(a)
REPORT To: Chairman
From: Management accountant Date: XX.XX.XXXX
Subject: Destroying value in V plc
This report considers the recent observations by the analyst of X Stockbrokers on our 20XX results. It will explain the principles of the approach taken by the analyst and will provide a commentary on the treatment of the specific adjustments made to our reported profit figure and balance sheet.
I Principles of the approach taken: economic value added
1. A management team is required by an organisation’s shareholders to maximise the value of their investment in the organisation and several performance indicators are used to assess whether or not the management team is fulfilling this function.
2. The majority of these performance measures are based on the information contained in the organisation’s published accounts.
These indicators can be easily manipulated and often provide misleading information. Earnings per share, for example, are increased by deferring expenditure in research and development and in marketing.
3. The financial statements themselves do not provide a clear picture of whether or not shareholder value is being created or destroyed:
(a) The profit and loss account, for example, indicates the quantity but not quality of earnings
(b) It ignores the cost of equity financing and only takes into account the costs of debt financing, thereby penalising organisations such as ourselves which choose a mix of debt and equity finance.
(c) Neither does the Cash flow statement provide particularly appropriate information. Cash-flows can be large and positive if an organisation reduces expenditure on maintenance and undertakes little capital investment in an attempt to increase short-term profits at the expense of long-term success.
4. The analyst has therefore adopted an approach known as economic
C H A P T E R 1 1 – V A L U A T I O N S , A C Q U I S I T I O N S A N D M E R G E R S : S E C T I O N 3
expect their returns to accrue. They also provide a profit-after-tax figure, which is a more realistic measure of the actual cash yield generated for shareholders from recurring business activities.
It is not very surprising that if management are assessed using performance measures calculated using traditional accounting policies, they are unwilling to invest in activities which immediately reduce current year’s profit.
II The Treatment of specific items 1. Research and development
The analyst has added back expenditure of £2.1 million to the 20XX profit figure on the grounds that the expenditure is providing a base for future activities. Similarly the research and development expenditure over the last seven years of £17.4million has been added back to the capital employed figure on the basis that we are continuing to benefit from the expenditure. A depreciation charge should probably be made against this capitalised value, however, to reflect any fall in its value.
2. Advertising
The analyst has added back advertising expenditure of £2.3 million to the 20XX profit figure on the assumption that the expenditure has supported sales, raised customer awareness and/or increased brand image/loyalty, all of which could produce significant cashflows in the future and hence are for the long-term benefit of the organisation. The advertising expenditure over the last five years of £10.5 million has been added back to the capital employed figure (in much the same way as the research and development expenditure) to reflect the fact that the costs will provide for future growth. Again, an amortisation charge should be made if brand values are being eroded, possibly by competition.
3. Interest and borrowings
Because our profits are being earned using both debt and equity
The analyst has added back goodwill amortisation of £1.3 million to the 20XX profit figure. Goodwill is the difference between the price paid for a business acquisition and the current cost valuation of that acquisition’s net assets. On the assumption that a realistic price was paid, the goodwill purchased should provide benefits in the future, not just in the year of purchase. And the goodwill of
£40.7 million, which has been written off against reserves on acquisitions in previous years has been added back to the capital employed figure so as to provide a more realistic base upon which we must earn a return. Again, the goodwill capitalised should be regularly reviewed and amortised to reflect any reductions in its value.
I hope this information has been of use. If I can be of any further assistance please do not hesitate to contact me.
Signed: Management Accountant (b)
REPORT To: Chairman
From: Management accountant Date: XX.XX.XX
Subject: Where is value being destroyed?
An analyst working for X Stockbrokers has recently commented that ‘the management of V plc is destroying value’. In an attempt to establish where value is being destroyed in our organisation, a revised statement of divisional performance has been prepared, adopting an approach similar to that used by the analyst. The statement, plus supporting explanations, is set out in Appendix 1.
The analysis shows that value of £0.1 million was destroyed in Division B, while value of £2.3 million was destroyed in Division C. Division A, on the other hand, created value of £1 million.
This is in marked contrast to the performance indicated in the conventional divisional performance report prepared for 20XX. This shows all three divisions earning a return on investment in excess of 20%, with Divisions B and C, the destroyers of value, making higher returns on investment than Division A, the creator of value.
The analyst’s approach is similar to performance evaluation using residual income in that a charge is made for the capital employed within the division.
Further adjustments are also made to both profit and capital employed to provide more realistic measures for performance analysis (as explained in my earlier report and in Appendix 1). The results of the analysis are dependent upon the following factors:
1. Head office expenses are assumed to have been incurred in relation to divisional turnover. Any one of a number of other bases might be equally valid.
C H A P T E R 1 1 – V A L U A T I O N S , A C Q U I S I T I O N S A N D M E R G E R S : S E C T I O N 3
Despite the limitations set out above, the analyst’s approach provides an alternative insight into how our divisions are performing and could well prove useful in enabling us to create value for our shareholders in the future.
Signed: Management Accountant
APPENDIX 1
Statement of profitability
Divisions
A B C Head office Total
£m £m £m £m £m
20XX PBIT 5.7 5.6 5.8 (1.9) 15.2
Add back
Advertising 2.3 - - - 2.3
R & D - 2.1 - - 2.1
Goodwill (1) - 0.3 1.0 - 1.3
Head office expenses (2) (0.4) (0.3) (1.2) 1.9 -
Less: tax paid (2.0) (1.6) (1.2) - (4.8)
Revised profit 5.6 6.1 4.4 - 16.1
Statement of capital employed
Divisions
A B C Head office Total
£m £m £m £m £m
Total assets less current liabilities
27.1 23.9 23.2 3.2 77.4
Adjustments
Advertising 10.5 - - - 10.5
R & D - 17.4 - - 17.4
Goodwill - 10.3 30.4 - 40.7
Head office assets (4) 0.7 0.5 2.0 (3.2) -
Revised capital 38.3 52.1 55.6 - 146.0
Economic value added
Divisions
A B C Head office Total
£m £m £m £m £m
Revised profit 5.6 6.1 4.4 - 16.1
Required return (5) 4.6 6.2 6.7 - 17.5
Value added/(destroyed) 1.0 (0.1) (2.3) - (1.4)
Explanation of adjustments made 1. Goodwill
Goodwill amortised has been apportioned to Divisions B and C in proportion to the value of goodwill written off to capital and reserves.
Division Goodwill
write-off Goodwill amortised
£m % £m
B 10.3 25.3 x £1.3m 0.3289
C 30.4 74.7 x £1.3m 0.9711
40.7 100.0 1.3000
2. Head office expenses
No direction is provided as to the way in which head office expenses should be apportioned to the three divisions. An activity-based approach could be the most suitable but, in the absence of appropriate data, allocation based on turnover has been adopted.
3. Tax paid
The tax liability of £4.8 million for V plc has to be apportioned over the three trading divisions. Given that the divisions’ taxable profits will be affected by the allocation of head office expenses and the interest paid, the overall tax liability has been apportioned on the basis of divisional profit after interest paid and allocated head office costs.
Division PBIT Interest paid
Head office expenses
Apportionme
nt figures Charge
£m £m £m % £m
A 5.7 − (0.4) − 0.4 = 5.7 41 2.0
B 5.6 − 0.7 − 0.3 = 4.6 33 1.6
C 5.8 − 0.9 − 1.2 = 3.7 26 1.2
14.0 100 4.8
4. Head office assets
Head office assets have been apportioned to the three trading divisions on the basis of divisional turnover so as to be consistent with the basis used to apportion head office expenses
5. Required return
The required return is based on a weighted average cost of capital of