10 Developments in Financial Reporting Ue Se aa CCE The concept of value added is considerably old. It originated in the U.S. Treasury in the ‘18th Century and periodically accountants have deliberated upon whether the concept should be incorporated in financial accounting practice. But actually, the value added statement has come to be seen with greater frequency in Europe and more particulary in Britain. The discussion paper "Corporate Report’ published in 1975 by the then Accounting Standard Steering Committee (now known as Accounting Standards Board) of the U.K. advocated the publication of value added statement along with the conventional annual corporate report. In 197, the Department of Trade, UK. published "The Future of Company Reports’ which stated that all substantially large British Companies should include a value added (V.A) statement in their annual reports. Also, a few companies in the Netherlands include V.A. information in their annual reports, but the disclosures often fall short of being a full V.A, statement and also the method of arriving at V.A. is grossly non- standardized. In India, Britannia Industries Limited and some others prepare value added statement as supplementary financial statement in their annual reports. Pee Teas 1.2.4 Value Added (VA): VA is the wealth a reporting entity has been able to create through the collective effort of capital, management and employees. In economic terms, value added is the market price of the output of an enterprise less the price of the goods and services acquired by transfer from other firms. VA can provide a useful measure in gauging performance and activity ofthe reporting entity 4.2.2 Gross Value Added (GVA): GVA is arrived at by deducting from sales revenue the cost of all materials and services which were brought in from outside suppliers. We know that the retained profit of a company for a given accounting year is derived as below: R=S-B-Dep.-W-|-T-Div (1) Where R = Retained profit, $ = Sales revenue, B = Bought in cost of materials and services, Dep = annual depreciation charge, W = Annual wage cost, | = Interest payable for the year, T = Annual corporate tax and Div = Total dividend payable for the year. Rearranging the equation (1) we get GVA as below: S-B=R+Dep.+W+l+T+Dv Q) © The Institute of Chartered Accountants of India40.2 _ Financial Reporting Each side of equation (2) represents GVA. However, this is a very simple definition of GVA. In practice GVA includes many other things. Besides sales revenue, any direct income, investment income and extraordinary incomes or expenses are also included in calculation of GVA. Including these items in the above equation No, 2, we get (S + Di)-B + Inv + E1=R + Dep. +W+T +14 Div, (3) Where Di = Direct incomes, In Investment incomes, El = Extraordinary items. The above equation can be shown by way of the following statement. Gross value added of a manufacturing company Sales ‘Add: Royalties and other direct income Less: Materials and Services used Value added by trading activities ‘Add : Investment Income Add/Less: Extraordinary items Gross Value Added be x be x P< be Applied as follows: To employees as salaries, wages, etc. To government as taxes, duties, et. To financiers as interest on borrowings x x «x x To shareholders as dividends To retained earnings including depreciation x 1.2.3 Net Value Added (NVA): NVA can be defined as GVA less depreciation. Rearranging the equation (1) we can get NVA as below: S-B-Dep=R+W+1+T + Div 1.3 Reporting Value Added A significant experience regarding the publication of the value added statement is represented by the UK. In 1975, the Accounting Standard Steering Committee (ASSC) published the Corporate Report containing the suggestions for British companies to present the value added statement in addition to the traditional profit and loss account. The ‘Corporate Report of the U.K. advised the British companies to report Gross Value Added (GVA). The ‘Report’ did not consider the possibilty of the alternative Net Value Added (NVA). As a result the majority of British companies prefer to set forth their VA statement as a report © The Institute of Chartered Accountants of IndiaDevelopments in Financial Reporting 10.3 on GVA, so that depreciation is an application of VA rather than a cost to be deducted in caloulating VA. In India also GVA is more popular among reporting companies than NVA. The reasons for reporting GVA are as follows: (2) GVA can be derived more objectively than NVA. This is because depreciation is more prone to subjective judgement than are bought-in costs. (b) GVA format involves reporting depreciation along with retained profit. The resultant sub- total usefully shows the portion of the year's VA which has become available for re- investment. (c) The practice of reporting GVA would lead to a closer correspondence between VA and national income figures. This is because economists generally prefer gross measures of national income to net one. However, there are also valid reasons for reporting NVA. They are: (2) Wealth Creation (i.e. VA) will be overstated if no allowance is made for the wearing out or loss of value of fixed assets which occurs as new assels are created. (0) NVAis a firmer base for caloulating productivity bonus than is GVA. The productivity of a company may increase because of additional investments in modernisation of plant and machinery. Consequently, the value added component may improve significantly. The employees of the company will naturally claim and be given some share of additional VA as productivity bonus. But if the share is based on GVA then ‘no recognition is given to the need for an increased depreciation charge. (c) The concept of matching demands that depreciation be deducted along with bought- in costs to derive NVA. GVA is inconsistent, for costs would be charged under the bought-in heading ifthe item has a life of less than or one year. But i he item has a longer life it would be treated as a depreciable fixed asset and its cost would never appear as a charge while ariving at GVA. From the above discourse it can be said that itis better to report on NVA rather than on GVA. 1.4 Necessity of Preparing VA Statements The debate on the role of value added among accounting measurements has received attention in the last fifty years, with a particular emphasis in the 1970's and 1980's. The analysis of value added can be classified in at least three fields of research: management control (internally oriented), financial reporting (externally oriented), and social reporting (externally oriented). The first field emphasizes the role of value added as an indicator of efficiency among the tools to appraise the “economic productivity’ (Sutherland 1956; Ponzanelli 1967: 186). Therefore, the value added measurement is used as one of the performance indicators in the management control system, particularly in the industrial sector, with the main purpose of controlling costs and the performance of productive factors, especially labour. The second field of analysis looks at value added reporting as additional information to the traditional income statement, which is focused on eamings and net profit. An externally © The Institute of Chartered Accountants of India40.4 _ Financial Reporting oriented value added statement can synthesize the contribution of the whole business in different sectors, not only the industrial one. The third approach considers the value added statement as an embryonic form of social reporting. Its worth noting that the label ‘value added statement" in the English version of the International Accounting Standard (IAS 1) (2004) is translated into italian by the words “bilancio sociale” (social reporting) It is a means of communication in the overall business reporting process which is added to the traditional and official annual report. The most relevant concept of income in this broad social responsibilty concept of the enterprise is the value added concept. Therefore, the origin of concept of value added lies in the enterprise theory which says that the reporting entity is a social institution, operating for the benefit of many interested groups. Proponents of VA argue that there are advantages in defining income in such a way as to include the rewards of a much wider group than just the shareholders. The various advantages of the VA statement are as follows: (a) Reporting on VA improves the attitude of employees towards their employing companies. This is because the VA statement reflects a broader view of the company’s objectives and responsibilities. (0) VA statement makes it easier for the company to introduce @ productivity linked bonus ‘scheme for employees based on VA. The employees may be given productivity bonus on the basis of VA/Payrol ratio. (0) VA-based ratios (¢.9. VA/Payroll, Taxation/VA, VAISales etc.) are useful diagnostic and predictive tools. Trends in VA ratios, comparisons with other companies and international ‘comparisons may be useful. However, it may be noted that the VA ratios can be made more useful if the ratios are based on inflation adjusted VA data, (a) VA provides a very good measure of the size and importance of a company. To use sales figures or capital employed figures as a basis for company rankings can cause distortion. This is because sales may be inflated by large bought-in expenses or a capital-intensive ‘company with a few employees may appear to be more important than a highly skilled labour intensive company. (e) VA statement links a company's financial accounts to national income. A company's VA indicates the company's contribution to national income. (f) Finally VA statement is built on the basic conceptual foundations which are currently accepted in balance sheets and income statements. Concepts such as going concern, matching, consistency and substance over form are equally applicable to the VA statement. 1.5 Value Added Statement (VA Statement) The VA statement is a financial statement which shows how much value (wealth) has been created by an enterprise through utilization of its capacity, capital, manpower and other resources and allocated to the following stakeholders: The workforce - for wages, salaries and related expenses; © The Institute of Chartered Accountants of IndiaDevelopments in Financial Reporting 10.5, The financiers — for interest on loans and for dividends on share capital The government - for corporation tax. The business — for retained profits A statement of VA represents the profit and loss account in different and possibly more useful manner. The conventional VA statement is divided into two parts — the first part shows how VA is arrived at and the second part shows the application of such VA. Mlustration 4 Given below isthe summarised Profit and Loss Account of Creamco Ltd. ‘Summarised Profit and Loss Account for the year ended 31st March, 2017 ‘Notes | Amount (#000) Income Sales 1 | 28,525 Other Income 156 29,281 Expenditure Operating cost 2 | 25,658 Excise duty 1718 Interest on Bank overdraft 3 93 Interest on 10% Debentures 1.187 28,626 Profit before Depreciation 655 Less: Depreciation 1255) Profit before tax 400 Provision for tax 4 (275) Profit after tax 125 Less: Transfer to Fixed Asset Replacement Reserve 128) 100 Less: Dividend paid and payable (45) Retained profit 55 Notes: 1. This represents the invoice value of goods supplied after deducting discounts, retums and sales tax. © The Institute of Chartered Accountants of India40.6 _ Financial Reporting 2. Operating cost includes # ('000) 10,247 as wages, salaries and other benefits to employees. 3. The bank overdraft is treated as a temporary source of finance. 4. The charge for taxation includes a transfer of & (000) 48 to the credit of deferred tax account. You are required to: (a) Prepare a value added statement for the year ended 31st March, 2017. (6) Reconcile total value added with profit before taxation Solution (a) CREAMCO LTD. VALUE ADDED STATEMENT for the year ended March 31, 2017 # (000) |_# ('000) % Sales 28,525 Less: Cost of bought in material and services: Operating cost 15411 Excise duly 4718 Interest on bank overdraft 23) «7220 Value added by manufacturing and trading activities 11,303 ‘Add: Other income 156 Total value added 12.059 Application of value added: To pay employees: Wages, salaries and other benefits 10247 | 94.7 To pay government Corporation tax 230 1.91 To pay providers of capital: Interest on 10% Debentures 4187 Dividends 5 1,202 9.97 To provide forthe maintenance and ‘expansion of the company: Depreciation 255 Fixed Assets Replacement Reserve ry Deferred Tax Account 45 Retained profit _85| _300| 315 12,059 | 100.00 © The Institute of Chartered Accountants of IndiaDevelopments in Financial Reporting 10.7. (b) Reconciliation between Total Value Added and Profit Before Taxation # (000) ® (000) Profit before tex 400 ‘Aad back Depreciation 255 Wages, salaries and other benefits 10,247 Debenture interest 412 | 11.959 Total Valve Added 12,059 Notes: (1) Deferred tax could alternatively be shown as a part of To pay government (2) Bank overdraft, being a temporary source of finance, has been considered as the provision of a banking service rather than of capital. Therefore, interest on bank overdraft has been shown by way of deduction from sales and as a part of ‘cost of bought in material and services’ aN It is argued that although the VA statement shows the application of VA to several interest groups (like employees, government, shareholders, etc.) the risk associated with the company is only borne by the shareholders. In other words, employees, government and outside financiers are only interested in getting their share on VA but when the company is in trouble, the entire risk associated therein is borne only by the shareholders. Therefore, the concept of showing value added as applied to several interested groups is being questioned by many academics. They advocated that since the shareholders are the ultimate risk takers, the residual profit remaining after meeting the obligations of outside interest groups should only be shown as value added accruing to the shareholders. However, academics have also admitted that from overall point of view value added statement may be shown as supplementary statement of financial information. But in no case can the VA statement substitute the traditional income statement (i.e. Profit & Loss Account). Another contemporary criticism of VA statement is that such statements are non-standardised One area of non-standardisation is the inclusion or exclusion of depreciation in the calculation of value added. Another major area of non-standardisation in current VA practice is taxation Some companies report only tax levied on profits under the heading of “VA applied to governments”, Other companies prefer to report on extensive range of taxes and duties under the same heading. In the case of Britannia Industries Limited, it has shown taxes and duties paid under the heading “VA applied to Government’. In the illustration given in para 1.5 excise duty has been shown as a part of bought-in cost and deducted while calculating value added. Some academics argued that such excise duty should be shown as an application of VA. However, this practice of non-standardisation can be effectively eliminated by bringing out an accounting standard on value added. Therefore, this criticism is a temporary phenomenon. © The Institute of Chartered Accountants of India40.8 _ Financial Reporting We have stated in para 1.3, the reasons for preferring NVA to GVA. We prepare the NVA statement on the basis of the information given in Illustration in para 1.5. it can be mentioned here that in preparing VA statement on NVA basis excise duly has been shown as an application of VA. (a) CREAMCO LTD. VALUE ADDED STATEMENT for the year ended March 31, 2017 = (000)| #000) % Sales 28,525 Less: Cost of bought in material and services: Operating cost 18411 Interest on bank overdraft 93] 15.504 Gross Value Added 13,021 Less: Depreciation (255) Net Value Added 12,766 ‘Add: Other income 156 ‘Avalable for application 13522 Applied as follows: To pay employees: Wages, salaries and other benefits 10,247 75.78 To pay government Corporation tax & excise duty 1048 | 14.41 To pay providers of capita: Interest on 10% Debentures 1,157 Dividends 45 1,202 8.89 To provide for the maintenance and expansion of the company: Fixed Assets Replacement Reserve 25 Deferred Tax Account 45 Retained profit $5) 128] _092 13.522 | 100.00 (b) Reconciliation between Total Value Added and Profit before Taxation (000) | # (000) Profit before tax 400 ‘Add back Excise duty 1,718 © The Institute of Chartered Accountants of IndiaDevelopments in Financial Reporting 10.9 Wages, salaries and other benefits 10,247 Debenture interest assr | 13.122 Total Value Added 13,522 We can see that VA based ratios have changed significantly particularly with respect to payments to employees and government (i.e, Payral/VA and taxation /VA). Taxation/VA ratio has increased from @ meager 1.9% to @ significant 14.41%, whereas payrollVA ratio has come down from 84.97% to 75.78%. It suggests that although the employees are enjoying the major share of VA, government's share has also increased significantly. As a result the retained profit of the company has significantly come down, Mlustration 2 From the following data, prepare @ Value Added Statement of Merit Lt, forthe year ended 31.93.2017: Particulars | Particulars = Decrease in Stock 24,000 | Sales 40,57,000 Purchases 20,20,000 | Other income 55,000 Wages & Salaries 10,00,000 ‘Manufacturing & Other Expenses 2,30,000 Finance Charges 4,689,000 Depreciation 2,44,000 Proft Before Taxation 1,25,000 Total 41,12,000 41.12,000 Particulars z Profit Before Taxation 1,25 000 Less: Tax Provisions (40,000) Income Tax Payments (for earlier years) 3,000) Profit After Taxation 82,000 Appropriations of PAT Debenture Redemption Reserve 10,000 General Reserve 10,000 Proposed Dividend 35,000 Balance carried to balance Sheet 27,000 Total 82,000 Solution Value Added Statement of Merit Ltd, For the year ended 31.03.2017 Particulars z Sales/Tumover 40,57,000 © The Institute of Chartered Accountants of India40.10 Financial Reporting Less: Bought in Materials - Dividends + Depreciation - Debenture Redemption Reserve - General Reserve + Retained Earnings Total Application of Value Added Decrease in Stock 24,000 Purchases 20,20,000 Manufacturing and other expenses 2,30,000 (22,74,000) Value Added by Trading Activities 47,83,000 ‘Add: Other Income 55,000 Gross Value Added 18,38,000 Applied as follows: = 4. To Pay Employees - Salaries, Wages, etc 10,00,000 2. To Pay Government as + Taxes, Duties etc (40,000+3,000) 43,000 3. To Pay Providers of capital = Interest on borrowings 469,000 4. To Pay for Maintenance and Expenses of the Company 35,000 | 5,04,000 2,44,000 410,000 40,000 27,000 | _2,91,000 18,38,000 Mlustration 3 Prepare a Gross Value Added Statement from the following summarised Profit and Loss Account of ‘Strong Ltd. Show also the reconciliation between Gross Value Added and Profit before Taxation: Profit & Loss Account for the year ended 31st March, 2017 income ‘Notes ‘Amount (in lakhs) | (# in lakhs) ‘Sales 610 Other Income 25 635 Expenditure Production & Operational Expenses 1 465 ‘Administration Expenses 2 19 Interest and Other Charges 3 a © The Institute of Chartered Accountants of IndiaDevelopments in Financial Reporting 10-14 Depreciation 4 525 Profit before Taxes 110 Provision for Taxes (16) 4 Balance as per Last Balance Sheet 1 104 Transferred to: General Reserve 60 Proposed Dividend ary 1 ‘Surplus Carried to Balance Sheet 20 tot Notes: 1. Production & Operational Expenses (€ in lakhs) Decrease in Stock 12 Purchases of Raw Materials 185 Purchases of Stores 2 Salaries, Wages, Bonus & Other Benefits 4" ess and Local Taxes " Other Manufacturing Expenses MM 465 2. Administration expenses include inter-alia audit fees of € 4.80 lakhs, salaries & commission to directors ¢5 lakhs and provision for doubtful debts # 5.20 lakhs. 3. Interest and Other Charges: (# in lakhs) (On Working Capital Loans from Bank a (On Fixed Loans from IDBI 12 Debentures i 2 Solution Strong Limited Value Added Statement for the year ended 31st March, 2017 Tinlakhs | © inlakhs % Sales 610 Less: Cost of bought-n material and services: Production and operational expenses 413 © The Institute of Chartered Accountants of India40.12 _ Financial Reporting Administration expenses 14 Interest on working capital loans 8 (435) Value added by manufacturing and trading activities 115 ‘Add : Other income 5 Total Value Added 200 Application of Value Added: To Pay Employees Salaries, Wages, Bonus and Other Benefits a 20.50 To Pay Directors ‘Salaries and Commission 5 250 To Pay Government Goss and Local Taxes " Income Tax 16 a 13.50 To Pay Providers of Capital Interest on Debentures 7 Interest on Fixed Loans 2 Dividend un 30 15.00 To Provide for Maintenance and Expansion of the Company. Depreciation 14 General Reserve 60 Retained Profit (30-7) 23 i Grand Total 200 Reconciliation between Total Value Added and Profit Before Taxation: Tinlekis | @inlakhs Profit before Tax 110 ‘Add back Depreciation 4 Salaries, Wages, Bonus and other Benefits “1 Directors’ Remuneration 5 Coss and Local Taxes " Interest on Debentures 7 Interest on Fixed Loans 2 Total Value Added 20 200 © The Institute of Chartered Accountants of IndiaDevelopments in Financial Reporting 10.13 Mlustration 4 Hindusthan Corporation Limited (HCL) has been consistently preparing Value Added Statement (VAS) as part of Financial Reporting. The Human Resource department of the Company has come up with a ‘new scheme to link employee incentive with Value Added’ as per VAS, s per the scheme an Annual Index of Employee cost to Value Added annuelly (% of employee cost to Value Added rounded off to nearest whole number) shall be prepared forthe last 5 years and the best index out of results ofthe last 5 years shall be selected as the ‘Target Index’. The Target Index percentage shall be applied to the figure of Value Added’ for a given year to ascertain the target employee cost. Any saving in the actual employee cost for the given year compared to the target employee cost will be rewarded as ‘Variable incentive’ to the extent of 70% of the savings. From the given data, you are requested to ascertain the eligibility of ‘Variable Incentive’ for the year 2016-2017 forthe employees of the HCL. Value added statement of HCL for last 5 years (@ in lakhs) Yes 2011-12| 2012-13) 2013-14] 2014-15] 2015-16 Sales 3,200] 3,250| 2,900|3,800| 4,900 ‘Less: Bought out goods and services 2.900 2,080/ 1,940] 2,510] 3.200 Value added 1100| 1.170) 960} 1,290) 1,700 Application of Value Added Year 201-42] 2012-43] 203-14| 2014-15] 2016-16 To Pay Employees 20/480] 450) «600 750 To Providers of Capital 160 170 120 190) 210 To Government Tax 210 190] 220) 300} 250 For Maintenance and expansion 20] 330 17o| 200] 490 ‘Summarized Profit and Loss Account of the HCL for 2016-207 (in lakhs) Sales 5.970 Less: Material consumed 1,950 Woges 400 Production salaries 130 Production expenses 500 Production depreciation 150 Administrative salaries 150 Administrative expenses 200 ‘Administrative depreciation 100 Interest 150 Selling and distribution salaries 120 Selling expenses 350 Selling depreciation 120 4320 Profit 1,650 © The Institute of Chartered Accountants of India40.14 Financial Reporting Solution 1. Calculation of Target index (#in lakhs) Year 2014-12] 2012-13] 2019-14] 2014-15] 2016-16 Employees cost s2o| 480/450] 600] 750 Value added 4,100} 4,170) 960] 1,290] 1,700 Percentage of Employee cost! to Value] 47%| 41%] 47%] 47%] 44% ‘added! (tothe nearest whole number) Target index percentage is taken as least ofthe above from companies viewpoint on conservative basis ie. 41%. 2. Value Added Statement for the year 2016-17 (Finlakhs) |__(Pinlakhs) Sales 5,970 Less: Cost of bought in goods & services Material consumed 1,950 Production expenses 500 ‘Administrative expenses 200 Seling expenses 350 (3,000) Added value =2970 3. Employee cost for 2016-17 (#in lakhs) Wages 400 Production salaries 130 ‘Administrative salaries 150 Selling salaries 120 800 4, Calculation of target employee cost = Target Index Percentage x Value added = 41% x & 2,970 lakhs = & 1217.70 lakhs 5. Calculation of savings ‘Target employee cost 4,217.70 lakhs Less: Actual Cost 800.00 lakhs ‘Saving S £417.70 lakhs 6. Calculation of Variable incentive for the year 2016-17: 70% of saving is variable incentive = 70% x & 417.70 lakhs = € 292,39 lakhs. © The Institute of Chartered Accountants of IndiaDevelopments in Financial Reporting 10.15 Illustration 5 Following information is provided in respect of Pradeep Ltd. as on 31% March, 2017: (Fin takh) Turnover (including discounts and returns worth ® 35 lakh) 2,500 lant and machinery (net) 785 Depreciation on plant and machinery 132 Debtors 205 Dividend to ordinary shareholders 85 Creditors 180 Stock (net ofa als, WIP. fi Opening stock 180 Closing stock 240 ‘Raw material purchased m4 Cash at bank 98 Printing and stationery 4 ‘Auditor's remuneration 15 Retained profit (opening balance) 998 Retained profit for the year 445 Transfer to reserve 120 Rent paid 172 Other expenses 88 Ordinary share capital (¢ 100 each) 1700 Interest on borrowings 40 Income tax for the year 280 Wages and salaries 352 Employees state insurance 32 Provident fund contribution 26 You are required to: (Prepare Value Added Statement and its application forthe period 31.3.2017. (il) Value Added per Employee (if 87 employees work in Pradeep Ltd.) (ii) Average Earnings per Employee (If 87 employees work in Pradeep Lt) (iv) Sales per Employee (If 87 employees work in Pradeep Ltc,) © The Institute of Chartered Accountants of India40.16 _Financial Reporting Solution ) Value Added Statement of Pradeep Ltd. for the period ended on 31.3.2017 (#in lakhs) Sales (net) (2,500 - 36) 2,465) Less: Cost of Bought in Materials and Services: Raw material consumed (180 + 714 - 240) 654 Printing and stationary 24 ‘Auditors’ remuneration 45] Rent paid 172 Other expenses 88 953 Value added by manufacturing and trading activities 1.512 Application of Value Added (Zin takh)|_(#iniakh) %| To Pay Employees: Wages and salaries 352 Employees state insurance 32 Provident fund contribution 26 410] 27.12] To Pay Government Income-tax 200) 18.52] [To Pay Providers of Capital: Interest on borrowings 40 Dividend 5 125 8.27] ‘To Provide for maintenance and expansion of| the company: Depreciation 132 Transfer to reserve 120 Retained profit 445 oar} 46.09 1512 | 100] Value Added Per Employee = Value Added! No. of Employees = 1,512\87 = 17.38, (iii) Average Earnings Per Employee = Average Eamings of Employee / No. of Employees = 10087 = 4.71 (iv) Sales Per Employee = Sales / No. of Employees 465 | 87 = 28.33 © The Institute of Chartered Accountants of IndiaDevelopments in Financial Reporting 10.17 cena While the absolute value of net VA and its proportion to gross output are very important, the factor components of value addition reveal more information. It is generally found that value addition is highest for service companies and lowest for a trading business. Consider a hypothetical situation. There are three companies A, B and C. Each sells the finished product for % 1,000. Company A buys a lump of metal in the market for % 500, performs four operations on it - annealing, forging, trimming and polishing - and sells the finished product for & 1,000. Company B buys the semi-finished product in the market for & 800, performs certain operations and sells the finished product at the said price of & 1,000. Company C buys the finished product from another company for & 950 and sells it for ® 1,000. Thus, even though all the three companies have the same turnover, company A has added highest net value to its product and Company C the least. As a percentage of the gross output, company A's value addition is 50%, company B's 20% and company C's a meager 5%. At this point it appears that company A, having highest value addition, will give highest returns to shareholders. But if it so happens that out of total value addition of % 500 by company A, almost 90% goes out for meeting wage bill, the position is entirely different. Therefore, considering the ratio of net value added to gross output does not yield a complete picture. If much of a company's net value added comes from an unproductive labour force, there will be litte left over for future investments or for addition to reserves. Hence, besides considering the ratio of net value addition to gross output, one must consider the contribution of various factor costs to the net value added. © The Institute of Chartered Accountants of India40.18 Financial Reporting UNIT 2: ECONOMIC VALUE ADDED| In corporate finance, Economic Value Added or EVA, a registered trademark of Stern Stewart & Co. (Stem Stewart & Co. is a worldwide management consulting firm founded in New York in 1982. The company developed the Economic value added concept and currently ‘owns the trademark), is an estimate of a firm's economic profit - being the value created in excess of the required return of the company's investors (being shareholders and debt holders). Quite simply, EVA is the profit earned by the firm less the cost of financing the firm's capital. The idea is that value is created when the return on the firm's economic capital employed is greater than the cost ofthat capital EVA is net operating profit after taxes (or NOPAT) less a capital charge, the latter being the product of the cost of capital and the economic capital. The basic formula is: EVA=(t-C) x K= NOPAT-C x K where NOPAT - is the Return on Invested Capital (ROIC); + Cis the weighted average cost of capital (WAC); + Kis the economic capital employed; + NOPATis the net operating profit after tax, with adjustments and translations generally for the amortization of goodwill, the capitalization of brand advertising and other non-cash items. EVA Calculation: EVA = Net operating profit after taxes ~ a capital charge (the residual income method] Therefore, EVA = NOPAT - (cx capital), or alternatively EVA= (rx capital) -(¢ « capital) so that EVA= (1-0) x capital where: ate of return, and c= cost of capital, or the Weighted Average Cost of Capital (WACC). NOPAT is profits derived from a company's operations after cash taxes but before financing costs and non-cash book-keeping entties. It is the total pool of profits available to provide a cash return to those who provide capital to the firm. © The Institute of Chartered Accountants of IndiaDevelopments in Financial Reporting 10.19 Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less non- interest-bearing current liabilities. The capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of economic capital invested. The cost of capital is the minimum rate of return on capital required to compensate investors (debt and equity) for bearing risk, their opportunity cost. ‘Another perspective on EVA can be gained by looking at a firm's return on net assets (RONA).. RONA is a ratio that is calculated by dividing a firm's NOPAT by the amount of capital it employs (RONA = NOPATICapital) after making the necessary adjustments of the data reported by a conventional financial accounting system. EVA = (RONA required minimum return) x net investments IF RONA is above the threshold rate, EVA is positive. CR ae cl The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities’. It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing Capital to the company, thus setting a benchmark that a new project has to meet. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be expected to eam in an alternative investment of equivalent risk. If a project is of similar risk to a company's average business activities itis reasonable to use the company's average cost of capital as a basis for the evaluation. A company's securities typically include both debt and equity; one must therefore caloulate both the cost of debt and the cost of equity to determine a company's ost of capital. However, a rate of return larger than the cost of capital is usually required. The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure The more complex the company's capital structure, the more laborious it is to calculate the wacc. Cost of Debt Capital: The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since, all other © The Institute of Chartered Accountants of India10.20 _ Financial Reporting things being equal, the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-lax as well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be written as (Rf + credit risk rate) (1-T), where T is the corporate tax rate and Rfis the risk free rate, Cost of Equity Capital: The cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely Unknown. The cost of equity is therefore inferred by comparing the investment to other investments (comparable) with similar risk profiles to determine the "market" cost of equity Cost of Equity Capital is the market expected rate of return. Equity capital and accumulated reserves and surpluses which are free to equity shareholders carry the same cost. Because the reserves and surplus are created out of appropriation of profi, that is, by retention of profit attributable to equity shareholders. As it is shareholders’ money, the expectation of the shareholders to have value appreciation on this money will be same as in case of equity share capital. Hence, it bears the same cost as the cost of equity share capital Cost of Preference Capital is the discount rate that equates the present value of after tax interest payment cash outflows to the current market value ofthe Preference Share Capital PREC aan Cost of Debt Capital and cost of Preference Share Capital are easy to calculate as they depend on actual after tax cash outflows on account of interest payment but calculation of cost of Equity Capital is litle tough as it depends on market expected rate of return. There are many theories to calculate cost of Equity Capital. Out of all those theories Capital Asset Pricing Model (CAPM) is the most widely used method of calculating the Cost of Equity Capital. Under CAPM cost of Equity Capital is expressed as Risk Free Rate + Specific Risk Premium or Risk Free Rate + Beta x Equity Risk Premium or Risk Free Rate + Beta x (Market Rate - Risk Free Rate) The risk free rate represents the most secure retum that can be achieved. There is no consensus among the practitioners regarding risk free rate. Specific Risk Premium is @ multiple of Beta and Equity Risk Premium. Equity Risk Premium is almost same for all the listed companies in the stock market. Uniess the volatility of share prices and share market indices of two companies are same, their Beta will be different. Beta is a relative measure of volatility that is determined by comparing the return on a share to the return on the stock market. In simple terms, greater the volatility riskier the share and higher the Beta. If a company is affected by the macroeconomic factors in the same way as the market is, then the company will have a Beta of one and will be expected to have returns © The Institute of Chartered Accountants of IndiaDevelopments in Financial Reporting 10.24 equal to the market. A company having a Beta of 1.2 implies that if stock market increases by 10% the company’s share price will increase by 12% (i.., 10% x 1.2) and if the stock market decreases by 10% the company’s share price will decrease by 12%. Beta is a statistical measure of volatility and is calculated as the Covariance of daily return on stock market indices and the return on daily share prices of a particular company divided by the Variance of the return on daly Stock Market indices. While considering market index a broad based index like S & P 500 should be considered. For the companies, which are not listed in stock exchanges, beta of the similar industry may be considered after transforming it to un-geared beta and then re-gearing it according to the debt equity ratio of the company. The formula for un-gearing and gearing beta is shown below. Ungeared Beta = Industry Beta / [1 + (1—Tax Rate) (Industry Debt Equity Ratio)] Geared Beta = Ungeared Beta x [1 + (1 tax rate) (Debt Equity Ratio)} PoE Equity Risk Premium is the excess return above the risk free rate that investors demand for holding risky securities. It is calculated as “Market rate of Return (MRR) minus Risk Free Rate’. Market rate may be calculated from the movement of share market indices over a period of an economic cycle basing on moving average to smooth out abnormalities Practitioners do not have a consensus on the methodology of calculation of MRR. Many of them do not calculate the MRR but on an ad-hoc basis they assume 8% to 12% as the equity risk premium. Example: An hypothetical example of computing cost of capital of a company with a 12.5% Debt Capital of € 2,000 crores (redeemable in 10 years), Equity Capital of % 500 crores, Reserves & Surplus of & 7,500 crores, and without taking Preference Share Capital is shown below. Assuming the return on Tax-free Government Bonds at 11%, a Beta of 1.06, market rate at 18% and corporate tax rate at 30%, the cost of capital employed of the company works ut as shown below: Capital employed = Debt Capital + Equity Capital = € 2,000 crores + & 500 crores + & 7,500 crores = & 10,000 crores Equity to Capital Employed = 8,000 / 10,000 = 0.80 Debt to Capital Employed = 2,000 / 10,000 = 0.20 Debt cost ater tax = 12.5% ~ (12.5 x 30%) = 8.75% Cost of Equity Capital = Risk free rate + Beta (Market rate — Risk free rate) = 11% + 1.06 (18-11) = 11% + 7.42% = 18.42% Weighted Average Cost of Capital (WACC) = (0.80 x 18.42%) + (0.20 x 8.75%) = 16.49% Cost of Capital Employed = 10,000 crores x 16.49% = 1649 crores © The Institute of Chartered Accountants of India10.22 _ Financial Reporting Maintenance of shareholders’ value (EVA) will require the company to ean a NOPAT over 1649 crores i.e, over its cost of capital. In other words, to maintain shareholders’ value to positive or zero, the % of NOPAT to Capital Employed should be greater or atleast be equal to the % of WACC. For the sake of simplicity, if we presume NOPAT is equal to Accounting Profit then, to maintain shareholder's value as positive or zero, Return on Capital employed (ROCE) has to be more than or equal to WACC. In case of a banking and financial company, return on Tier | and Tier Il capital has to be more than WACC to generate a positive EVA, Mlustration 4 LH Ltd. provides you with th following summarized balance sheet as at 31st March 2017. (#in lakhs) Liabities ‘Amount | Assets Amount ‘Share Capital 961.46 Fixed Assets (Net) 2,409.90 Reserves and Current Asset 50.00 Surplus 1,313.62 | 2,295.08 Long term Debt 144.44 Sundry Creditors 20.38 2,459.90 2,459.90 ‘Adaitional information provided is as follows: (Profit before interest and tax is # 2,202.84 lakhs (i) Interest paid is # 13.48 lakhs. (il) Tax rate is 40% (iv) Risk Free Rate = 11.32% (¥) Long term Market Rate = 12% (W) Beta = 1.62 (highest during the period) (vi) Cost of equity = 12.42% and cost of debt = 5.6% You are required to calculate Economic Value Added of LH Lid. Solution EVA = NOPAT - Weighted Average cost of Capital Employed mice = 2280% 24m MM 505 = 11.69% + 0.33% = 12.02% + 2atsoe + aan #245052 ate NOPAT = _[PBIT-- Interest - Tax] Interest (net of tax) © The Institute of Chartered Accountants of IndiaDevelopments in Financial Reporting 10.23 Tin lakhs. PaIT 2,202.86 Less: Interest 13.48) 2,189.36 Less: Tax @ 40% 875.14) 1,313.62 ‘Ada: Interest (net of tax) [13.48 x (1 ~ 0.40)] 8.09 432171 EVA = NOPAT-WACC x CE = 1,821.71 lakhs ~ (12.02% x 2,439.52 lakhs) = 1,821.71 lakhs - 293.23 lakhs = & 1,028.48 lakhs. Mlustration 2 The Capital Structure of Define Ltd, is as under: ‘© 80,00,000, Equity Shares of #10 each = 7800 lekhs ‘© 1,00,000, 12% Preference Shares of # 250 each = #250 lakhs ‘© 1,00,000, 10% Debentures of #500 each = £500 lakhs ‘© Terms Loan from Bank @ 10% = 450 lakhs The Company's Statement of Profit and Loss for the year showed PAT of # 100 lakhs, after ‘appropriating Equity Dividend @ 20%. The Company is in the 40% tax bracket. Treasury Bonds carry 6.5% interest and beta factor for the Company may be taken as 1.5. The long run market rate of retum ‘may be taken as 16.5%. Calculate Economic Value Added. Solution Computation of Economic Value Added Particulars Tin lakhs Profit before Interest and Taxes (from W.N.1) 578.33 Less: Interest (50 + 45) (95.00) 483.33, Less: Taxes 193.33 290 ‘Add: Interest (net of tax) [95x (1 -0.40)] st Net Operating Profit After Taxes 37 Less: Cost of Capital (WACC x Capital Employed) (2,000 x 12.95%) (259.00 Economic Value Added 28.00 © The Institute of Chartered Accountants of India10.24 Financial Reporting Working Notes: 1, Calculation of Profit Before Tax Particulars (Computation Tin aks Profit before Interest and Taxes Balancing figure 578.33, Less: Interest on Debentures 10% x 8 500 lakhs (60.00) Interest on Bank Term Loan 10% x € 450 lakhs (45.00) Profit Before Tax (© 280.00 + 60%) 483.33 Less: Tax @ 40% (& 280.00 + 60%) x 40% 193.33 Profit after Tax 290.00 Less: Preference Dividend 412% x € 250 lakhs (30.00) Residual earnings for equity shareholders 260.00 Less: Equity Dividend 20% x & 800 lakhs 160.00) Net balance in Profit and Loss Account Given 4100.00 2. Computation of Cost of Equity: = Risk Free Rate + Beta x (Market Rate = 6.5% + 1.5 (16.5% -6.5%) = 21.5% 3. Cost of Debt Interest & 45 lakhs Less: Tax (40%) & 18 lakhs) Interest after Tax 27 lakhs Cost of Debt = 2100 6% 450 4, Computation of Weighted Average Cost of = Risk Free Rate) Capital Component Amount) Ratio| Individual Cost| _ WACC| Equly T00akns| —8002000=040| Ke =215] 85 Preference %260lakns| 250 +2000 = 0.128 15 Debt (500+ 450) | <960lakns| 950+ 2000= 0.475 Ke=6] 285) Total % 2,000 lakhs Ko] 12.95% | Illustration 3 The following information (as of 31-03-2017) is supplied to you by Fox Ltd.: (inerores) wi Profit after tax (PAT) 205.90 (i) | Interest 435 © The Institute of Chartered Accountants of IndiaDevelopments in Financial Reporting 10.25 (ii) | Equity Share Capital ‘Accumulated surplus ‘Shareholders fund Loans (Long term) Total long term funds (iv) | Market capitalization ‘Additional information: (a) | Risk free rate (0) | Long Term Market Rete (Based on BSE Sensex) (o) | Effective tax rate forthe company (d) | Beta (B) for last few years Year 1 777.00 2,892.00 12,00 percent 15,50 percent 25.00 percent 2 3 4 5 Using the above data you are requested to calculate the Economic Value Added of Fox Ltd. as on 3 March, 2017. Solution Net Operating Profit After Tax (NOPAT) = Profit After Tax (PAT) + Interest (net of tax) = 205,90 + 4.85 x (1-0.25) = & 209.54 crores Debt Capital 37 crores Exuity capital (40 + 700) = E740 crores Capital employed = €37+E740= E777 crores Debt to capital employed Equity to capital employed 37 croresi® 777 crores = 0.0476 © 740 crores I& 777 crores =0.952 Interest cost before Tax 74,85 crores Less: Tax (25% of & 4.85 crores) 1.21 crores) Interest cost after tax 23.64 crores Cost of debt = (® 3.64 crores! & 37 crores) x 100, = 9.83% ‘According to Capital Asset Pricing Model (CAPM) Beta for calculation of EVA should be the highest ofthe given beta forthe last few years. Accordingly, Cost of Equity Capital = _—Risk Free Rate + Beta (Market Rate — Risk Free Rate) © The Institute of Chartered Accountants of India10.26 Financial Reporting 12% + 1.10 x (15.50% - 12%) 12% + 1.10 x 3.506 = 15.85% Weighted Average Cost of Capital (WACC) = Equity to Capital Employed (CE) x Cost of Equity Capital + Debt to CE x Cost of Debt = 0,952x 15.85% + 0.0476 x 9.83% = 15.09% + 0.47% = 15.56% Cost of Capital Employed (COCE) = WAC x Capital Employed = 15.56% x € 777 crotes = € 120.90 crores, \OPAT - COE © 209.54 crores € 120.90 crores CAS SSE aero EVA as a residual income measure of financial performance is simply the operating profit after tax less a charge for the capital, equity as well as debt, used in the business, Because EVA includes both profit and loss as well as balance sheet efficiency as well as the opportunity cost of investor capital itis better linked to changes in shareholder's wealth and is superior to traditional financial metrics such as PAT or percentage rate of retum measures such as ROCE, or ROE. In addition, EVA is a management tool to focus managers on the impact of their decisions in increasing shareholder's wealth. These include both strategic decisions such as what investments to make, which businesses to exit, what financing structure is optimal; as well as operational decisions involving trade-offs between profit and asset efficiency such as whether to make in house or outsource, repair or replace a piece of equipment, whether to make short or long production runs etc. Most importantly the real key to increasing shareholder's wealth is to integrate the EVA framework in four key areas: to measure business performance; to guide managerial decision making; to align managerial incentives with shareholders’ interests; and to improve the financial and business literacy throughout the organisation. Economic Value Added (E.V.A.) 88.64 crores. To better align managers interests with Shareholders ~ the EVA framework needs to be holistically applied in an integrated approach — simply measuring EVAs is not enough it must also become the basis of key management decisions as well as be linked to senior management's variable compensation, EVA companies typically find benefits come from three main areas: better asset efficiency; improved business and financial literacy at all levels, and more owner-ike behaviour by managers. The EVA approach to management has been endorsed by many influential investors and independent experts. EVA has already become the primary focus in many companies around the world across a wide range of industry sectors. In India NIIT, Tata © The Institute of Chartered Accountants of IndiaDevelopments in Financial Reporting 10.27 Consultancy Services and the Godrej Group and number of other companies have formally adopted the EVA framework. However, the practitioners differ with one another in regard to the methodology of calculation of adjustments required for conversion of accounting profit to NOPAT, market rate, beta and risk free rate, The technique of computing EVA requires making several adjustments in arriving at the NOPAT. The developers of the concept have identified 164 potential adjustments to obtain a ‘real’ reflection of a company’s performance. Omitting even a few may lead to serious errors. A large number of adjustments tend to complicate the concept and put off the management. Thus, it has been suggested that companies identify four-fve critical adjustments that are simple to implement. There are also no standard ways or statutory guidelines for making the adjustments, Consequently, different companies can adopt ways of adjusting the NOPAT. This could impair seriously the comparability of EVA figures of different companies. Though a useful measure, Until proper standards are evolved, EVA will remain at best an internal measure of shareholder value. © The Institute of Chartered Accountants of India