Discuss the relationship between accounting methods of measuring divisional performance and economic methods, identify the formula used for calculating economic value added, and discuss methods for adjusting accounting earnings and the importance of

making these adjustments.
What will be an ideal response?

Economic methods build on accounting methods but adjust those methods to incorporate short-term investments that may generate long-term benefits. Economic methods also compare a division's performance with a firm's cost of capital. This avoids some of the gaming that can characterize the use of other standards of comparison in applying accounting measures of divisional performance.

Perhaps the most popular of these economically oriented measures of division performance is known as economic value added or EVA. EVA is calculated by subtracting the cost of capital employed in a division from that division's earnings in the following manner:

EVA = adjusted accounting earnings - (weighted average cost of capital x total capital
employed by a division)

The calculation of economic value added begins with a division's "adjusted" accounting earnings. These are a division's traditional accounting earnings adjusted so that they approximate what would be a division's economic earnings. Several adjustments to a division's accounting statements have been described in the literature. For example, traditional accounting practices require R&D spending to be deducted each year from a division's earnings. This can lead division general managers to underinvest in longer-term R&D efforts. In the EVA measure of divisional performance, R&D spending is added back into a division's performance and R&D is then treated as an asset and depreciated over some period of time. By adjusting a division's earnings and accounting for the cost of investing in a division, economic value added is a much more accurate estimate of a division's economic performance than are traditional accounting measures of performance.