Question

Depreciation is considered as accounting policy and operational expense for the accounting period.

The value to be included in the financial statement is calculated based on the decision of the Board.

(a) You are required to:

1. Explain the difference between capital expenditure and revenue expenditure, and how each type of expenditure will affect the financial statements of a business.     (
2. Explain why it is important to distinguish between capital expenditure and revenue expenditure, and briefly explain the accounting treatment of each type of expenditure.
3. (iii) Under what circumstances will you consider the reducing balance method as the most appropriate method in calculating depreciation?                                           (b) Does depreciation decrease cash in a business? Explain your answer.

Answer 1

Ans 1)

Difference between Capital & Revenue Expenditure and their financial affect

Capital expenditures are incurred for acquiring the fixed assets or for increasing the productivity of existing fixed assets. It provides long term benefit to the business. These expenditures are charged to expense via depreciation over the life of asset. Also, a heavy amount is involved in capital expenditure. Therefore, these amounts are always shown on the assets side of balance sheet.

On the other hand, Revenue expenditure are the expenditure incurred for day to day conduct of the business i.e. salaries and wages, rent, electricity etc. These expenditures have a charge on Income Statement of the business. Therefore, these amounts are always shown under expenses head of profit and loss statement.

Ans 2)

Distinguish between Capital and Revenue expenditure is imporatnt due to following reasons:

1) Capital expenditures increases the earning capacity of the business whereas revenue expenditures doesn't increase the earnong capacity but it maintains the earning capacity of business.

2) Benefit of capital expenditure arises in more than 1 year but revenue expenditure generally benefits 1 current accounting year.

3) Capital expenditure is recorded in asset side of balance sheet but revenue expenditure is shown in profit and loss statement.

Accounting Treatment of Capital Expenditure

Fixed Assets head is debited and cash/ payables is credited in books of accounts with the amount of capital expenditure.

Accounting Treatment of Revenue Expenditure

Expense head is debited and cash/ payables is credited in books of accounts with the amount of revenue expenditure.

Ans 3)

a) Reducing balance method depreciation is appropriate when it is evidenced that consumption of asset decreases over time during its life in business i.e. this method is important when asset has higher utility in earlier years of its life. In this method, higher depreciation is charged initially and after that amount of depreciation started to reduce.

b) No, Depreciation doesn't decrease cash in a business as depreciation is a non cash expense which doesn't involve flow of cash with it unlike other expenses. However, it is shown as an expense in books of accounts and also decreses profit but it nowhere affects the cash flow of the business.