Biddle Company uses EVA to evaluate the performance of division managers. For th

Question

Biddle Company uses EVA to evaluate the performance of division managers. For the Wallace Division, after-tax divisional income was $685,000 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, 30 percent in year 2, and 20 percent in year 3. Advertising expenses in year 2 will be expensed 50 percent, 30 percent in year 3, and 20 percent in year 4. Advertising expenses in year 3 will be amortized 50 percent, 30 percent in year 4, and 20 percent in year 5. Third, unamortized advertising expenses become part of the divisional investment in the EVA calculations Wallace Division incurred advertising expenses of $184,000 in year 1 and $334,000 in year 2. It incurred $394,000 of advertising in year 3. Before considering the unamortized advertising, the Wallace Division had total assets of $7,150,000 and current liabilities of $1,070,000 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. Adjusted divisional investment Cost of adjusted divisional investment Economic Value Added (EVA)

Explanation / Answer

Advertising may be valuable—even crucial for some businesses—and will lead to additional assets, but accountants and others are unable to quantify the future economic value necessary for reporting it as an asset. As a result, advertising expenditures will be reported as expenses in the accounting period in which the ads are run.

So what should be done is to record and amortised fully the advertising expenses in the year they incurred and should not carry forward in future years.

The company does the correct treatment ie record the total expenses of advertising in that year for the taxation purpose. But adding back the expenses and then amortising a specific percentage is not the correct treatment. And the advertising Unamortised expenses should not be considered in EVA calculation.

Although the advertising expenses are operating expenses so will be considered in calculating NET OPERATING PROFIT AFTER TAX.

So for the purpose of calculating EVA for 3rd year

NOPAT. = $ 685000

Cost of Capital = 10%

Cost of Adjusted divisional Investment = $ 6080000* 10% = $ 608000

Adjusted Divisional Investment = Total Assets- Current Liabilities

=. $ 7150000- 1070000

= $ 6080000

EVA= NOPAT - ( ADJUSTED INVESTMENT * COST OF CAPITAL)

   = $ 685000 - (6080000* 10%)

= $ 77000

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