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 Journal of Business Finance & Accounting 
, 34(1) & (2), 111–138, January/March 2007, 0306-686Xdoi: 10.1111/j.1468-5957.2006.00660.x
Corporate Financial Control Mechanismsand Firm Performance: The Case of  Value-Based Management Systems
Harley E. Ryan
and Emery A. Trahan
We examine the performance of 84 firms that adopt value-based management (VBM)systems during the period 1984-1997. The typical firm significantly improves matched-firm-adjusted residual income after adopting VBM. This improvement persists for the five post-adoption years studied. After controlling for possible sample bias, we find that large firms showless improvement than small firms. We find a negative relation between tying compensationto VBM and post-adoption performance. We also find that firms reduce capital expendituresfollowing VBM adoption, but that the reductions in spending do not differ based on the firms’growthopportunities.Overall,theevidencesuggeststhatVBMimproveseconomicperformanceand the efficient use of capital.
value-based management, residual income, management compensation, corporategovernance
Effective corporate governance and financial control includes the use of monitoringand incentive mechanisms to align divergent interests between shareholders andmanagers and encourage the creation of shareholder value. Value-based management systems(VBM)provideanintegratedmanagementstrategyandfinancialcontrolsystemintended to increase shareholder value by mitigating agency conflicts. In concept, VBM reduces agency conflicts and helps create shareholder value since it reveals value-increasingdecisionstoemployees,allowsforeasiermonitoringofmanagers’decisions,and provides a method to tie compensation to outcomes that create shareholder value.
TheauthorsarerespectivelyfromRobinsonCollegeofBusiness,GeorgiaStateUniversityandtheCollegeof Business Administration, Northeastern University, USA. They appreciate helpful comments from OlubunmiFaleye,SherryJarrell,ShaneJohnson,JayantKale,OmeshKini,JohnMartin,SheilaRyan,JamesWallace,Sam Weaver, J. Fred Weston, Roy Wiggins, the Editor (Pete Pope) and an anonymous referee. They acknowledgethe excellent research assistance of Pingshun Huang, Huihua Li, Roy Song and Lingling Wang. The authorsareresponsibleforanyremainingerrors.(PaperreceivedAugust2005,revisedversionacceptedAugust2006.Online publication December 2006)
EmeryA.Trahan,NortheasternUniversity,CollegeofBusinessAdministration,Finance Group, 413 Hayden Hall, Boston, MA 02115, USA.e-mail: e.trahan@neu.edu
2006 The Authors Journal compilation
2006 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.
However,thedegreetowhichVBMsystemsactuallyimprovetheeconomicperformanceof publicly held firms is an open question. To gain insight into this issue, we examinethe use and economic efficacy of value-based management systems by 84 firms that adopt VBM systems from 1984 to 1997. We investigate two related research questions:(1)DoestheadoptionofaVBMsystemimproveeconomicperformance?and(2)What factors enhance or hinder the effectiveness of VBM systems?Our primary goal is to examine whether the adoption of a VBM system improveseconomic performance. We recognize that firm performance and the decision to tiecompensation to a VBM metric can be endogenous, which creates a potential sampleselection bias. For instance, firms that are performing poorly face tougher challengesto creating economic value and could be more likely to tie compensation to VBM toprovidemanagerstheincentivestoovercomethesechallenges.Alternatively,managers who expect to achieve a certain level of performance can negotiate a compensationcontract based on the VBM metric that essentially assures a bonus payout. Our sampleincludes firms that base compensation on VBM metrics, but also firms that use VBMfor analysis and evaluation only. Thus, we can examine why firms choose to tiecompensationtoVBM,whichallowsustocontrolforpotentialsampleselectionbiastharesultsfromendogenousrelationsbetweencompensationplansandfirmperformance. With regard to our first research question, we find that firm performance increasesfollowing the adoption of value-based management systems. Compared to a matchedfirm based on industry, prior performance, and size, firms that adopt VBM systemsincrease residual income for the five years subsequent to the adoption of a VBMsystem relative to the year before adoption. The median firm in our sample increasesindustry-andperformance-adjustedresidualincomedividedbyinvestedcapitalbyover7 percentage points for the five-year period subsequent to VBM adoption. We do not find evidence that VBM encourages underinvestment in high-growth firms, suggestingthat the improvement in residual income does not come at the expense of long-term value. With regard to our second research question, we find that firm size is the only firm-specific characteristic that relates to the effectiveness of VBM in all years. Aftercontrolling for possible sample selection bias, we find that large firms show lessimprovement than small firms. We note, however, that these regressions have lowadjusted
s.Possibly,thisresultsuggeststhatlargerfirmsfacegreatermonitoringcosts, whichmakeitmoredifficulttoimplementprogramsinlargerfirms.Inourmultivariateanalysis, we also find that (i) firms that perform better prior to adoption are morelikely to tie compensation to VBM and (ii) the post adoption adjusted performance inthe first two years after adoption negatively relates to the use of VBM to determinecompensation.Thiseffectisnotstatisticallysignificantaftertwo years. Itispossiblethat firms that already focus on value creation are more likely to tie VBM to compensationand that these firms simply have less potential for improvement. Alternatively, firmsmight cap bonus payouts too low when they implement plans, which reduces initialefficacy. We also find that firms reduce capital expenditures following VBM adoption.These reductions in spending do not differ based on the firms’ growth opportunities.Thus, the improvement in performance does not appear to come at the expense of long-term value.Overall, our results provide support that value-based management systems areeffective mechanisms for improving corporate performance. The remainder of thepaper is organized as follows. In Section 2 we provide a summary of the value-based
2006 The Authors Journal compilation
Blackwell Publishing Ltd. 2006
113management literature and the objectives of this research. In Section 3 we describe thesample and research method. Section 4 contains the empirical results. In Section 5 weprovide a summary and conclusion.
The literature on property rights (e.g., Alchian and Demsetz, 1972) and agency theory (e.g., Jensen and Meckling, 1976) maintains that different incentives lead to conflictsbetween shareholders and managers of the public firm that result in a loss in firm value.Ultimately,theshareholdersbearthisloss.Value-basedmanagementprovidesanintegratedmanagementstrategyandfinancialcontrolsystemdesignedtomitigatetheseagency conflicts and increase shareholder value.
 VBM systems attempt to accomplishthis goal by providing managers with a set of decision-making tools (metrics) that, at least in theory, identify which alternatives create or destroy value, and often by linkingcompensation and promotions to shareholder value. Firms can use these metrics tomonitorandrewardmanagementperformance.Theyprovideamechanismforlinkingmanagers’ decisions to firm performance outcomes that create shareholder value andprovide a means to further align shareholder and managerial interests. Value-based management has captured the interest of the corporate and investment communities. Ryan and Trahan (1999) report that 87% of 86 CFOs surveyed indicatethat they are familiar with value-based management. Most of these CFOs also indicatethattheirfirmusesoneormoreVBMsystems.Thisinteresthasalsobeendemonstratedinthebusinesspress.Articlesin
(e.g.,Stires,2001;Colvin,2000;andTully,1999)include a list of 1,000 companies ranked by how much market value they added duringthe past decade, based on Stern Stewart’s market value added (MVA) metric. Thesearticlesprofileseveralcorporationsthathaveadoptedavarietyofmanagementsystems,based on different VBM metrics, in an effort to increase their value. We identify four variations of VBM metrics from these articles in the popular press. All of the metrics are similar in that they are single-period measures of performancethat take into account return on invested capital and the relevant cost of capital.
They are all consistent with discounted cash flow valuation. Although consulting firmshave popularized these metrics (for example, EVA 
is widely adapted and marketed by Stern Stewart & Co., who have trademarked the name), many companies apply theirown versions of the metrics. We do not take any given metric to represent the work of a consulting firm that may have popularized the method. We provide a summary of these four metrics below.
Discounted Cash Flow (DCF)—DCF methods, for instance shareholder value added(SVA), express value as expected future cash flows discounted to the present time at thecompany’s cost of capital. See Rappaport (1998) for a more detailed discussion of DCFmethods as they relate to value-based management.CashFlowReturnonInvestment(CFROI)—CFROIexpressesanestimateofacompany’ssingle-period cash flow as a percentage of total investment. Madden (1999) provides adetailed discussion of CFROI.
1 See Ittner and Larcker (2001) for a general discussion of the VBM model and a thorough review of theempirical research in managerial accounting from a VBM perspective.2 Note that ROIC does not directly consider cost of capital in calculating the metric; however, the metric iscompared to the cost of capital to evaluate performance.
2006 The Authors Journal compilation
Blackwell Publishing Ltd. 2006

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