|ACC 222 - Managerial Accounting|
|Notes For Class 18|
Motivation and Control through Accounting Information
|Compute ROI and Residual Income
The Formulas: ROI
The relationship between RI and ROI as simply the difference between the ROI and the cost of capital employed (COC) multiplied by the investment.
GAAP accounting is much better at measuring short-term rather than long-term company value. By using these measurements, accounting control systems often bias management towards short-term profits. EVA assumes stock market prices approximate long-term value. Using this criterion, EVA techniques change existing financial accounting data to better measure activities that influence company value. The economic value added is the adjusted operating income less a charge for the capital employed. This is similar to residual income except EVA adjusts the financial accounting data to more correctly measure value. Using this approach, the influence of manager’s activities on stock market values can be estimated. If EVA is correct, its measures should motivate managers to always increase value by “managing by the numbers.”
19. Why do we use residual income as a performance measurement tool?
20. Is profit the best performance measure?
|5 Ethical Concerns with Management's use of Accounting Control Measures
1. Segments may not be comparable. Different segments may be facing different risk and competitive situations. Thus, to compare them on profit alone is not appropriate. These are referred to as “deadly parallel” evaluations.
2. Segment managers may be placed in conflict with each other. If segments can influence each other’s performance, as in our department store, failure to coordinate efforts could results in lower combined earnings.
3. Comparing last year and this year may not correctly evaluate performance. Comparing sequential years without considering changes in operating conditions can lead to incorrect evaluations.
4. Managers may be motivated to maximize accounting’s reported profit instead of long-run value. When only short-term profit is considered to evaluate managers, long-term value may be ignored. Reductions in maintenance, research and development, and training can reduce short-term expenses but damage long-term value.
5. We may need nonfinancial process measures in addition to the output
measures accounting systems usually report. Long-term value is realized
by future cashflows. Often measures like market share rather than
current sales revenue are better indicators of future value.
22. What is a “deadly parallel” evaluation strategy?
|P10 -- Return on investment and residual income
a. Calculate the ROI and RI for Commercial Construction.
b. Calculate the ROI and RI for Apartment Construction.
Segment margin = Sales
- Variable costs - Fixed costs
c. Calculate the ROI and RI for the Company.
Net income = Sales
- Variable costs - Segment fixed costs - Common
Residual Income = Investment x (ROI -
Cost of Capital)
|P12 -- Segmented income statements
ROI = Profit
= Segment margin
x Segment sales
ROI = 25.0%
x 2.0 times
|P13 -- Ethics and Accounting Control Measures
a. A supervisor lowers the production quota for one shift foreman to increase her bonus.
|KEY TERMS AND DEFINITIONS
Asset turnover: This calculation is a short-run measure of how well assets are used in generating sales. It is the ratio of sales revenues to the investment in assets generating those revenues.
Controllable segment margin: This information reports the profit resulting from activities under the segment manager’s control. It is used in evaluating the segment manager’s performance (contrast this subtotal with segment margin).
Cost centers: These centers are responsible for controlling the costs of their activities. They do not have profit or investment responsibilities. Cost variance reports often are used in evaluating their performance.
Economic value added (EVA): This measure modifies residual
income by adjusting profits and investments from the accounting system
values to better reflect long-term shareholder value.
Profit centers: These centers are responsible for costs and revenues. They do not have the responsibility for investment decisions. Segmented income statements and variances often are used in evaluating their performance.
Profit margin: This calculation is a short-run measure of operating efficiency, which expresses profit as a percentage of sales.
Return on investment (ROI): This calculation is the profit earned on money invested, expressed as a ratio of profit to the investment amount. ROI is the mathematical product of two ratios: profit margin (profit as a percentage of sales), and asset turnover (how many sales dollars result from a $1 investment).
Residual income: This calculation is the remaining profit after deducting the cost of financing an investment.
Segment margin: This information is the profit contributed directly by a segment to the company. The sum of all segment margins is used to pay for the company’s common costs, with anything left over being profit. Segment margin is used to evaluate the profit contribution of the segment (versus evaluating its manager; see controllable segment margin).
Segmented income statement: This overall statement includes
an income statement for each profit center.
|In Class ==>
under Student Resources for additional notes from Chapter 8
Assignment for Wednesday, April 5th...
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