B215 FINANCIAL ACCOUNTING

AC08
Mochi Kochi
Learning Objectives

Distinguish between capital and revenue expenditure.

Show an understanding of the impact in respect of the
management’s decisions regarding capital and revenue expenditure
in the financial statements.

Illustrate the ledger entries to record the acquisition of fixed assets,
using separate accounts for different categories of fixed assets at
costs.

Define and explain the purpose of depreciation.

Explain and illustrate how depreciation is presented in the financial
statements.

Differentiate and apply the various depreciation methods for fixed
assets.

Determine the treatment of revenue/capital expenditure incidental to
inventory.
Problem Analysis
 How should the transactions be accounted
and reflected on the financial statements?
 Leasehold factory
 Food Processing Machines

 Delivery Van

 Stationery

 What is depreciation policy?

 What is net book value?
Capital vs Revenue Expenditure

Expenditure
• Payment of money to acquire goods or services.
• Can be recorded as either assets or expenses, depending
on whether they benefit future periods or only the current
period.

Asset
Capital Expenditure
Expenditures that provide
benefits for one or more
accounting periods beyond the
current period.
Expense
Revenue Expenditure
Expenditures that provide
benefits during the current
accounting period only.
Capital or Revenue Expenditure?

 Mainly based on whether benefits are within or beyond

current account periods

 Companies will capitalise assets above a certain amount

and expense off assets below a certain amount due to
the materiality constraint

 Materiality constraint – may waste too much time

considering the benefits received

 Such policies are acceptable as long as they are in line

with accounting standards i.e. FRS
Capital Expenditure
Capital expenditure is made when a business:
 acquires non-current assets

 adds value to existing non-current asset

Costs needed to get the non-current asset ready for use

are to be included as capital expenditure.

Journal entries to record capital expenditure is

Dr Non-current asset (B/S) XX
Cr Cash / Other payables (B/S) XX
( To record acquisition of assets)
Revenue expenditure
Revenue expenditure is incurred:
 for running the business operation

 for maintaining of non-current assets, such as repair and

maintenance expenses

Journal entries to record revenue expenditure

Dr Expenses (P/L) XX
Cr Cash / Other payables / Accruals (B/S) XX
(To record repairs and maintenance of fixed assets)
 Non-Current Assets

Non-current assets are tangible items that:-

 are held for use in the production or supply of goods or
services, for rental to others or for administrative purposes;
 are expected to be used during more than one period; and

 acquired for use in operations rather than for immediate

consumption or for resale to customers.

Journal entries to record purchase of non-current asset

Dr Non-current asset (B/S) XX
Cr Cash / Other payables (B/S) XX
(To record purchase of non-current asset)
 Cost Determination

 Recap historical cost principle: to record at historical cost.

 Costs include all normal and reasonable expenditures

necessary to get the asset in place and ready for its
intended use i.e. shipping and installation costs.
What is Depreciation?

An expense that is recognised systematically for the

purpose of allocating the depreciable amount of a
depreciable asset over its useful life.

Journal entries to record depreciation expenses

Dr Depreciation expense (P/L) XX
Cr Accumulated depreciation (B/S) XX
(To record depreciation expenses of fixed assets)
 Concept of Depreciation
Example
Recap: Matching principle
 A non-current asset generates economic

$500k

$1m
benefits to the company over a few financial
periods.

 Capital expenditure – asset

$500k

$1m
 Number of financial periods that asset generate
economic benefits: Useful Life

$500k

$1m
 To allocate the cost of the asset over the useful
life in order to match to the economic benefits
(revenue) generated.
Cost Revenue
$1.5m $3m
Concept of Depreciation

Example:
A delivery truck is purchased for the stream of
transportation services it provides over the years that
the truck is owned and used. As the truck is used over
time, the cost of the truck is allocated to expense
through the process of depreciation.
Statement of Statement of
Financial Position Comprehensive
Income
Assets: As the truck
Cost of truck Balance
Motor Vehicles
Revenue
is used Less: Expenses
Depreciation
 Depreciation

Calculation of depreciation expense requires three amounts:

Acquisition cost

Estimated useful life to company

Estimated residual/salvage value at end of asset’s
useful life
Depreciation is an ESTIMATE!!!
 Estimated Useful Lives
 Useful Life - Number of financial periods that asset
generate economic benefits:
 Differs for different classes of assets and industry
 Example (RP):-
Classes of assets Useful lives
Leasehold land and buildings Lease period or 50 years, whichever is lower.

Building systems 10 to 20 years

Building improvements 5 years
Furniture, fittings and equipment 5 years
Computer systems (Cost more than $100k) 5 years

Computer systems (Cost less than $100k) 3 years

Cost below $2,000 Charged to Income statement

Methods of Depreciation

Methods of calculating depreciation

Straight line

Units of production

Reducing/Declining balance method

The depreciation method used shall reflect the pattern

in which the asset’s future economic benefits are
expected to be consumed by the entity.
Depreciation – Straight Line
Straight line:

(Cost – Residual value)

Depreciation
expense =
Estimated useful life

 Number of years of used is estimated. The cost of the

non-current asset is then divided by the number of
years expected to be used to give the depreciation
charge for the year.

 Charges an equal share of an asset’s cost to each

period.
Depreciation – Straight Line
Straight line:

Example :
A motor vehicle was purchased at $35,000. The
management expects the motor vehicle to be in used
for 10 years. The motor vehicle is expected to have a
residual value of $2,000.
(Cost – Residual value)
Annual
Depreciation =
Estimated useful life
expense

= ($35,000 - $2,000) / 10 = $3,300

Depreciation – Units of Production

Units of production:

Depreciation (Cost – Residual value)

expense = X Actual
Estimated total production production units
unit

 Depreciation of asset is based on actual number of units

produced during the period compared to the total
estimated number of units to be produced.

 Charges a varying amount of expense for each period

of an asset’s useful life depending on its usage.
 Depreciation – Units of Production
Units of production:
Example:
A machine is purchased at a cost of $50,000. The
machine is expected to produce 10,000 units. During the
year ended 31 December 2008, the machine produced
3,000 units. The management does not expect the
machine to have any residual value.
Depreciation (Cost – Residual value)
expense for 2008 = X Actual production
Estimated total production unit units

= ($50,000 - $0 / 10,000 units) X 3,000 units = $15,000

Depreciation – Reducing/Declining Balance

Reducing/Declining Balance:
 Two formulas that can be used: If the asset’s useful life is given
(total number of years), the following formula can be used:

Depreciation = (NBV – Residual *Rate

X
expense Value) Total Useful Life

 * The rate is determined by the company, typically 150%, 175% or

200% (but not more than 200%). A rate of 200% is equal to double
the depreciation rate of an asset using straight-line depreciation.

 Results in larger depreciation expenses in the early years of an

asset’s life and less depreciation in later years.
Depreciation – Reducing/Declining Balance
(Cont’d)
If you are unsure of the non-current asset’s useful life, you would
have to estimate a reasonable depreciation rate that compliments the
particular asset. The following formula can be used:

Depreciation = # Fixed
(NBV – Residual
X Depreciation
expense Value)
Rate
The reducing balance is also known as the diminishing balance
method.

# If the normal deprecation rate of other assets is 20% and

management thinks the asset will depreciate at twice the rate, then a
fixed depreciation rate of 40% may be used.

Note: Mathematically, using the reducing balance method, the NBV will not become
zero.
Depreciation – Reducing/Declining Balance
(Cont’d)

According to FRS 16 para 53

The depreciable amount of an asset is determined after deducting its
residual value. In practice, the residual value of an asset is often
insignificant and therefore immaterial in the calculation of the
depreciable amount.

Note: There are some textbooks which ignores residual value and
uses (cost less accumulated depreciation) to calculate the yearly
depreciation charge using reducing/declining balance method as the
residual value of the asset is insignificant and immaterial.

If the residual value is of significant value (eg. >50% of cost of asset),

it may make more sense to use the straight line method instead.
Depreciation – Reducing/Declining Balance
(Cont’d)
Example
A machine was purchased at $3,000 on 1 January 2007. The
machine is expected to have a residual value of $50. The
estimated useful life is 5 years. Therefore, the straight line
depreciation rate is 20%.
Management wants to depreciate the machine using 200% of the
straight line rate. In this case, the depreciation rate will be 40%
instead of 20% (20% straight line rate X 200% = 40% or 200% / 5
years = 40%). Calculate the depreciation expense for the year
2008.

Depreciation expense for year 2007 = ($3,000 - $50) X 40%

= $1,180

Depreciation expense for year 2008 = ($3,000 - $50 - $1,180) X 40%

= $708
Depreciation – Reducing/Declining Balance
(Cont’d)
 Comparison of methods
Depreciation Expense

Straight-line

Declining
Balance

Years
 Pros and Cons of Straight-line
and Reducing balance methods
Methods Pros Cons

Straight-line Simple, easy to calculate. Depreciation is only an estimate

- may not usually reflect the
true decline in market value.
Reducing This method is more Higher charge in the first year
Balance conservative than the than later years – can be
straight line method as subjective.
there is a higher charge to
depreciation expense in the
early years of the asset’s
life.
Units of Can better match expenses Subjective estimate of an
Production with revenues. asset’s total future productive
capacity which is difficult to
determine.
 Concerns to be addressed

Can we omit or reduce depreciation expense? No!!!

 All assets capitalised on the balance sheet should be

depreciated with some exceptions i.e. freehold land.
 Not all fixed assets last forever.
 Most assets have finite useful life.
 The cost of an non-current asset should be allocated over
its useful life so as to reflect the use of the asset by the
business. This cost will be should be reflected in the
statement of comprehensive income.
 So that matching principle can be adhered to.
What is Net Book Value (“NBV”)?

 The value of an asset after deducting accumulated

depreciation and accumulated impairment loss*.

 Also known as carrying amount.

 This will be covered in the subsequent lesson.

Cost
Less: Accumulated Depreciation
Less: Accumulated Impairment Loss
= Net Book Value
 Application to the Problem

Item Initial Useful Residual Remarks

Cost Life value
$ (Mths)

Food 120,000 60 - Shipping costs $12K?

Processing Installation costs $18K?
Machines Routine maintenance $6K?

Delivery Van 25,000 60 5,000 Scrap value $5k?

Factory 500,000 120 - 10-year leasehold – to

depreciate?

Stationary 50 12 - Useful life assumed to

be 12 months? Revenue
or Capital expenditure?
Application to the Problem
Food Processing Machines
 Acquired for $120,000 on 10 Jan 2008.

 How should we account for the shipping costs of $12,000?

 How should we account for the installation costs of

$18,000?
 How should we account for the 6 months routine
maintenance of $6,000?
 Estimated that machine will last for five years.

 Expected to be used more heavily in first 3 years of

operations.
 Expected reduction in net book value (NBV) by 50%
annually.
 Food Processing Machine
Shipping and installation costs
 Capitalised and added to cost.

 Basis:

 “Costs include all normal and reasonable expenditures necessary to get

the asset in place and ready for its intended use i.e. shipping and
installation costs.”
 Add value to the asset (capital expenditure).

Maintenance
 Accounted for as revenue expenditure.
 Basis:

 Assume to generate economic benefits for current period only.

Cost = $120,000 + $12,000 + $18,000 = $150,000

 Food Processing Machine
Depreciation Method:
 Expected to be used more heavily in the first 3 years.
 Estimated to be able to last for 5 years.
 Takeshi expects NBV will decrease by 50% annually.
 Method to use: Declining balance method
 Depreciation Expense = NBV x 50%
Year Computations Depreciation Accumulated Net Book
Expense Depreciation Value
$ $ $
2008 $150,000 x 50% 75,000 75,000 75,000
2009 $75,000 x 50% 37,500 112,500 37,500
2010 $37,500 x 50% 18,750 131,250 18,750
2011 $18,750 x 50% 9,375 140,625 9,375
2012 Remainder of NBV 9,375 150,000 0
 Food Processing Machines
Journal Entries for 2008

10/1/08 Dr Non-current Asset – Machinery (B/S) $150,000

Cr Cash (B/S) $150,000
To record purchase of machinery.

6/7/08 Dr Maintenance Expenses (P/L) $6,000

Cr Cash (B/S) $6,000
To record maintenance for machinery.

31/12/08 Dr Depreciation Expense (P/L) $75,000

Cr Accumulated Depreciation (B/S) $75,000
To record first year depreciation for
machinery.
Delivery Van
Delivery Van
 Acquired for $25,000 on 25 March 2008.

 Useful life of 5 years

 Scrap value of $5,000.

Depreciation Method:
 Assumed to be constantly used throughout the remaining
5 years.
 Method to use: Straight-line method

 Depreciation Expense = (Cost – residual value)

Estimated useful life
= ($25,000 - $5,000) / 60 months
= $333/mth
= $4,000/year
Delivery Van

Year Depreciation Accumulated Net Book Value

Expense Depreciation
$ $ $
2008 (9 mths 3,000 3,000 22,000
from Apr 2008)
2009 4,000 7,000 18,000
2010 4,000 11,000 14,000
2011 4,000 15,000 10,000
2012 4,000 19,000 6,000
2013 (3 mths) 1,000 20,000 5,000
 Delivery Van
Journal Entries for 2008

25/3/08 Dr Non-current Asset – Van (B/S) $25,000

Cr Cash (B/S) $25,000
To record purchase of delivery van.

31/12/08 Dr Depreciation Expense(P/L) $3,000

Cr Accumulated Depreciation (B/S) $3,000
To record 9 months (Apr to Dec 2008)
depreciation for delivery van.
Factory
Factory
 Acquired for $500,000 on 10 Jan 2008.

 10-year leasehold.

 Useful life of 10 years

Depreciation Method:
 Assumed to be constantly used throughout the 10 years.

 Method to use: Straight-line method

 Depreciation Expense = (Cost – residual value)

Estimated useful life
= ($500,000) / 120 months
= $4,167/mth
= $50,000/year
Factory
Year Depreciation Accumulated Net Book
Expense Depreciation Value
$ $ $
2008 50,000 50,000 450,000
2009 50,000 100,000 400,000
2010 50,000 150,000 350,000
2011 50,000 200,000 300,000
2012 50,000 250,000 250,000
2013 50,000 300,000 200,000
2014 50,000 350,000 150,000
2015 50,000 400,000 100,000
2016 50,000 450,000 50,000
2017 50,000 500,000 0
 Factory
Journal Entries for 2008

10/1/08 Dr Non-current Asset – Factory (B/S) $500,000

Cr Cash (B/S) $500,000
To record purchase of factory.

31/12/08 Dr Depreciation Expense (P/L) $50,000

Cr Accumulated Depreciation (B/S) $50,000
To record depreciation for factory.
 Stationery
Stationery
 Acquired for $50 on 25 March 2008.

 Accounted as revenue expenditure.

 To be expensed off in current year.

 Assumed to generate benefits for current year only.

 Materiality constraint.

25/3/08 Dr Stationery Expenses (P/L) $50

Cr Cash (B/S) $50
To record purchase of stationery.
Presentation in the Financial Statements (Extract)
Presentation in the Financial Statements (Extract)
Conclusion

 Expenditure is either capitalised as capital expenditure

or expensed off as revenue expenses.

 Different fixed assets have different characteristics i.e.

cost, useful life and usage patterns.

 Such assets have to be depreciated to match against

the economic benefits generated.

 Based on the characteristics of the fixed assets, there

are different methods of depreciating them.
Mindmap
Revenue
Expenditure < 12 mths
Expenditure

> 12 Useful Life

mths

Salvage / Residual Value

Capital
Cost
Expenditure Depreciation methods

Matching
Depreciation Straight-line
Principle

Units of Production
Net Book
Value Reducing/Declining Balance
 Resources

Textbooks

Frank Wood & Alan Sangster; Frank Wood’s Business Accounting 1, Tenth
Edition 2005; FT Prentice Hall; Chapter 26, Pages 284 to 293.

David Marshall, Wayne William McManus, Daniel Viele, Accounting what the
numbers mean, Seventh Edition 2005; McGraw-Hill Irwin; Chapter 6, Pages 190
to 236.

Kermit D.Larson, John J.Wild and Barbara Chiappetta; Fundamental Accounting

Principles, 17th edition; Mc-Graw-Hill Irwin; Chapter 10.

Robert Libby, Patricia A.Libby and Daniel G.Short; Financial Accounting, Third
edition; Mc-Graw Hill; 2001; Chapter 8.

Jan R.Williams, Susuan F.Haka and Mark S.Bettner; Financial & Managerial
Accounting – The Basis for Business Decisions; 13th edition; 2005; Chapter 9.
Resources

Websites

Accounting Standards Committee, FRS 16

http://www.asc.gov.sg/frs/index.htm, Retrieved on 28 April 2009.

Depreciation – Wikipedia, the free encyclopedia

http://en.wikipedia.org/wiki/Depreciation, Retrieved on 28 April 2009.

Revision Notes: Depreciation of Fixed Assets I Basic College Accounting.com

http://basiccollegeaccounting.com/revision-notes-depreciation-of-fixed-assets/,
Retrieved on 28 April 2009.