I’m trying to understand the logic and the impact of each adjustment to the financial statements before calculating NOPAT and Invested Capital. Would you guys be able to help out in terms of how will the adjustments below impact the economic value added?
(1) Capitalize and amortize research and development charges, and then add them back to earnings to calculate NOPAT ( Ex. I got this question wrong in one of the topic test because I didn’t assume that R&D charges would be added back)
(2) Add back charges on strategic investments that will generate returns in the future
(3) Eliminate deferred taxes and consider only cash taxes as an expense
(4) Treat operating leases as capital leases and adjust nonrecurring items
(5) Add LIFO reserve to invested capital and add back change in LIFO reserve to NOPAT
You don’t need to know the impacts, because if they are NOPAT adjustments. If a question asks you what happens if company reduces R&D, the result is no impacts to EVA because R&D capitalization was added back to calc nopat.
For performance evaluation purposes, EVA makes adjustments for costs that are considered to be accounting distortions by treating them as if they are capitalized assets instead of the GAAP-mandated treatment as expenses. Why adjustments? Because it removes the anomolies such as expensive spending on R&D.
Stern Stewart & Company created EVA to provide financial information without the “anomalies” that result from following U.S. GAAP. One example of an anomaly is the expensing of research and development (R&D) costs even though R&D breakthroughs often benefit companies in future years.
Finding operating income after taxes simply requires deducting income taxes from operating income. Second, adjustments are made to operating income and average operating assets. Although more than 150 possible adjustments can be made, most firms limit adjustments to 15 or less.