Question

Depreciation is considered as accounting policy and operational expenses 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:

(i) Explain the difference between capital expenditure and revenue expenditure, and how each type of expenditure will affect the financial statements of a business.

ii) Explain why it is important to distinguish between capital expenditure and revenue expenditure and briefly explain the accounting treatment of each type of expenditure

iii) Under what circumstance 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

1.

Capital expenditures are for fixed assets, which are expected to be productive assets for a long period of time. Revenue expenditures are for costs that are related to specific revenue transactions or operating periods, such as the cost of goods sold or repairs and maintenance expense. Thus, the differences between these two types of expenditures are as follows:

• Timing. Capital expenditures are charged to expense gradually via depreciation, and over a long period of time. Revenue expenditures are charged to expense in the current period, or shortly thereafter.

• Consumption. A capital expenditure is assumed to be consumed over the useful life of the related fixed asset. A revenue expenditure is assumed to be consumed within a very short period of time.

• Size. A more questionable difference is that capital expenditures tend to involve larger monetary amounts than revenue expenditures. This is because an expenditure is only classified as a capital expenditure if it exceeds a certain threshold value; if not, it is automatically designated as a revenue expenditure. However, certain quite large expenditures can still be classified as revenue expenditures, as long they are directly associated with revenue transactions or are period costs.

Capital expenditures are fixed assets like property plant and equipment. Revenue expenditures are short-term expenses used in the current period or typically within one year.

Capital expenditures are typically a larger amount than revenue expenditures. However, there are exceptions when large asset purchases are consumed in the short term or in the current period.

Capital expenditures are typically expensed over many periods or years through depreciation whereas revenue expenditures are expensed in the current year or period.

2.

The following points of difference between capital expenditure and revenue expenditure gives the importance of the distinction:

1. Capital expenditure increases the earning capacity of business whereas revenue expenditure is incurred to maintain the earning capacity.
2. Capital expenditure benefits more than one accounting year where as revenue expenditure normally benefits one accounting year.
3. Capital expenditure is incurred to acquire fixed assets for operation of business whereas revenue expenditure is incurred on day-to- day conduct of business. In other words, revenue expenditure is generally recurring expenditure and capital expenditure is non-recurring in nature.
4. Capital expenditure ( in case of Depreciation) is recorded in Balance Sheet whereas revenue expenditure (subject to adjustment for outstanding and prepaid amount) is recorded in either Trading or Profit and Loss Account.

• When the management chooses to classify revenue expenditure as capital expenditure, the revenue expenditure that is ought to be taken up into the Income Statement is suspended or deferred into the Balance Sheet. In this process, lesser expenses are being charged into the Income Statement, hence profit are overstated to impress the investors or outsiders.

3.The reducing balance method of depreciation is most useful when an asset has higher utility or productivity at the start of its useful life, as it results in depreciation expenses that reflect the assets' productivity, functionality, and capacity to generate revenue.

For example, many types of machinery have higher functionality when they’re new and therefore generate more revenue in the earlier years of their lives. The reducing balance method of depreciation reflects this more accurately than other depreciation methods.

4.

Depreciation does not directly impact the amount of cash flow generated by a business, but it is tax-deductible, and so will reduce the cash outflows related to income taxes. Depreciation is considered a non-cash expense, since it is simply an ongoing charge to the carrying amount of a fixed asset, designed to reduce the recorded cost of the asset over its useful life. When creating a budget for cash flows, depreciation is typically listed as a reduction from expenses, thereby implying that it has no impact on cash flows. Nonetheless, depreciation does have an indirect effect on cash flow.

When a company prepares its income tax return, depreciation is listed as an expense, and so reduces the amount of taxable income reported to the government (the situation varies by country). If depreciation is an allowable expense for the purposes of calculating taxable income, then its presence reduces the amount of tax that a company must pay. Thus, depreciation affects cash flow by reducing the amount of cash a business must pay in income taxes.

However, depreciation only exists because it is associated with a fixed asset. When that fixed asset was originally purchased, there was a cash outflow to pay for the asset. Thus, the net positive effect on cash flow of depreciation is nullified by the underlying payment for a fixed asset.