Question 2 (41 marks) JK Building Equipment Ltd is a Windhoek based company that supplies building equipment. The company has a policy of measuring...

Question 2 (41 marks)

JK Building Equipment Ltd is a Windhoek based company that supplies building equipment. The

company has a policy of measuring the two divisions it has using residual income. The following figures

relate to the two divisions for the year ended 31st December 2017.

Division A Division B

N$ N$

Sales 30 000 000 11 000 000

Divisional variable costs 17 000 000 5 000 000

Divisional fixed costs 4 200 000 4 000 000

Divisional contribution to corporate profits 8 800 000 2 000 000

Allocation of corporate fixed costs 3 400 000 900 000

Divisional profit 5 400 000 1 100 000

The cost of capital in both divisions is 8% and taxation is ignored for the purpose of performance

evaluation. The net book value of non-current assets is used in determining the residual income. The

extracts from the statement of financial position relate to the two divisions as at 31st December 2017:

Division A Division B

N$ N$

Noncurrent assets (net book value) 25 000 000 10 000 000

Current assets 18 000 000 5 000 000

Current liabilities 6 500 000 2 800 000

Division A incurred N$600 000 in advertising expenditure to promote brand image while by Division B

spent N$840 000 for the same purpose. It is expected that both divisions will benefit from this

expenditure commercially in the years 2017 to 2020 inclusive.

In the years 2016 and 2017, Division B spent significant amounts on research and development which

were written off as divisional fixed costs in the year of expenditure because they were not meeting the

definition of intangible assets as required by IAS 38. The amounts were N$900 000 in 2016 and N$2 250

000 in 2017. The manager for Divisional B is of the opinion that the accounting treatment adopted is

correct for reporting externally but does not think it should be used to measure the performance of his

division. He believes these expenditures are an investment in which future economic benefits will flow

to the division for the next six years. Division A didn't incur reasonable costs in research and

development in the years 2016 and 2017.

Division B relies heavily on delivery vehicles. JK Building Equipment Ltd had the capacity to purchase

these vehicles but the divisional manager opted to lease them instead using a short term arrangement

that is renewed on an on-going basis. This arrangement resulted in divisional fixed costs of N$400 000

incurred as lease rental instalments. If these vehicles were purchased, they could have been having a

carrying amount of N$2 000 000 at 31st December 2017 after deducting the current year depreciation of

N$250 000.

Requirement:

a) Compute the Residual Income (RI) of each division for 2017. (8

marks)

b) Compute the Economic Value Added (EVA) of each division for 2017. (24

marks)

c) Using the information about Division A and Division B to illustrate your answer, should JK use

RI or EVA in evaluating performance of these two divisions. (9