Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 42

Economic Value Added

Biddle Company uses EVA to evaluate the performance of division managers. For the Wallace Division, after-tax divisional income was $400,000 in year 3.

The company adjusts the after-tax income for advertising expenses. First, it adds the annual advertising expenses back to after-tax divisional income. Second, the company managers believe that advertising has a three-year positive effect on the sale of the company’s products, so it amortizes advertising over three years. Advertising expenses in year 1 will be expensed 50 percent, 40 percent in year 2, and 10 percent in year 3. Advertising expenses in year 2 will be expensed 50 percent, 40 percent in year 3, and 10 percent in year 4. Advertising expenses in year 3 will be amortized 50 percent, 40 percent in year 4, and 10 percent in year 5. Third, unamortized advertising expenses become part of the divisional investment in the EVA calculations. Wallace Division had incurred advertising expenses of $100,000 in year 1 and $200,000 in year 2. It incurred $240,000 of advertising in year 3.

Before considering the unamortized advertising, the Wallace Division had total assets of $4,200,000 and current liabilities of $600,000 at the beginning of year 3. Biddle Company calculates EVA using the divisional investment at the beginning of the year. The company uses a 10 percent cost of capital to compute EVA.

Required

Compute the EVA for the Wallace Division for year 3. Is the division adding value to shareholders?

Step 1 of 3

Economic value added (EVA) for a division should be computed by subtracting the cost of adjusted divisional investment from the adjusted after-tax income from that division.

Adjusted after-tax income is determined by making adjustments to the after-tax income of the division for impaired or non-performing assets, research and development expenditure, differed taxes, provisions, goodwill written-off, leases and restructuring charges.

Adjusted divisional investment is determined by making adjustments to the divisional investment for current liabilities, impaired or non-performing assets, research and development expenditure, differed taxes, provisions, goodwill written-off, leases and restructuring charges.