CHAPTER 8DEPRECIATION OF FIXED ASSETS AND CAPITAL & REVENUE EXPENDITURE
Learning Objectives• To explain the term of depreciation• To explain the need for depreciation• To identify and explain the causes of depreciation• To calculate depreciation expense using straight line @ reducing balance method• To account for depreciation expense in the books• To show the depreciation charges in the profit & loss a/c• To show the accumulated depreciation charges in the balance sheet• Distinguish between capital & revenue expenditure• Describe the effect on final a/c mainly net profit if Rev. Exp. is wrongly treated as Cap. Exp. & vise versa
Introduction• Fixed Asset is acquired @ bought by a business either by cash @ credit.• The value of the fixed asset recorded will not be the cost itself but its book value i.e. the value of fixed asset at the end of certain period.• This is because we have to show the fact that the asset has lost its value when it is being used by the business in its daily operation.• When business is using a fixed asset, it must record the cost of the fixed asset in the balance sheet & the expense related to the used of the fixed asset (depreciation) is shown in the profit & loss a/c.• To determine the cost of fixed asset, the concept of capital & revenue expenditure is applied.
Definition & Need of DepreciationAs defined by the MASB 14:Depreciation is =“ The allocation of the depreciable amount of an asset over its useful life”• Depreciation for the accounting period is charged to the net profit & loss a/c.Reasons for charging depreciationa) To find net profit @ loss for an actg period, the revenue for the period is matched against the costs incurred in earning that revenue.b) Unless depreciation on fixed assets is charged, the value of these assets may be overstated in the balance sheet.c) By charging depreciation against profits, the net profit available for distribution is reduced & the results is that fund are retained in the business.
Causes Of Depreciationa) Wear and tear - The physical using up of a fixed asset, i.e. corrosion, rot, rust, decay. Although repairs & maintenance may extend the life of the asset, they can never keep the asset working indefinitely.b) Obsolescenc - The fixed assets becoming out of date or obsolete e because of new technological advancements.c) Physical - Floods, dampness or excessive heat @ cold may factors make a fixed asset lose its value.d) Defluxions of - Certain assets such as patents & copyrights have a time fixed time limit of ownership.e) Depletion - Wasting assets such as mines or quarries is being depreciated because of the decrease in value.
Factors In Determining Depreciation The following costs have to be considered when determining depreciation:a) Cost of asset i. Purchase price of the asset ii. Transportation cost to get the asset to the purchaser’s premises iii. Insurance on the purchase of the asset iv. Taxes on the purchase of asset v. Installation cost of assetsb) Useful life of the assetc) Scrap value/salvage value @ residual value of the asset.
Methods Of Depreciationa) Straight line method: The amount of depreciation for each accounting period will be the same. The annual depreciation is calculated by taking the depreciable amount (cost less estimated scrap value) divided by the estimated useful life; or cost multiplied by percentage.b) Reducing Balance Method A greater amount of depreciation is being charged in the earlier accounting years & smaller amount in the later accounting years. Annual depreciation is calculated by multiplying the book value with a certain percentage
Accounting Entries For Fixed Asset & Depreciation Expensea) To record acquisition of fixed assetDr. Fixed Asset XX Cr. Bank/Creditor XXb) To record depreciation expense for the yearDr. Depreciation expense XX Cr. Provision for depreciation XXc) To close depreciation to profit and lossDr. Profit and Loss XX Cr. Depreciation expense XX
Profit and Loss & Balance Sheet Presentation Profit and Loss for the year ended…..Expenses:Depreciation xx Balance Sheet as at……Fixed Asset:Cost xxLess: Provision for Depreciation (xx)Book Value xx_
Capital & Revenue ExpenditureIntroduction Expenditure relating to the acquisition of fixed assets is treated as capital expenditure. Expenditure for the maintenance of fixed assets is treated as revenue expenditure. If revenue is incorrectly capitalised, expenses will be understated and assets will be overstated.Definition Capital Expenditures Expenditures that increases the assets value because of the improvement on the capacity or efficiency Revenue Expenditures Expenditures that will not improved the asset’s value but they are expenses incurred running of the business operation daily.
Capital expenditure & treatments Increase the value of the fixed assets in the Balance Sheet, thus the capital of the organization. It must be added to the cost of the fixed asset on the debit side of the fixed assets a/c. The capital expenditure items are: a) Freight charges, b) sales taxes, c) legal costs, d) installation costs, extensions or additions to buildings, e) replacing a new motor or engine to a vehicle that would extend the vehicle’s useful life, f) cost to acquire the fixed asset, g) any other cost to bring the fixed asset ready for its intended use. Whenever a capital expenditure is wrongly classified as revenue expenditure, the effects are:a) Expense are overstated, and therefore the net profit is understatedb) The fixed asset and thus capital of organization is understated
Revenue expenditure & treatments It will be debited to expense a/c, thus chargeable to the trading profit & loss a/c. It reduce the net profit & treated as operating expenses, The revenue expenditure items are: a) repainting an office block, b) replacing a broken window screen, c) motor vehicle registration & insurance, d) fuel for motor vehicle If revenue expenditures wrongly classified as capital expenditures, the effects are:a) Expenses are understated, & therefore the net profit is overstated.b) The fixed assets and thus capital of the organization is understated