Accounting Measures of Performance

Most organizations have based their managers’ evaluations and rewards heavily on standard
accounting-based, summary financial measures. Accounting-based, summary or bottom-line
performance measures come in two basic forms:
(1) residual measures (or accounting profit measures), such as net income, operating profit,
earnings before interest, tax, depreciation and amortization (EBITDA), or residual income; and

(2) ratio measures (or accounting return measures), such as return on investment (ROI), return on
equity (ROE), return on net assets (RONA), or risk-adjusted return on capital (RAROC).

These measures are typically derived from the rules defined by standard setters for financial
reporting purposes.

Advantages:
•Accounting profit and profit can be measured in a timely manner that is relatively precise and
objective, timeliness, precision, and objectivity are important for all critical measurement
qualities.
•Compared to other quantities, it can be measured precise and objective
•Accounting measures can usually be more controlled by the money manager evaluating
performance
•Accounting measurement is a measurement that can be understood. ccounting is a standard
course in every business school, and managers have used the measures for so long that they are
well familiar with what the measures represent and how they can be influenced.

Limitations:
•The accounting system is a transaction-oriented system. Accounting profit is primarily a
summation of the effects of the transactions that took place during a given period.
•Accounting profit depends on the method of measurement. Multiple measurement methods
are often available to account for identical economic events.
•Accounting profit is derived from measurement rules that are often conservatively biased.
Accounting rules require slow recognition of gains and revenues but quick recognition of
expenses and losses.
•Profit calculations ignore some economic values and value changes that accountants feel cannot
be measured accurately and objectively.
• profit reflects the cost of borrowed capital (through interest deductibility) but ignores the cost
of equity capital.
• Accounting profit ignores risk and changes in risk. Firms, or entities within firms, that have not
changed the pattern or timing of their expected future cash flows but have made the cash flows
more certain (less risky) have increased their economic value, and vice versa.
• Profit figures also focus on the past. Economic value is derived from future cash flows, and
there is no guarantee that past performance is a reliable indicator of future performance.

Investment and operating myopia

Accounting performance measures can cause managers to act myopically in making either
investing or operating decisions. Holding managers accountable for short-term profits or returns
may induce managers to reduce or postpone investments that promise payoffs in future
measurement periods, even when those investments have a positive net present value and meet
other criteria to make them worthwhile. This is called investment myopia.

Investment myopia can be sourced directly from two accounting measurement problems, namely
conservative bias and uncertainty over intangible assets. Whereas Operation Myopia which is
generally referred to as "Shipping bricks and other tricks" is a practice of increasing profits by
destroying goodwill