ENEMS MICROSYSTEMS RESEARCH SPOT: CAPITAL EXPENDITURE AND REVENUE EXPENDITURE

CAPITAL EXPENDITURE AND REVENUE EXPENDITURE

Capital Expenditure

This is an expenditure from which the business organization will derive benefits for more than one year.

Capital expenditure is incurred when a business spends money either to

- Buy fixed assets or

- Add to the value of existing fixed asset.

For instance, money spent on the following are capitalized.

- Acquiring of fixed assets

- Bringing them into the premises

- Legal cost of buying buildings

- Any other cost needed to get a fixed asset ready for use for the first time.

Being capitalized means that such expenditure should not be completely charged to profit and loss account in the year it occurred but is held in the balance sheet and charged in bits to profit and loss account over a number of years on some rational basis, as depreciation / provision for depreciation.

Revenue Expenditure:

This is an expenditure the full benefit of which are used up within one year. Or expenditure which is not spent on increasing the value of fixed assets, but is incurred in running the business on a day – to –day basis.

It is completely charged to the profit and loss account as an expense in the year that it occurred. However, some fixed assets may be charged as expense to profit and loss in full in the year they occurred due to their immaterial nature (insignificant amount).

Example of capital and revenue expenditure:

1. Buying of van Capital

2. Petrol cost for van Revenue

3. putting extra head lamp Capital

4. Repairs to the van Revenue

5. Painting the outside of a new building Capital

6. Repainting the building exterior after some years Revenue

Some times it may be difficult to decide which expenditure is capital or revenue. In such instances apply the following rules.

1. If the expenditure is directly incurred in bringing a fixed asset into use for the first time, it is capital expenditure.

2. IF the expenditure improves a fixed asset (by making it superior to what it was when it was first bought by the organization e.g. building an extension to a warehouse). It is capital expenditure

3. All other expenditures are revenue expenditure.

Capital and Revenue Receipts

When an item of capital expenditure is sold, the receipt is called capital receipt. E.g. money received from selling motor van that has been in used.

Revenue receipts are sales and other revenue items that are added to gross profit, such as rent receivable and commission receivable.

ADJUSTMENTS IN FINAL ACCOUNT

DEPRECIATION

Depreciation can be defined as the gradual reduction in the value of a fixed asset as a result of wear and tear, passage of time and obsolescence.

TERMINOLOGIES

1. Depreciable Asset: This is an asset which has the following qualities

a. Useful life of over one years

b. Acquired primarily for use in production of goods and services

c. Limited useful life

d. Not intended for sale in the ordinary course of the business

2. Residual Value: This is also known as the scrap value. It is the estimated amount recoverable from the disposal of a fixed asset after its expected useful economic life.

3. Depreciable Value: This refers to the net book value of a depreciable asset that could be allocated to future operations through depreciation.

4. Useful Life: The estimated number of years through which an asset can be cost.

The causes of depreciation may be classified into physical deterioration, economic factors, time factors and depletion.

1. Physical Deterioration

i. Wear and Tear: This is physical deterioration or loss of value suffered by a fixed asset as a result of usage.

ii. Erosion, rust, rot and decay: These are physical deterioration or loss of value suffered by fixed assets as a result of exposure to wind, sun, rain and other elements of nature.

2. Economic Factor:

i. Obsolescence: This is the process of becoming obsolete or out-of-date. It is the loss of value suffered by a fixed asset as a result of advancement in technology. E.g. Black and white TV as a result of development of colour TV, Nokia 3310 as a result of Java phones, coal engine as a result of diesel engine.

ii. Inadequacy: This is the loss of value suffered by an asset as a result of growth and changes in size of a firm. E.g. computers with less capacity will be inadequate to a larger firm.

In both inadequacy and obsolescence the asset may not necessary be scrapped but may be used by other smaller firm who may need them.

3. Time Factor: although the other causes of depreciation may be connected to time, there are fixed assets whose values are specially connected to time. These are assets with fixed period of legal life such as leases, patents, copyright. Instead of using the term depreciation, the term amortization is often used for the provision for the consumption of these assets.

4. Depletion: This is the loss of value suffered by assets of wasting nature as a result of exploitation. Examples include natural resources such as mines, quarries, oil wells and forest reserve.

To provide for the consumption of assets of wasting nature is called provision for depletion.

Methods of Calculating Depreciation

1. Straight Line Method: In this method, the number of years of use is estimated. The cost is then divided by the number of years. This gives the depreciation for each year. It is also referred to as equal installment method or fixed installment method.

The annual depreciation is calculated in two ways

i) Annual Depn = Cost - Scrap Values

Useful life (in years)

ii) Annual Depn = r (cost – scrap value)

Where r = depn rate in %

The advantage of this method is that it is simple. However its disadvantage is that charges equal amount each year where as the contribution of the asset to income may not be equal.

Illustration I

The following data relate to a fixed asset belonging to Federal Polytechnic Nasarawa.

Cost = N11,000

Useful life = 5 years

Residual value = 1000

The institution’s financial year ends 31^st December.

You are required to calculate the annual depreciation for the asset using straight line method

Solution

Annual Depreciation = Cost - Scrap Values

Useful life (in years)

Annual Depreciation = N2,000

Reducing Balance

In this method, a fixed percentage is applied to the net book value to arrive at annual depreciation. It is also called diminishing balance or diminishing debit balance method.

The depreciation rate is calculated using the formular

Where

r = depreciation rate in %

n = number of year of useful life

S = scrap value of the assets

C = Cost of the asset

The advantage is that more depreciation is charged in earlier year while less is charged in later years.

This is in line with the contribution of the asset to the income generation. A major disadvantage is that it is difficult to compute. And it will produce ridiculous high rate if the scrap value is not significant compared to the cost.

Illustration II

Naspoly Consult acquired a power generating machine at a cost of N100,000. the machine is expected to have a useful life of 5 years at the end of which it is expected to have a scrap value of N23,730. It is the policy of the company to depreciate generators using reducing balance method.

You are required to calculate the annual depreciation charge for useful years.

Solution

Yr Details

2010 Cost of Asset 100,000

Depn = (25% x 100,000) 25,000

Net Book Value (NBV) 75,000

2011 Depn = (25% 75,000) (18,750)

NBV 56,250

2012 Depn = (25% x 56250) (14,063)

NBV 42,187

2013 Depn = (25% x 42,187) (10,547)

NBV 31,640

2014 Depn = (25% x 31640) (7,910)

Net Book Value 23,730

Sum of the Year Digit Method

Like the reducing balance method, this method assumes that more of the cost of the asset should be allocated in the earlier years but it avoids the disadvantage of the reducing balance.

Under this method serial digit weights are assigned in reverse order to the years of useful life of the asset with the first year assigned the highest and last year assigned 1.

The depreciation rate for each year is then the proportion which the digit assigned to it bears to the summation of the digits. This rate is used to multiply cost less residual value of the asset to arrive at the value of depreciation for the year.

Illustration III

Assuming Naspoly Consult uses sum of the years digit method to depreciate its assets, recompute the annual depreciation for the power generating machine referred to in the last illustration.

Solution

Initial Cost 100,000

Residual value (after 5 years) 23,730

Accumulated Dep. (after 5 years) 76,270

Yr digit Weight Computation Annual Dep.

1 2010 5

25,423

2 2011 4

20,339

3 2012 3

15,254

4 2013 2

10,254

5 2014 _1_

5,085

15 76,270

Revaluation Method

Under this methods the asset will be revalued at the end of the financial year and the depreciation charge for the year would be any loss in value since the last valuation.

This method is suitable where there are many low cost assets such that it may be impossible to provide for depreciation following the due process for each of the assets. E.g. engineering workshops, where there are so many spanners, screw drivers etc. in such case, the depreciation is calculated as follows:

Value of asset at beginning of the year x

Add cost of assets purchase during the year x

Less: Value of asset at end of the year (x)

Depreciation for the year x

Illustration IV

An engineering firm has a lot of spanners surrounding and other how cost tools used in their workshop.

On Jan. 1 2014, the tool were valued at 35000

During the year tools were purchased costing 13,000

On 31 Dec. 2014 the tools were valued at 38000

Compare the depreciation change for tools for the year ended 31 Dec.2014

Solution

Valued at start period 35,000

Add cost of new tools bought 13,000

48,000

Less value as at 31 Dec. 2014 38,000

Dep. Change for the year 10,000

Other methods of depreciation unit method

1. Machine hour method, units out-put method and annuity and sinking fund methods.

DOUBLE ENTRY RECORDS FOR DEPRECIATION

Depreciation change is an expenses and appears on the debit side of the profit and loss account like other expenses. The assets account is maintained at cost while the depreciation change is accumulated provision for depreciation account but simply called Accumulated depreciation account or provision for Depreciation A/C. The double entry requires for depreciation change e. g

Dr Profit and loss Account

Cr Accumulated Provision for depreciation account

Illustration V

A company whose financial year ends in 31 Dec. Bought a machine at cost of N20,000 on 1 January 2012. The assets is to be depreciated at a rate 20% using reducing balance method. You are required to show

a. The assets account

b. The accumulated provision for depreciation account for 3 years

ii. profit and loss extract for first 3 years

iii. balance sheet extracted for 3 years.

Solution

MACHINE ACCOUNT

1/1/12 cash 20,000

1/1/13 Bal/ b/d 20,000

1/1/14 Bal b/d 20,000

31/12/12 Bal/ c/d 20,000

31/12/13 Bal c/d 20,000

31/12/13 B/ c/d 20,000

ACCUMULATED PROVISION FOR DEPRECIATION ACCOUNT

31/12/13 B/ c/d 4000

31/12/13 B/ c/d 7,200

7,200

31/12/14 B/ c/d 9,760

9,760

31/12/12 prof. & loss 4000

1/1/13 Bal/ b/d 4000

31/12/13 prof. & loss 3,200

7,200

1/1/14 Bal/ b/d 7,200

31/12/14 prof. & loss 2,560

9,760

1/1/15 Bal/ b/d 9760

BALANCE SHEET (extracted )

As at 31/12/12 N N

Machine at cost 20,000

Less. Accumulated depreciation 4000 16,000

As at 31/12/13

Machine at cost 20,000

Less accumulated depreciation 7,200 12,800

As at 31/12/14

Machine at cost 20,000

Less accumulated depreciation 9,760 10,240

PROFIT AND LOSS ACCOUNT (extracted)

31/12/12 Acc. Prov. For. Dep. 4000

31/12/13 Acc. Prov. For. Dep. 3,200

31/12/14 Acc. Prov. For. Dep. 2,560

DISPOSAL OF FIXED ASSETS

When a fixed assets is sold, the cost of assets together with accumulated depreciation to date should be transferred to an assets disposal account.

The sales of a fixed assets can result to some profit or some loss.

The profit and loss may be ascertained by comparing the sale proceed and the net-book value at the date of sale.

The following steps are followed; on the sale of a fixed asset.

A. Transfer the cost of the assets to an asset disposal account.

Dr. Asset disposal A/C

Cr. Asset A/C (with least of asset)

B. Transfer the accumulated depreciation in respect of the asset to the asset disposal A/C

Dr. Accumulated prov. For depreciation A/C

Cr. Asset disposal A/C (with accumulated depreciation)

C. For the cash received on disposal

Dr. Cash book

Cr. Asset disposal A/C

After these entries, the balance of the asset disposal A/C represents the profit or loss on sales of the fixed asset. Thus roil be transferred to the profit and loss account

A credit balance represents profit on sales of the fixed asset

Dr Asset Disposal Account

Cr. Profit and loss Account.

A debit balance represents a loss on the sale of the fixed asset.

Dr. Profit and loss Account

Cr. Asset disposal Account.

ACCRUALS AND PREPAYMENTS

One of the fundamental concepts of accounting is the accrual concepts it states that expenses must be matched with income and reported for the period which they relate regardless when the cash was actually received or paid.

In keeping to this concepts, these could be

i. Accrued expenses/ accruals

ii. Prepaid expenses/prepayments

iii. Accrued incomes

iv. Incomes received in advance.

i. Accrued expenses: these are expenses due but which are not yet paid as at balance sheet date.

In the profit and loss account, it is added to the expenses shown on the trail balance to obtain the actual expenses incurred for the period. In balance sheet it is shown as a current liability.

ii. Prepaid Expenses/Prepayments: These are expenses which are not yet due but have been paid as at trail balance date.

In the profit and loss account it is deducted from the amount on the trail balance to arrive at the actual expenses, it is shown as a current asset.

iii. Accrued Income: These are income due but not yet received as at trail balance date. In the profit and loss, it is added to the amount of that income shown on the trail balance. In the balance sheet it is shown as current asset.

iv. Incomes Received in Advance: These are incomes not yet due but had been received as at trial balance date. In the profit and loss account, it is deducted from the amount of that income shown on the trail balance. In the balance sheet it is shown as current liability.

Illustration I

Tola stated a business on April 2013 and prepares her final accounts on March 31^st 2014. On July 1^st she paid an annual insurance premium of N3, 000 by cheque to cover her premises and stock for twelve months from that date.

You are required to show the insurance account indicating the figure to be transferred to profit and loss account at the end of March 2014.

Solution

Insurance Account

1/7/13Bank 3, 000

_____

3, 000

1/4/14 Bal ^b/_f 750

31/3/14 Profit & Loss 2, 250

31/3/14 Bal ^c/_d 750

3, 000

Illustration II

A trader Mr. Obi sublets part of his premises to two tenants Green and Brown. At December 31 2013, Green owed N 600 rent for the month of December and Brown has paid N 1, 000 for the month of January in advance.

During the following year, the trader received N8, 400 from Green representing rent for fourteen months to January 31^st 2015 and N10, 000 from Brown representing rent for the months to November 2014. The trader Mr. Obi makes up his account annually at 31^st December.

Required:

Show the rent receivable account in Mr Obi’s book for the year 2014

Solution:

Rent Receivable Account

1/1/14 Bal ^b/_f 600

31/12/14 Profit & loss (w1) 19, 200

31/12/14 Bal ^c/_d (w2) 600

20, 400

1/1/15 Bal ^b/_f 1, 000

1/1/14 Bal ^B/_F 1, 000

Jan-Dec. Bank (Green) 8, 400

Jan-Dec. Bank (Brown) 10, 400

31/12/14 Bal ^C/_D(W3) 1, 000

20, 400

1/1/15 Bal ^b/_f 600

Workings

1) Monthly Rent from Green = 600

Annual rent due from Green 600 x 12 = 7200

Monthly rent from Brown = 1000

Annual rent due from Brown 1000 x 12 = 12000

Amount of rent receivable recognized in

profit and loss account = 19,200

2) Payments from Green (14 months) 8,400

Less: Accrued rent last yr (1month) (600)

Rent due for current yr. (12months) (7,200)

Rent income in advance (1month) 600

3) Rent in advance from Brown (1month) 1000

Payments made by brown (10 months) 10,000

Rent due for current yr (12 months) (12,000)

Accrued rent income (1month) 1000

ERRORS

An error is a mistake made in the book keeping entries, balancing of accounts or extraction of trail balance. There are two types of errors

(2) Errors that do not affect the trial balance

(3) Errors that affect the trial balance

Errors not Affecting the Trial Balance

1. Error of Omission: This is a case where a transaction is completely omitted from the books.

2. Errors of commission: This occurs when the correct amount is entered in the right class of account but in the wrong account. E.g. a purchase from C. Aba was wrongly credited to C. Aba.

3. Error of Original Entry: This occurs when the double entry is obeyed but with wrong amount. E.g. a sale of N10,000 was recorded as N100,000 in the correct accounts.

4. Error of Principle: in this case the right amount was used but in wrong class of account. E.g. the purchase of a car was debited to motor expenses accounts

5. Compensating errors: This occurs when an error in one account is cancelled out by another error in another account e.g. sales account is over cost by N20 and purchase account is over cost by exactly N20.

6. Complete reversal entry error: This error occurs when the double entry required for a transaction is completely reversed. E.g. When the payment of cash to a supplier is recorded as a receipt of money from the supply.

7. Error of Transposition: This occurs where the wrong sequence of the individual characters in the number were used for the double entry records. E.g. 1243 written as 1423. however, where this occurs on only one side, the trial balance will not balance.

Errors Affecting the Trial Balance

Many other errors affect the trial balance. These include casting errors (under casting or over casting). Posting only one side of the ledger for a transaction, error of transposition occurring on only one side of the ledger, over / understatement of opening or closing balance etc.

Correction of errors not affecting the trial balance

Once these errors are discovered, entries are made in the ledger accounts involved based on double entry principles in order to correct the errors.

Illustration

Show the journal entry needed to correct the following errors:

i. A credit sale of N590 to E. Gemade has been completely omitted from the book.

ii. Credit purchase of N440 from C. Gbaje was erroneously entered in C. Baje’s account.

iii. The purchase of a machine which is to be used by the firm was debited to purchases account N20,000.

iv. In the cash book, the amount of cash sales transferred to the sales account was overstated by N200 and the amount transferred to wages account was over stated by N200.

v. A sale of N380 to A. Shade was recorded as N280 in the books.

vi. A cheque of N1600 paid to M. Dike was mistakenly debited to cashbook and credited to M. Dike’s account.

vii. A credit purchase from P Mailafia N5,600 was entered in the books as N6,500.

Solution

Journal

	Dr N	Cr N
E. Gemade	590
Sales		590
Being credit sales omitted Completely omitted
C. Baje	440
c. Gbaje		440
Being credit purchase from C. Gbaje entered wrongly
Machinery	20,000
Purchases		20,000
Being purchase of machine mistakenly recorded in purchases account now corrected
Sales	200
Wages		200
Being overcasts on the two accounts which compensated each other now corrected
A. Shade	100
Sales		100
Being correction of understatement sales
Cash book	3,200
M. Dike Being correction of payment of cash recorded as receipt		3,200
P. Mailafia	900
Purchases		900
Being correction of overstatement of purchases by N900

Correction of Errors Affecting the Trial Balance

These errors should be located and corrected as soon as possible. But where this can not be done before the preparation of final accounts, the trial balance can be made to balance by posting the difference to a suspense account.

In the balance sheet, the suspense account balance would be shown under current assets, if it is a debit balance or under current liabilities if it is a credit balance.

If the errors are located, entries are made based on double entry principle to the accounts involved. The entry to the particular account would be such that the effect of the error would be nullified while the second entry would be to the suspense account.

Illustration

The trial balance of Mr. Obi showed a difference of N6,220 which was credited to a suspense account. On further investigation, the following omission and errors were discovered.

i. Purchase of an additional machine for N7,500 was debited to office expenses account.

ii. Discounts allowed, N7,840 have not been posted from cashbook to ledger.

iii. Drawings in the form of goods N8000 have not been recorded anywhere in the books.

iv. Sales day book was, overcast by N10,000.

v. An invoice for N5230 received from a supplier was entered correctly in the purchases day book but was posted to the debit side of supplies personal account.

vi. A debtor who owed a sum of N1200 died. The debt was written off as bad debt but no other entry was made in the books.

vii. A credit note for N6,200 issued to a debtor was entered in the returns inward book as N2600 and was posted to the ledger accordingly.

viii. A payment of N1300 for wages and salaries was correctly entered in the cash book but as N3100 in the wages and salaries account.

ix. A motor vehicle was bought for N15,000 and the payment was made by cheque this fact was recorded only in the motor vehicle account.

You are required to show the

1. Journal entries necessary to correct these errors

2. Suspense account duely balanced.

ENEMS MICROSYSTEMS RESEARCH SPOT

Friday, 27 November 2015

CAPITAL EXPENDITURE AND REVENUE EXPENDITURE

CAPITAL EXPENDITURE AND REVENUE EXPENDITURE

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