Accounting Business Reporting for Decision Making

578 Accounting: Business Reporting for Decision Making

The use of profit after tax (PAT) takes into account all returns to the division prior to any financing

charges. Regardless of how the investment is financed, all returns and expenses are accounted for in the

PAT. How the investment is financed is considered in the second part of the equation through the ‘Cost

of capital × Capital’ component.

It is argued that the EVA measure is a true measure of economic profit, since it subtracts from earn-

ings a suitable charge for capital. By doing this, all costs to the entity are considered. The logic of its

use rests on the importance of ensuring that managers act in the best interests of the owners of the

entity. If the purpose of an entity is to maximise the wealth of its owners, then using the EVA as a

performance measure will ensure that managers make decisions that increase the owners’ economic

wealth.

The EVA is calculated from the financial accounting figures, with adjustments made to reflect the

conservative basis of accounting measurement. Stern Stewart has developed more than 100 adjustments

that can be made to both profit and capital, depending on the nature of the entity. It is argued that in

reality only a handful of adjustments will be made, as some would not have a significant effect on the

resulting EVA. This flexibility in the use of adjustments could also be seen to allow for manipulation of

the measure.

Some of the adjustments include the following.

• Adding back the research and development costs. It is argued that these costs should be capitalised

and written off in the financial years in which they bring benefits, not when they are incurred. The

amount spent on research and development should be seen as an investment rather than an expense.

• Adding back the marketing costs. For the same reason stated above, the costs spent on marketing

should be capitalised and written off over the years in which the benefit accrues.

Illustrative example 14.6 demonstrates the calculation of the EVA.

ILLUSTRATIVE EXAMPLE 14.6

The calculation of the EVA for the Fun Hats Company is demonstrated in table 14.5.

TABLE  14.5 Fun Hats Company — calculation of the EVA

Corporate Department stores Specialty stores

Assets

Less: Current liabilities

$2 200 000

$ 110 000

$75 000

$ 36 750

$ 225 000

$ 12 600

= Long-term assets

×   Weighted    average cost    of   capital

=

$ 2 090 000

15.4%

$ 321 860

$38 250

15.4%

$ 5 890

$ 212 400

15.4%

$ 32 710

PAT $400 000 × (1 − 0.30)

= $280 000

−$70 000 × (1 − 0.30)

= −$49 000

$70 000 × (1 − 0.30)

= $49 000

EVA $280 000 − $321 860

• $41 860

−$49 000 − $5 890

= –$54 890

$49 000 − $32 710

= $16 290

The  PAT     used   is   the     segment    profit  adjusted    for  tax.    In  our     example,   the  tax     rate    is  30  per     cent.  Cap-

ital refers to long-term assets and is calculated as total assets less current liabilities. Some adjustments

may be made to this based on the judgement of those involved. As mentioned earlier, over 100 possible

adjustments have been put forward by Stern Stewart.

The use of the weighted average cost of capital is used regularly in finance-related decisions. The

weighted    average cost    of   capital    (WACC)  is   calculated on   the     entity’s   cost    of   equity and  debt.  In   our    

example,    the  weighted   average cost    of   capital    was  assumed    to   be  15.4   per  cent.  The  actual WACC    

calculation is beyond the scope of this chapter.