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A Comparison of Error Rates for EVA, Residual Income, GAAP-earnings, and Other Metrics Using a Long-window Valuation Approach
Author(s)
Date Issued
2008
Date Available
2016-02-12T15:17:56Z
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.
Other Sponsorship
Centre for Business Performance, ICAEW
Type of Material
Journal Article
Publisher
Taylor and Francis
Journal
European Accounting Review
Volume
17
Issue
3
Start Page
471
End Page
502
Copyright (Published Version)
2008 European Accounting Association
Language
English
Status of Item
Peer reviewed
This item is made available under a Creative Commons License
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