4.1 Capital and revenue expenditure and receipts (3)
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1.
A company purchased a new delivery van for £15,000 on 1st January 2023. The van is expected to have a useful life of 5 years. Explain how the company should account for this purchase, distinguishing between the initial cost and subsequent years' accounting treatment. Include a brief explanation of depreciation.
The initial purchase of the delivery van for £15,000 should be treated as capital expenditure. This is because the van is a long-term asset that will benefit the company for more than one accounting period. The van will be recorded on the balance sheet as a fixed asset at its cost of £15,000.
Subsequent accounting treatment: Because the van is a depreciable asset, the company will need to account for depreciation each year. Depreciation is the systematic allocation of the cost of an asset over its useful life. It reflects the gradual decline in the van's value due to wear and tear and obsolescence.
Depreciation Calculation: The company can use various methods to calculate depreciation. A simple method is the straight-line method, which allocates an equal amount of depreciation each year. In this case, the annual depreciation would be: £15,000 / 5 years = £3,000 per year.
Journal Entry (Initial Purchase):
| Debit: Delivery Van £15,000 | Credit: Cash £15,000 |
Journal Entry (End of Year 1):
| Debit: Depreciation Expense £3,000 | Credit: Accumulated Depreciation £3,000 |
2.
A company purchased a vehicle for £20,000 on finance. The finance agreement states that the vehicle will be depreciated over 5 years using the straight-line method. The company incorrectly recorded the depreciation expense for the first year as £4,000 instead of £4,000/5 = £800. Describe the impact of this error on the company's financial statements and explain the necessary corrective action.
Impact on Financial Statements:
- Profit and Loss Account: The incorrect depreciation expense of £4,000 will result in an overstatement of profit in the profit and loss account. Profit will be higher than it should be.
- Balance Sheet: The carrying value of the vehicle on the balance sheet will be overstated. The accumulated depreciation will be overstated, and the vehicle's book value will be higher than it should be.
Corrective Action:
- Calculate the Correct Depreciation: The correct annual depreciation should be calculated as £20,000 / 5 = £4,000.
- Adjust Depreciation Expense: A debit balance of £4,000 should be made to the Depreciation expense account to reduce the profit figure.
- Adjust Accumulated Depreciation: A debit balance of £4,000 should be made to the Accumulated Depreciation account to correct the accumulated depreciation balance.
- Adjust Carrying Value: The carrying value of the vehicle on the balance sheet should be reduced by £4,000. This will reflect the correct value of the asset. The accumulated depreciation should also be reduced by £4,000.
3.
Explain why it is important to correctly classify receipts as either capital or revenue. Give an example of how incorrectly classifying a receipt could affect a company's financial statements.
It is crucial to correctly classify receipts as capital or revenue because it significantly impacts the company's financial statements, particularly the balance sheet and income statement. The classification determines where the receipt is recognised and how it affects the company's reported financial position and performance.
Importance of Correct Classification:
- Balance Sheet: Capital receipts increase the company's capital, which is a key component of its long-term financial strength. Revenue receipts, on the other hand, are typically not directly reflected in the balance sheet.
- Income Statement: Revenue receipts directly contribute to the calculation of profit or loss. Capital receipts generally do not.
Example of Incorrect Classification:
If a company incorrectly classifies a loan received from a bank as a revenue receipt, it would artificially inflate its profit in the income statement. This would give a misleading impression of the company's profitability. Furthermore, it would not accurately reflect the company's liabilities on the balance sheet, potentially understating its financial risk. This could mislead investors and creditors.