Question

QUESTION THREE Red Tree Limited (Red). Blue Tree Limited (Blue), and Green Tree Limited (Green) are three independent companies owned by three different groups of shareholders in the City of Lightbridge. Red owns 5 parcels of land north of Avenue X. The parcels are of equal size in square blocks measuring 25 square kilometres each. Blue owns another 5 parcels of land, all the same size, in the area between Avenue X and Avenue Y. Green owns 5 other parcels of land, also of the same size, in the area south of Avenue Y. The 15 parcels of land were purchased by the three companies at different time and at different prices over the past 40 years. Cost $10,000 purchased 40 years Cost $10,000 purchased 40 years | Cost $10,000 purchased 40 years Cost $10,000 purchased 40 years $10,000 purchased 40 years 5 parcels of land owned by Red Tree Limited Avenue X Cost $10,000 purchased 40 years apo Avenue Y Cast $50,000 purchased 5 years Cost $20,000 purchased 30 years ago Cost $30,000 purchased 20 years apo Cost 560.00 purchased 10 years ago Cost 550.000 purchased five years ago 5 parcels of land owned by Blue Tree Limited Cost $50,000 purchased 5 years | Cost $50,000 purchased 5 years Cost $50,000 purchased 5 years 120 Cost $50,000 purchased 5 years 5 parcels of land owned by Green Tree Limited ao LO Mr. Slack, Mr. Good, and Mr. Diligent, are the managers of Red, Blue, and Green respectively. The managers were all hired two years ago at the same time but separately by the shareholders of the respective companies. Each manager is responsible for managing the daily operations of the company and making decisions on how the land is to be used to generate income for the company. The 15 parcels of land are all identical in terms of their market values and their revenue-generating capabilities. The three companies are identical in all respects except for the cost of the land and the managers who run the companies. In this setting, managerial skills and abilities are the only factors that affect the amount of income earned by each company. Each company has adopted the policy of keeping only $50,000 in cash for operational needs and distributing all remaining cash income to the shareholders. You have also found out that the market value of land in the area has not changed in the past five years. Mr. Slack is known for slacking off and Red reported $20,000 of net income for the current year. Mr. Good puts in a good amount of work and Blue reported $25,000 of net income. Mr. Diligent works diligently and Green reported $30,000 of net income for the year.

first two photos are the background information for the questions. There are requirements in the third image.

Answer 1

Ans. (i)

As mentioned in the question, the managerial skill and abilities are the only factors that affect the amount of income generated by each company as all the assets employed for earning income are identical in terms of market value and revenue earning capabilities.

Based on the net income (Net income is completely attributable to the skill set of the managers ) and ROA with two different sets of accounting , the mangers are ranked as follows

Manager	Company	Net Income	Rank based on Net Income	Rank based on ROC (Historical Cost Accounting)	Rank based on ROC (Market value based Accounting)
Slack	Red	20000	3	1	3
Good	Blue	25000	2	2	2
Diligent	Green	30000	1	3	1

It is evident from the above table that Mr Diligent who generated the highest net income is ranked worst based on ROA or ROE when historical cost accounting is followed whereas both the ROA and ROE give the ranking compatible with net income measure. ROA calculated using historical cost accounting gives wrong measure of management performance as the capital employed (the denominator used in the ROA) varies across the companies based on the time of acquisition of assets. Hence the ROA or ROE calculated using market value accounting gives the results which are more meaningful and useful comparing and evaluating managerial performance.

Ans. (ii]

Manager Good can cherry pick the parcel of land with lowest cost and sell for the same market price as other land parcels yield and thereby able to overstate the net income so as to boost his own performance if net income is arrived employing the historical cost method. Under the market value accounting, the increase in the market value is accounted separately from results of operations. Hence, Market value based accounting gives a more reliable measure of net income.

Ans. (iii)

Entities’ capital employed and the various measures shows inconsistent results based on timing of asset acquisition as the cost of acquisition is different for the same set of assets because of various factors like inflation and demand supply dynamics of the time period of acquisition. Hence the argument of enhancement of comparability is not necessarily true for Historical cost accounting.