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

Exercise 41

Economic Value Added

Suwon Pharmaceuticals invests heavily in research and development (R?D), although it must currently treat its R?D expenditures as expenses for financial accounting purposes. To encourage investment in R?D, Suwon evaluates its division managers using EVA. The company adjusts accounting income for R?D expenditures by assuming these expenditures create assets with a two- year life. That is, the R?D expenditures are capitalized and then amortized over two years.

BK division of Suwon shows after-tax income of $2.5 million for year 2. R?D expenditures in year 1 amounted to $1 million and in year 2, R?D expenditures were $1.6 million. For purposes of computing EVA, Suwon assumes all R?D expenditures are made at the beginning of the year. Before adjusting for R?D, BK division shows assets of $10 million at the beginning of year 2 and current liabilities of $200,000. Suwon computes EVA using divisional investment at the beginning of the year and a 12 percent cost of capital.

Required

Compute EVA for BK division for year 2.

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.