erc/metu
INTERNATIONAL CONFERENCE IN ECONOMICS  IV
September 13-16, 2000, Ankara

Accounting and Economic Profit Measurements of Entities: Uses and Misuses

Noyan Arsan (State University of West Georgia, USA and Koç University)
Oral Erdoğan (ISE)

Abstract

Accounting income and economic profit are two measures used for evaluation of divisional and/or overall corporate performance. This paper discusses some of the relevant issues investigated in financial literature in determination of these measures as they relate to entity performance. The discussion covers inadequacy of accounting income in determining economic performanceand the cost of equity capital. Residual income is a concept that uses a combination of net income and cost of capital in performance assessment. As used by General Motors Corporation in the early 1920s, and later by Matsustita and General Electric Corporation for evaluation of divisional performance, Solomon's research (1965) contributed to the analysis of residual income in such applications.

Early research by Modigliani and Miller (1958) referred to economic profit in the form of free cash flow. The free cash flow concept was used by Rappaport (1979, 1998) in relating free cash flow to cost of capital and shareholder value, by Stewart (1990), and Grant (1996) in relating free cash flow to cost of capital and economic value added. Many security dealers and financial consulting firms seem to use discounted cash flow method based on projected accounting income and/or dividends in determining shareholder investment performance in equities. In the meantime, some entities use these approaches as well as residual income, economic value added, shareholder value added, Tobin's q, cash value added, and economic profit to determine total entity and divisional effectiveness. Their practical use may be biased

due to the degree of market perfection, which may influence the measurement of inputs used. Considering the approach by Fama and French (1999), which states that determination of the true cost of capital and return on investment is an essential step for evaluating corporate performance, this paper addresses the issue of correct model use and misuse in assessing entity's total and divisional performance.

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Middle East Technical University
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