In order to calculate Economic Profit on the basis of realistic Net Operating Profit After Tax (NOPAT) and Net Operating Assets (NOA) rather than the pure accounting figures, a range of adjustments are required. These adjustments were mentioned in a previous chapter in the calculation schema for NOPAT and NOA.

In calculating the net operating assets, we firstly deduct all those assets that were either not employed operationally in the time period under consideration or were not (yet) available for the operational processes. Secondly, we carry out a range of valuation adjustments by calculating "Equity Equivalents". These adjustments represent the total of those assets that are not included in the traditional balance sheet. The adjustments form part of the calculation of both NOA and NOPAT if they are directly related to the operating profit.

Plant under construction was not available for use by the company during the accounting period under consideration. Therefore, it can justifiably be deducted from the balance sheet total.

Plant under construction is usually posted as a separate line item in the balance sheet and is, therefore, listed in SAP FI-AA as a distinct class of assets with its own account determination. This separate account determination for plant under construction is a prerequisite for it to be deducted in reporting. The deduction is only temporary and ends automatically with the reposting of the facility under construction to a completed asset when the construction period is over.

Marketable securities are readily tradable securities. They are a near-cash asset and are classified under current assets. When we calculate net operating assets, these are also deducted from the balance sheet total, since their absence would have no direct influence on the operational activities of the enterprise.

Current asset securities are listed in separate accounts in SAP FI. Therefore, in reporting, they can also be deducted when you determine net operating assets.

The economic model recognizes that a portion of the capital that is necessary for the development of successful products and services, also flows into unsuccessful measures. For this reason, the NOPAT should be "normalized" by excluding or smoothing out non-recurring profits and losses, for example, restructuring costs, or profits and losses on disposal of assets. Accumulated extraordinary losses less any profits should be reassigned to the capital.

We can make this adjustment in SAP FI with a simple general ledger posting. We might make an allocation here to operational profit centers, or use an allocation profit center to make the allocations.

Posting of previous year’s portion:

The following applies to the adjustments above, and all further adjustments explained below:

Explicit posting of the previous year’s portion is only necessary in the SAP System if adjustments for the calculation of Economic Profit are being made, and these adjustments contain elements from previous years. In all subsequent years, these will automatically be included in the balance carried forward.

Enterprises could not only capitalize such extraordinary losses, but also depreciate them over a reasonable time period. In this case, the SAP System handles the operation with FI-AA Asset Accounting. The value of the (accumulated) extraordinary losses is the basis for manual posting to a "fictitious" asset in SAP FI-AA. This "fictitious" asset can then be depreciated over the desired useful life. Note that, with this procedure, a distinct class of assets with separate account determination must be defined for the capitalized extraordinary losses. This guarantees that capitalized extraordinary losses and their depreciation can be deducted from the financial statements which correspond to the relevant statutory accounting provisions. Once the "fictitious" asset is assigned to a cost center, it can then be assigned to a profit center.

For acquisition posting, you can use the Asset Accounting function, "acquisition purchase with offsetting entry". You should set up an adjustment account for extraordinary losses as a clearing account in the account determination assigned to the selected asset class. Since the original extraordinary losses may not be changed in balance sheet preparation according to the relevant statutory accounting provisions, the above posting must be made against an adjustment account for extraordinary losses. Both accounts are then combined in one node in reporting.

Posting of previous year’s portion:

Non interest-bearing, short-term liabilities, for example accounts payable for goods and services, are eliminated from the calculation of Net Operating Assets, since we can assume that suppliers include financing costs for materials etc. in their prices. Since these financing costs are also included in the expenses, the operating profit shown before adjustments is too low – by this amount. Another example are accruals and deferrals on the liabilities side.

Non interest-bearing, short-term liabilities can be clearly identified using the following criteria:

• Cash flow relevance
• Short-term (payment is made within one year)
• Non interest-bearing

In SAP FI, accounts payable for goods and services and also prepaid/deferred items are maintained in separate accounts. This means that they can be clearly identified in reporting and can easily be deducted when you calculate Net Operating Assets.

Leased assets legally remain the property of the lessor for the duration of the lease. They are, therefore, fundamentally not relevant for the valuation of the lessee’s assets. However, according to international statutory accounting requirements today, the assets must be included in the lessee’s balance sheet in the case of a finance lease (lessee bears risk and opportunity). With an operating lease (lessor bears risk and opportunity), the lessee need not account for the assets in the balance sheet.

Operating lease assets that are not accounted for in the balance sheet also serve the objectives of the enterprise. Therefore, they must be included in Net Operating Assets for the calculation of Economic Profit. Besides this, the interest component in the lease and rental payments is taken into account when calculating Net Operating Profit After Tax.

In FI-AA in the SAP System, you can capitalize and depreciate leased assets using the capital lease method. The acquisition posting is made here against a creditor (liabilities). To arrive at the acquisition value, the system calculates the present value of the future lease payments according to the lease contract.

For assets that are to be capitalized using the capital lease method, you require a distinct asset class with separate account determination. All accounts in this account determination must be separated in the balance sheet and P&L structures according to the relevant statutory accounting provisions. Besides this, a separate valuation area is required where interest is calculated. You should not create cost elements for the P&L accounts, depreciation and interest expense. This way, these postings will not be reflected in cost accounting. However, by assigning a default profit center to the cost elements, you can ensure that depreciation and interest expense is apparent in Profit Center Accounting.

(The above postings are made automatically because of the opening entry for the leased asset and the periodic depreciation posting run in SAP Asset Accounting.)

Posting of previous year’s portion:

When determining Net Operating Profit After Tax, we assume the tax rate that the enterprise would be subject to in the case of complete equity financing. No taxation amounts may be considered that are not the result of normal business operations.

We can apply two methods to determine the adjusted tax, also known as Cash Operating Taxes:

• Application of a fictitious average tax rate to the operating profit. This automatically ensures that neither non-operational factors nor financing factors have any effect.
• Indirect calculation starting with the tax amount actually paid. The following adjustments must be made:

Posting of previous year’s portion:

Since you cannot assign tax expenses directly to operational profit centers, you can assign them to an allocation profit center. You can clear the tax expense in the same way using a manual G/L account posting by assigning an allocation profit center. You should make the adjustment posting for corporation tax in separate accounts.

How differentials arise and how to handle them is basically an issue for group accounting. As part of consolidation, German commercial law allows both capitalization of goodwill with its resultant depreciation and clearing with the reserves. IAS and US-GAAP do not allow a clearing with the reserves. Instead of this, they call for capitalization and then depreciation.

For corporations listed in the USA, the Securities and Exchange Commission (SEC) requires the use of "push down accounting" when more than a 95% stake in a company is acquired. The essence of the push down method is that goodwill is shown in the accounts of the relevant subsidiary, and not only in the consolidated balance sheet. The offsetting entry is made against the additional paid-in capital and thus increases the balance sheet total. Equity holdings of between 80% and 95% can be considered as "substantial" in this context so that the push down method can be applied. For equity holdings of less than 80%, the push down method may not be applied.

Independently of these rules, you would apply the push down method for the Economic Profit calculation at individual company level. There are different approaches for handling the depreciation of goodwill. If we consider goodwill and its depreciation as an Equity Equivalent, then the depreciation must be added to revenues as a non-payable and non tax-deductible figure, and thus reversed. The accumulated goodwill depreciation must then be added back to the current book value of the goodwill in the balance sheet.

You can use the SAP System‘s Asset Accounting to show goodwill and its depreciation in the individual financial statements. Goodwill is capitalized as an intangible asset in FI-AA and can be depreciated automatically over the desired useful life. The goodwill is assigned to a profit center via an assignment to a cost center in the asset master record. Since, as a rule, goodwill cannot be assigned to operational profit centers, but exists at the level of the legal entity, you choose an allocation profit center at the highest level of the profit center hierarchy for account assignment. The assignment to an operational profit center would be justified where the goodwill arises from acquisition of an equity holding that was acquired to strengthen a brand or product group.

You can use the Asset Accounting function Purchase acquisition with automatic offsetting entry for the capitalization. The clearing account to be set in account determination is the additional paid-in capital.

If the capitalized goodwill has already been depreciated, and includes not only acquisition and production costs but also accumulated depreciation, the acquisition must be posted gross. A transaction type with the indicator "Gross acquisition" must be used.

In the reversal of the goodwill depreciation in the context of the Economic Profit calculation, note that the accumulated depreciation account in the SAP System is a reconciliation account that cannot be posted to directly. This means that you must create a separate G/L account for these adjustments. This is then shown in reporting together with the reconciliation account.

Postings in current period to reverse the depreciation :

Posting of previous year’s portion:

By using the push down method and showing the goodwill in the individual financial statements, the consolidation in SEM-BCS will usually lead to the calculation and posting of a further element of goodwill. By entering a financial statement item for minority interest as a goodwill item in the configuration menu, you can prevent this differential amount from being shown as goodwill and simultaneously show the actual goodwill, the minority interests and the adjustment to net income resulting from the goodwill depreciation.

The following example should help to clarify the above. We assume a parent-subsidiary relationship of 80%:

Abbreviations:

EH: Equity holding
RE: Retained earnings/adjustment
GW: Goodwill from individual financial statements
GW*: Goodwill from consolidation in SEM-BCS
Cap: Capital
Min: Minority interests

From an economic point of view, some adjustments must be made in the area of current assets. In particular, the accounts receivable must be adjusted where flat-rate value adjustments have been made for anticipated bad debts and where these adjustments have no relationship to individual accounts.

Flat-rate value adjustments to accounts receivable are made in SAP FI as part of the closing operations and are reflected in the year-end closing. The flat-rate value adjustments are simple G/L account postings "per expense account to balance sheet account". The balance sheet account is an adjustment account for the accounts receivable reconciliation account, and is shown in the same item as the accounts receivable in the balance sheet. Flat-rate value adjustments such as these must be reversed if they are not once-off corrections but can be seen as recurring in normal business operations.

Inversely, individual adjustments that can be made in SAP FI using the special general ledger technique, (may) remain as an offsetting entry to the capital.

If we assume that the Economic Profit is calculated on the basis of profit centers or profit center groups, it would seem logical to distribute the flat-rate accounts receivable adjustments and the resulting expenses in Profit Center Accounting similar to the posted accounts receivable. In order to clearly show the adjustments in reporting, you must choose separate accounts receivable and expense accounts. If the original flat-rate value adjustments were distributed to profit centers, then the adjustments must be treated in the same way to allow them to be shown correctly at profit center (group) level.

According to German commercial law, you can apply both LIFO and FIFO when assessing the value of the inventory. For taxation purposes, you must assess according to LIFO. IAS permits the LIFO valuation method, but calls for the variance from the FIFO method to be shown. According to US-GAAP, both valuations are permitted. Generally, however, a footnote points out if LIFO has been applied.

In times of inflation – and taking statutory accounting requirements into account – an enterprise will apply the LIFO method for inventory valuation to gain a tax advantage. Application of the LIFO method leads to an undervaluation of the inventory. For this reason, and for a more realistic consideration, it is necessary to convert the LIFO inventory valuation to a FIFO-based valuation and to add the difference (LIFO reserve) to the capital as an Equity Equivalent. Accounting for the increase in the LIFO reserve in the current period in Net Operating Profit After Tax (NOPAT) means that the unrealized profits are shown in revenues.

In the SAP System, material receipts and withdrawals are valued at standard price (S price) or moving average price (V price) depending on price control. SAP Materials Management provides a facility to carry out an inventory valuation once a year or periodically (from SAP R/3 Release 4.0) according to either LIFO or FIFO.

If inventories have been assessed using the LIFO method, and are then subjected to a FIFO valuation, the value can be assessed per item and the resulting difference posted as an adjustment.

From SAP R/3 Release 4.0, you can update the results of the LIFO valuation in the material master record in the price fields Tax-based price 1, 2 or 3 or Commercial price 1, 2 or 3. Then you can use these results to value the material stocks.

In the subsequent FIFO valuation exercise, the FIFO stock values are determined. Following the FIFO valuation, the ending inventory value according to the inventory accounting valuation, the FIFO value, and the variance from the current stock value are shown in a reporting list.

This is the basis for posting the LIFO reserve. From SAP R/3 Release 4.0, you can automatically determine the difference between the LIFO and FIFO valuations for each materials management valuation class. The LIFO reserve is posted ideally per profit center.

Posting of previous year’s portion:

Other provisions, for example, for impending losses due to risky business transactions or for guarantees must also be treated as an Equity Equivalent, insofar as they are relevant to cash flow, are short-term and non interest bearing. Additions to the provisions must also be reversed. They are therefore reflected in the calculation of both Net Operating Assets and Net Operating Profit After Tax.

The additions to provisions in SAP FI are simple G/L account postings. Since you cannot assign provisions directly to operational profit centers, you can assign them to an allocation profit center. You can clear the provisions in the same way using a manual G/L account posting by assigning an allocation profit center. In order to show this posting clearly in reporting, you cannot simply cancel the original posting, you must show it with reversed debit/credit sign in separate accounts. These accounts can then be sorted out of the balance sheet and P&L structures when you prepare the accounts according to the relevant statutory accounting provisions. This way they do not have any effect here. In the Economic Profit calculation, however, they are considered.

Posting of previous year’s portion:

The basic idea behind the capitalization of expenses with investment character is to consider these costs as investments in future products and processes, and by capitalizing and depreciating them, to distribute these costs over a reasonable time period. This time period might be the assumed settlement phase for the (successful) project or also the lifetime of the newly developed product.

Examples of expenses with investment character are R&D expenses or preproduction costs to increase market value. According to US-GAAP, you are not permitted to capitalize R&D expenses. According to IAS, in certain circumstances it is absolutely necessary.

The result of the capitalization and depreciation of these expenses is a (net) intangible asset. By including the changes to the capitalized (net) intangible assets in Net Operating Profit After Tax, the expenses of the period are replaced by the depreciation of the capitalized expenses.

In the SAP System, R&D costs are collected by projects. As part of the settlement of costs collected for a project in SAP‘s Profitability Analysis (CO-PA), the project is credited using a separate settlement cost element (secondary cost element). After the settlement is completed, you can see the R&D expense amount in a project report.

This value is the basis for a manual posting to a "fictitious" asset in SAP FI-AA that can be automatically depreciated over the desired useful life. Just as with extraordinary losses after tax, you must define a distinct asset class with separate account determination for the capitalized intangible assets. You can assign this "fictitious asset" to a profit center by first assigning it to a cost center or an internal order. This means that for each relevant profit center, you must create an asset to show capitalized expenses.

You can use the Asset Accounting function Purchase acquisition with automatic offsetting entry for the acquisition posting. In the account determination assigned to the selected asset class, you should define an adjustment account for R&D costs as a clearing account. Since, according to the relevant statutory accounting provisions, the original R&D costs may not be changed, the above posting must be made against an adjustment account for R&D costs. In Economic Profit calculation reporting, the adjustment account for R&D costs is included in the R&D cost element group, so that the original R&D costs are no longer effective.

Posting of previous year’s portion: