures, which can be defined in either ___ (such as net income after taxes, operating profit, residual income or economic value added) or ____(such as ROI, ROE, ROA). These two categories of summary financial (market or accounting based) measures of performance are the focus of this chapter. These measurement categories represent financial measures of performance because they are either denominated in ____ (quarterly profits of 10 mil); as ____ ($0.12 earnings per share) or as a ____, such as 11% earnings growth.

aggregate or bottom line impacts of multiple performance areas changes in stock prices or shareholder returns residual terms ratio terms currency ratio of financial numbers change in financial numbers,

Divisionalization and decentralization are related concepts, but the two words are not synonymous. An organization is said to be decentralized when ___. All divisionalized organizations decentralize authority, at least to some extent, in specified areas of operations, notably a __ or a ___. But the converse is not true. When decentralization is effected along functional lines of authority (such as production or marketing), the responsibility centers are usually ____, not ____.

authority for making decisions is pushed down to lower levels of the organization line of business or a geographical area cost and revenue centers, not profit or investment centers.

Most managers have found that the advantages of accounting measures outweigh their limitations, and they continue to use them. But they must be aware that motivating managers to maximize accounting profits or returns rather than economic income can create a number of ___ problems. ___ is probably the most potentially damaging. Managers who focus on accounting profits or returns measured in short periods tend to be highly concerned with increasing (or maintaining) monthly, quarterly or annual profits. When managers' orientations to the ST become excessive, the managers are said to be myopic. In summary then, the major failure of accounting measures of performance is in terms of the ____. (Check third para on page 404)

behavioral displacement Myopia congruence criterion for evaluation.

Stock market valuations are affected by many factors that even top managers cannot control such as (6) Therefore one reason why accounting information is important and incentive contracting is that earnings can shield executives against the ___ inherent in firms stock prices EcoPoli Monepol HisComp Moo

changes in macro economic activity (economic growth), political climate (election results), monetary policy (interest-rate policy), and history events, and actions of competitors (major oil spill), as well as the general stock market mood (Bearish or bullish). noise

One way of assessing value changes is by using market measures of performance, which are based on ___ or, if dividends are also considered, ____. The value created (return to shareholders) can be measured directly for any period as the ___. For publicly traded, exchange listed firms whose stock is traded in actively traded and properly regulated capital markets, the market value of the firm is generally viewed as the ___, _____.

changes in the market value of the firm return to shareholders sum of the dividends paid to shareholders plus (or minus) the change in the market value of the stock closest, although imperfect

Another common "trick" is known as ____, which involves boosting near-term sales by extending lower prices to distributors, encouraging them to ______. These are examples of ____, sometimes also colloquially referred to as _____.

channel stuffing load up while potentially hurting later sales. operating myopia "shipping bricks and other tricks".

Second, accounting profit is highly dependent on the _____ (depreciable lives, for example). Third, accounting profit is derived from __. Accounting rules require slow recognition of gains/revenues, but quick recognition of losses/expenses. Revenues and expenses aren't always matched well especially when measurement periods are shorter than the firm's investment payoff horizons.

choice of measurement methods measurement rules that are often conservatively biased

Investment myopia stems directly from two of the problems with accounting measures described above: their ____ and their ignoring of ____. Accounting rules do not allow firms to recognize gains until they are realized, that is until the ___ activities - such as sale - have taken place and earnings can be____. On the other hand, the rules require firms to begin recognizing costs when ____. Projects with __ and ___, such as R&D profits and employee development and customer acquisition projects must be expensed as the costs are incurred and capital investments must be expensed over periods that are typically shorter than those with which returns will be realized.

conservative bias intangible assets with predominantly future payoffs. critical income producing measured in an objective, verifiable way the investments are made uncertain returns and little liquidation value

EVA also has some other measurement limits. It suffers from objectivity problems because the adjustments require ___. EVA also probably is not differentially affected by any of the usual controllability problems. EVA, however, is more likely to create some additional understandability problems, as the measures can be __. Many of the firms that have decided not to use EVA or similar types of measures developed mainly by consulting firms, (4) or which have tried such a measure and then abandoned it, seem to have done so mainly because of understandability failures. Moreover, __________ are rarely used because the cost of implementing these measurement systems can be expensive, requiring these consultants advice, management development and training.

considerable judgement complex and are not as widely familiar cubas CF ROI (Holt Value Associates), Total Business Return (Boston Consulting Group), Economic Profit (McKinsey and Co) or Shareholder Value Added (LEK/Alcar) value based metrics that relate performance to cost of capital

Market measures do have limitations. First, they suffer from ____ problems. They can generally be affected to a significant extent only by the ___ who can make important decisions. They say little about performance of lower individuals, even those with significant management responsibilities, except in __. Lower level managers really can't affect stock price "employees can be demotivated upon realizing that it can be like a lottery, we should only ask employees to control things they can influence, like earnings"

controllability top few managers a collective sense

Third, accounting measures usually can be largely ___ by managers whose performances are being evaluated. The measures can be tailored to match the ___ of any level of manager, from the CEO down to the lower level managers. As such, entity managers are typically held accountable for fewer ___ that they can control, compared to managers with more authority higher in the organizational hierarchy. Because of this, the ___ of an entity within the organization is almost certainly more controllable by the entity manager than the change in the company's ___. Accounting profits are also not, or not as severely, affected by ___.

controlled authority limits income statement and b/s line items profit performance overall stock price uncontrollable factors.

More generally, measurement congruence, or the _____, increases with the ___, which suggests a tradeoff between the ___ and ___ measurement evaluation criteria. The increasingly higher correlations with increasingly longer measurement windows occur primarily because accounting profits provide a ____. How lagged it is depends on ___ and ____.

correlation between accounting profits and firm value length of the measurement period congruence and timeliness lagged indicator of economic income what caused the economic income change and what type of accounting measurement rules are being used.

Fifth, profit reflects the ___ but _____. Firms earn real income only when the _____, and ignoring the cost of equity capital ___ the difference between returns and costs (that is, profits). This omission is serious because equity capital is typically ___ than borrowed capital, and the cost of equity capital is even higher for companies with ____. Failure to reflect the cost of equity capital also hinders comparisons of the ___ and ______.

cost of borrowed capital (through interest deductibility) but ignores the cost of equity capital. returns on capital are greater than the cost of that capital overstates more expensive risky (volatile) stocks. results of companies with different proportions of debt and equity in their capital structures.

The value of any economic asset can be calculated at any specific time by ___ that the firm is expected to generate_, where the discount rate reflects the ____. Thus, employees can, all else equal, increase value by ___ of future cash flows, by ___ of those CF (time value of money), or by making them ___. The change in firm value over any given period is called ___. Therefore, ___ is an alternative way of phrasing the basic corporate financial objective of value maximization.

discounting future cash flows time value of money and risk increasing the size accelerating the timing more certain or less risky (lower discount rate) economic income maximization of economic income

Fourth, profit calculations ignore some ___. Investments in major categories of companies' intangible assets such as research in progress, HR, IS, and customer goodwill are ___. The omission of intangible assets occurs even though for some companies these assets are more important than the ___. Profit also ignores the ___. Managers sometimes increase their sales and profits by ____, the costs of which ____.

economic values and value changes that accountants feel cannot be measured accurately and objectively expensed immediately old industrial era type assets of PP&E costs of investments in working capital. making poor investments in extra inventory do not appear on the income statement.

Warren Buffet doesn't like what he calls lottery ticket arrangements, such as stock options, in which the ultimate value could range from 0 to huge and is totally out of the control of the person whose behavior we would like to effect. Instead, goals should be tailored to the ____, simple and measurable, and directly related to the daily activities of plan participants.

economics of the business

There are various reasons why accounting profit measures fail to reflect economic income perfectly. Many things affect accounting income but not economic income and vice versa. Accounting profit is primarily a summation of the ____. Most changes in value that do not result in a transaction are not recognized in accounting profit. When a firm receives a new patent or regulatory approval for a new drug, accounting income is ____ but ___.

effects of the transactions that took place during a given period not affected (no transaction) economic income might be.

The third measurement category consists of combinations of measures. These combinations can involve the use of ___, ____, plus ____(revenues or expenses) and/or ____ measures (market share/customer satisfaction/turnover).

either type of summary measures, or both, plus some disaggregated financial measures non financial

If the residual income charge is made equal to the required corporate investment rate of return, the residual income measures give all division managers an ___, thereby addressing the ___.. Regardless of the prevailing levels of return in each division, the managers are motivated to invest in all projects that promise_____ (again, all else equal, thus ignoring any strategic considerations). Residual income also addresses the ___. By considering both debt and equity financing, by using a ___, residual income removes the managers' temptations to increase their entity's leverage through ____. Residual income does not address the distortions caused when managers ___, however. Many desirable investments initially reduce residual income, but then the residual income increases over time as the fixed assets get older and are depreciated.

equal incentive to invest sub optimization problem internal rates of return higher than or equal to the corporate cost of capital financing type sub optimization problem weighted average corporate cost of capital debt financing make new investments in fixed assets

The fourth problem with market measures is their ___ in certain circumstances. Market measures are also only readily available for ___; they are not available for either ___ or ____, and they do not apply to ____.

feasibility publicly traded firms privately held firms or wholly owned subsidiaries or divisions non-profit organizations

The primary objective of for-profit organizations is to maximize shareholder value or ___, for short. Thus, the results-control ideal would be to ___. However, because direct measurements of the contributions by employees to value creation is rarely possible, firms have to look for measures that ___ for this ultimate objective and resort to results-controls alternatives to either ____ or ______

firm value reward employees for their contributions to firm value proxy reinforce desired behaviors where proxies leave gaps or mitigate undesired consequences that may arise from relying on the proxies.

It is true that sub optimization problems can be avoided through the ___, as well as through their inherent ___. One might ask: Why use a measurement system that works effectively only in conjunction with bureaucratic oversight and processes that are needed to prevent managers from taking undesirable actions? The answer to that question is that ____.. There is no panacea, and better control is likely to arise from a set of ____

investment review processes, self-disciplining mechanism net benefits of such a system are greater than those of several other feasible alternatives mutually reinforcing and balancing mechanisms.

The actual forms of ROI type ratios that companies employ vary widely, as do the ____. Among the Advantages of ROI type measures: 1) they provide a ____. 2) They provide a _____ such as divisions and outside competitors or types of investments. 3) Because they are expressed in ____, they suggest that ROI figures are comparable to other financial return such as those for stocks and bonds, although such a direct comparison should be qualified. 4) Because ROI measures have been in use or so long by so many, virtually all managers __ and ____

labels companies put on their bottom line investment center measures single, comprehensive measure that reflects the trade offs managers must make between revenues, costs and investments common denominator that can be used for comparing returns on dissimilar businesses, percentage terms understand both what the measures reflect and how they can be influenced by changes in the numerator and denominators

A final problem with ROI measures is that it creates incentives for managers to ____.. Leased assets accounted for on an operating lease are not recognized on the B/S so they are __. Of course, corporations can easily include the capitalized value of assets employed in division ROI calculations even when those leases are __. This adjustment avoids the potential problem, but adjustments are ____ and may complicate the ____.

lease assets rather than buy them not included in the denominator not required to be capitalized for financial reporting purposes. costly administration of different books for different purposes.

Where division managers have the authority to make financing decisions (to finance their investment decisions), ROI type measures can also lead to suboptimization at that level. For example, ROE measures may induce managers to use debt financing (to reduce the equity put into the denominator of the ratio). This may push the entity's ____ to levels in excess of the desired corporate leverage.

leverage

The measures can then be further decomposed to understand whether the variance was due primarily to a decline in sales or more capital tied up in a specific kind of assets. ROI performance charts are also useful for ___. The chart can be expanded out to the right to show specific measures that can be used for ___. Sales performance can be disaggregated into ___ & _____.These factors can be further disaggregated by (4)

linking performance at various organizational levels control purposes down to the lowest levels in the organization sales volume and price factors. product, region, customer segment or sales team.

ROI measures can create a sub optimization problem by encouraging managers to make investments that ___. Conversely, ROI measures can cause managers of unsuccessful divisions to invest in investment projects that promise returns ____. Unless managers guard against these problems, the effect of situations like these examples is that the firm's capital will gradually be ___ or at least ___ and toward its ___, which is ___ with the objective to maximize firm value, all else equal.

make their divisions look good even though their investments are not in the best interest of the corporation below the corporate cost of capital allocated away from its most successful highest earnings divisions least successful divisions incongruent

The word "modified" refers to ____, such as capitalization and amortization of intangible investments such as for R&D, employee training and advertising and the expensing of goodwill. Just which modifications should be implemented requires ___. The weighted average cost of capital reflects the ______.

many adjustments to standard accounting treatments judgement weighted average cost of debt and equity financing.

Examples: Microsoft and Yahoo merger. Molycorp - owner of largest rare earth deposits outside china's substantial goodwill write down. Who is right, the market or the management of these firms, is hard to tell in advance but it shows that managers and ___ and ___. Market valuations do not always fully reflect the underlying value of the firm, decisions or transactions on any given day can be affected by the difference. Worse, the possibility for such differences may even trigger ____ such as by ____ are expected to overreact either with an upward or downward effect on stock prices, to bring about _____.

market expectations are not always aligned and that expectations are not to be equated with realizations opportunistic motivations by executives to try to affect stock prices coincident with certain decisions or transactions disclosing info to markets more favorable conditions for the granting or exercising of stock options, respectively

Many issues with divisionalization stem from problems with ____. ROI is a ratio of the _____. Divisionionalized corporations typically use some form of the various types of ROI measures to evaluation division performance. Variances from plans can be analyzed using ____.. Such analyses might show that a division's actual ROI of 15% was below the planned level of 20% even though the sales profitability (profit as a percentage of sales) was on plan but asset turnover (sales divided by total investment) Was below target. Planned ROI (20%) = _______. Actual ROI (15%)= ___

measurement of performance in terms of ROI accounting profits earned by the division divided by the investment tied up in the division formula charts (ROI trees) profit as a percentage of sales (20%) * asset turnover (1) profit as a percentage of sales (20%) * asset turnover (0.75).

Most organizations base their higher managerial results controls to a great extent on summary accounting measures of performance. Accounting measures of performance are in common use - they have significant advantages over other measurement alternatives. At ____, they provide a useful summary of results of the many actions and decisions that managers take. It must be recognized that even the best accounting measures are not perfect; they are only ____.

minimal incremental cost surrogate or proxy indicators of changes in firm value.

Difficulties in measuring the denominator of the ROI measure, particularly pertaining to fixed assets, can provide _____. The assets on a business B/S were added to the business at various times in the past, under varying market conditions and varying purchasing power of the monetary unit. As such, the BV of the various assets accumulated over time may say little about the _____; that is, their ability to ____. Nonetheless many firms use NBV to calculate ___, which ______. This overstatement is larger if the entity includes a ___ and assuming inflation, the NBV of older assets are ____, but even without taking inflation into account, because they have been ____.

misleading signals about performance of an investment center (division). economic value of the assets generate future cash flows divisional ROI, which overstates ROI large number of older assets below their replacement values because they were bought in a period of lower prices depreciated longer.

Another quirk about ROI measures is that ROI calculated using NBV automatically increases over time if ___. Assume Division E is operating at a steady state, earning 12% in year 1. Because depreciation, the ROI increases to 13 in year 2 and 15 in year 15. This ROI increase is not real, either.

no further investments are made

For all these reasons, pioneer business baron Alfred P Sloan may have had a point when he proclaimed that "no other financial principle with which I am acquainted serves better than accounting rate of returns as an ___." Nonetheless, accounting measures of performance are far from perfect. While research has shown that the correlations between annual accounting profits and stock price changes are __, they are not a ___ and thus only ____.

objective aid to business management positive perfect surrogate imperfect proxies for economic income.

Second, as compared with other quantities that can be measured precisely and objectively on a timely basis, such as CF, shipments or sales, accounting measures are at least conceptually congruent with the __ where _____. In this respect accounting profits provide an advantage over CF accounting because accounting accruals are designed to provide a better _____.

organizational goal of profit maximization profit is an archetypal accounting construct. understanding of cash inflows and outflows overtime.

In periods of inflation, as is almost always the case, old assets valued at GBC are still expressed at lower values than new assets, so ROI will still be ____. Another possibility is to use "___" by depreciating assets ___, where the rate of depreciation can be different (slower or faster and or nonlinear) from the depreciation rates used or allowed for financial accounting or taxation purposes. This takes ___ of the assets into account, which may be more crucial in times of __ but ____.

overstated adjusted NBVs commensurate with their economic lives productivity rapid technological change but low inflation.

A third and related problem with market measures of performance is actually a ____. ___ hampers the use of market valuations as a proxy value. For competitive reasons companies my treat information about (4) say, as confidential. Market valuations do not reflect information that is __. If sizable rewards are linked to market valuations, managers might be tempted to __ even if ___

potential congruence failure Info asymmetry R&D productivity, pricing and sourcing strategies, product and process quality, and layoffs intentions, not available to the market disclose information to affect valuations such disclosures could hurt their company

Second, market values do also not always reflect ____, instead the values merely represent __ and it can be risky to base incentives on ___ because ___. Indeed markets can _____ or even _____.

realized performance expectations expectations those expectations might not be realized overreact to news regular earnings announcements.

Market measures have broad appeal in part because they provide ___. Such measurement congruence allays political pressure that outsiders might bring on the company. Who is to complain if managers rewards are in sync with those enjoyed by firm owners? If the market value changes are measured in terms of recent transaction prices in an actively traded, efficient market, the market measures also have other advantages. For public firms, market values are available on a __ daily basis. They are __ with no or little random error and relatively __ with no or little systematic basis, assuming an efficient information environment, and the values are usually __ (not manipulable by managers whose performances are being evaluated) or at least not nearly as __ as some other measures. They are ___ at least in terms of what they represent and the are ___ because they do not require any company measurement expense.

relatively direct indications of changes in firm value timely precise accurate objective manipulable understandable cost effective

A number of researchers and consultants have argued that the use of ____ can help overcome the sub optimization limitation of ROI. Residual income is calculated by _____. The capital is charged at a rate equal to the __. Conceptually, one could adjust the the capital charge rate for each investment center's risk, thus making the performance measurement system consistent with the ________

residual income measure subtracting from profit a capital charge for the net assets tied up in the entity or division (investment center). weighted average corporate cost of capital capital budgeting system

While arguments presented in this chapter are based on the assumption of value maximization as the ultimate organizational objective in the context of for-profit organizations, we realize that corporations have ______, including employees, customers, suppliers, and society and that fulfilling these responsibilities is both important and requires tradeoffs. It's beyond our scope to discuss the ultimate balance of objectives of corporations. The ___ presented in this chapter and earlier ones, and the _____ in particular, can be used to evaluate performance measures no matter which objective an organization pursues. The framework can be applied to non profit settings where organizational purposes are not directed toward maximizing shareholder value.

responsibilities to a broader set of stakeholders evaluation framework congruence criterion

It must be recognized, however, that despite its name EVA is still only a proxy at best for economic income. It doesn't address all the problems that differentiate accounting income from economic income, although the proposed adjustments to the accounting numbers should attenuate the gap. In particular, EVA still reflects primarily the ___, and thus, the past, while economic income reflects charges in future cash flow potentials. Joel Stern, now chairman of Stern Value Management in NY, would argue that this is a matter of using an ___, suggesting that value management essentially "involves both ___ and also ____ for risk in achieving that corporate performance, thereby providing a way of ___"

results of a summation of transactions during a period appropriate rate of return for risk, selecting an appropriate measure of corporate performance and also a required rate of return measuring performance year-by-year contemporaneously

These ROI quirks cause managers to make poor decisions: they encourage managers to ___ and ____ that would increase the denominator in the ROI calculation. (This dysfunctional motivational effect is exacerbated when the managers expect ___, illustrating another myopia problem). 2) They can contribute to ____. 3) They can make managers ___, they can cause ______. Measuring fixed assets at Gross Book Value (GBV) - that is, gross of depreciation conventions that are used for financial reporting purposes - minimizes these problems because GBV is ___.

retain assets beyond their optimal life and not invest in new assets job tenures to be short the problems in Tables 10.1 and 2. unaware of these measurement effects or do not adjust for them, they can cause distortions in evaluating division manager's performance. closer to replacement value than is NBV.

The motivational effect of these measurement rules is ___ because managers who are motivated to produce accounting profits in the short term do so by ____.. By not making these investments, managers __ and do not suffer ___. Even worse, the quest for short term profits sometimes induces managers to engage in ____, such as not booking operating expenses immediately but instead pushing them into the future as _____.

reverse not making worthwhile investments reduce expenses in the current period lost revenue until future periods manipulative earnings management practices capital investments.

Sixth, accounting profit ignores ___ and ____. Firms or entities within firms that have not changed the pattern or timing of their expected future CF but have ____ have increased their economic value, and vice versa. This value change is not reflected in accounting profits. Finally, profit figures also focus on ___. Economic value is derived from future cash flows, and there is no guarantee that past performance is a ____.

risk and changes in risk. made the CF more certain (less risky) the past. reliable indicator of future performance.

Advantages of ROI type measures: 1) they provide a s____. 2) They provide a common denominator that can be used for ____, such as divisions and outside competitors or types of investments. 3) Because they are expressed in ___, they suggest that ROI figures are comparable to other financial return such as those for stocks and bonds, although such a direct comparison should be qualified. 4) Because ROI measures have been in use or so long by so many, virtually all managers ___ and ____

single, comprehensive measure that reflects the takeoffs managers must make between revenues, costs and investments comparing returns on dissimilar businesses percentage terms understand both what the measures reflect and how they can be influenced by changes in the numerator and denominators

It is generally understood that the primary objective of for-profit organizations is to maximize the value of the firm. As Michael Jensen, a financial economist phrases it "200 years' worth of work in economics and finance indicate that __ is maximized when all firms in an economy attempt to maximize their own total firm value"

social welfare

Traditionally, most firms have based their managers' evaluation and rewards heavily on ________. Accounting based, summary or bottom line performance measure come in two basic forms 1) ____ (or _____), such as (4) and 2) ___ (or _____) such as __. These measures are usually derived from the rules defined by _____

standard accounting based, summary financial measures residual measures (or accounting profit measures) net income ,operating profit, EBITDA, or residual income ratio measures (or accounting return measures) ROE standard setting for financial reporting purposes

In some types of firms, accounting profit measures are essentially meaningless. A good example is ____. These firms report significant __ in the early life cycle. The losses are just an artifact of ___ that require immediate or rapid expensing of ___. In these cases, managers are not or should not be greatly concerned with ST acc profits because the need for LT focus _____.

start up firms. losses conservative accounting rules LT focused business building investments. reduces the degree of congruence between earnings and firm value.

Summary accounting based measures advantages: Accounting measures and returns can be measured on a ___ basis (in short time periods) relatively __ and ___. Precision stems from the existence of __, and hence, different people assigned to measure the profit of an entity for any given period will ___. We say approx because the accounting rules require some judgement, such as about certain liabilities or the depreciable lives of assets. Further, for large firms or publicly traded firms, but also for privately held firms that require bond or equity capital, ___ provide an objective check of accounting calculations. Objectivity is important when incentives are linked to measures because it eliminates or reduces the _____ about the accounting treatment.

timely precisely and objectively accounting rules arrive at approx the same number independent auditors potential for arguments about measurement methods where judgements need to be made

Determining whether managers are acting myopically can be difficult. In 2014, IBM the IT giant, announced a $1 bit restructuring with major job cuts in the US to maintain company earnings growth in the face of flagging revenues, some started to question whether IBM's pursuit of *5 year earnings targets,* which were seen as long, may have led to excessively short term profit focuses. (EPS will hit $20 short term target for 2015, but long term there is concerns).This was because the cuts followed disappointing sales, which added to Wall Street concerns that IBM was missing out on cloud computing growing markets. The firm didn't see it this way. Was the company acting myopically for the sake of hitting its earnings targets, by slashing costs but eroding its capacity to move effectively into new high-growth markets? Or was it instead competitively positioning itself to achieve exactly that?

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Finally, accounting measures of performance are inexpensive because most firms have to measure and report financial results already (for publicly traded, firms over a certain size in some countries that require auditing or to obtain funding).

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