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A Comparison of Error Rates for EVA, Residual Income, GAAP-earnings and Other Metrics Using a Long-Window Valuation Approach

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  • John Forker
  • Ronan Powell

Abstract

Predictability and variability are two measures commonly used in the empirical literature to gauge the quality of earnings and hence, decision usefulness to investors. We adopt both measures to investigate empirically the relative quality of Stern Stewart's measure of economic value added (EVA) compared to GAAP (generally accepted accounting principles) earnings, residual income, cash flows and other mandated metrics in the USA and UK. We proxy for accounting quality by applying a long-window methodology to obtain hindsight valuation errors based on the difference between ex ante market value and discounted ex post metrics. Decision usefulness, in terms of ease of forecasting, is proxied by differences in valuation errors between the benchmark and alternative accounting methods. Contrary to the Biddle et al. (Journal of Accounting and Economics, 24, pp. 301-336, 1997) finding that mandated earnings were superior to EVA and residual income, we find that EVA and other residual income metrics consistently give rise to lower average valuation errors and thus have higher predictability across a variety of windows and terminal dates. Further, on the basis of our second measure of accounting quality, the variability of valuation errors, EVA performs best in the USA and third in the UK. The results strongly indicate that differences between residual income constructs, including EVA, are generally small but that earnings quality will be improved by recognition of a cost of equity capital in measuring reported income.

Suggested Citation

  • John Forker & Ronan Powell, 2008. "A Comparison of Error Rates for EVA, Residual Income, GAAP-earnings and Other Metrics Using a Long-Window Valuation Approach," European Accounting Review, Taylor & Francis Journals, vol. 17(3), pages 471-502.
  • Handle: RePEc:taf:euract:v:17:y:2008:i:3:p:471-502
    DOI: 10.1080/09638180802172420
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    Cited by:

    1. Kai Henning Blume, 2016. "Value-based management as a tailor-made management practice? A literature review," Journal of Management & Governance, Springer;Accademia Italiana di Economia Aziendale (AIDEA), vol. 20(3), pages 553-590, September.
    2. repec:gam:jsusta:v:10:y:2018:i:4:p:947-:d:137863 is not listed on IDEAS
    3. Lambert Jerman, 2015. "Les Enjeux De L'Application Des Normes Ias-Ifrs : L'Etude Des Preparateurs Des Comptes, Une Perspective De Recherche Encore Inexploree," Post-Print hal-01188736, HAL.

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