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Classification of Expenditure
Classification of Expenditure
Classification of expenditure
All firms spend money in their business operations. However, not all this
expenditure will appear immediately in the profit and loss account as an
expense. The reason this happens is due to the classification of all
expenditure into one of two kinds either capital expenditure or revenue
expenditure.
Capital expenditure
Money spent on fixed assets or any other long term projects is likely to be
classified as capital expenditure. The purchase of a fixed asset involves
money being spent on an item which is going to be (hopefully) used for
more than one period of time. Therefore, including it as an expense in the
current profit and loss account would be misleading and would violate the
idea of the accruals concept (where expenses are matched to the period
in which they 'belong'). The accruals concept is covered in more detail on
3.2
As a result, capital expenditure appears on the balance sheet. For
example, the purchase of new equipment would be capitalised and listed
as a fixed asset. Money has been spent on this asset and the bank or cash
figure would be reduced, but it initially appears as though the cost of the
asset does not appear as an expense. However, the asset does appear as
an expense but this is done over time and will appear as depreciation (a
provision, not an expense - don't worry, both provisions and expenses are
deducted as though they are expenses in the profit and loss account).
Capital expenditure would also include costs involved in getting the asset
into working condition. For example, these costs would all be classified as
capital expenditure:
1. Delivery costs for asset
2. Installation costs
3. Legal fees involved with the purchase of an asset
Revenue expenditure
Money spent on day-to-day running costs would be classified as revenue
expenditure. This is because the expense can be linked to belonging to a
specific period of time. The expense is 'used up' during that period of time
and will not be carried forward into the next period of time. Any items of
revenue expenditure will appear as an expense in that period's profit and
loss account
If the expenditure does not add value to the firm or have any long-lasting
impact then it is likely to be revenue expenditure.
The following table illustrates examples of capital and revenue
expenditure:
Capital expenditure
Revenue Expenditure
New premises
Repairs to premises
Type of expenditure
Revenue income
This usually includes the revenue from the sale of stocks, but may also
include money received from items such as commissions received, or
interest received. Revenue incomes will all be included in the profit and
loss account (sales revenue appears in the trading account section of the
overall account). Any other forms of income would be credited to the
profit and loss account normally added on to the gross profit before the
expenses are deducted.
Capital income
This refers to one-off sources of income. The sale of a fixed asset would
be treated as capital income. This means that the revenue from the sale
of a fixed asset, the money raised through the issue of shares, or money
obtained in the form of a loan would not be included as income in the
profit and loss account.
example, when a firm buys a set of chairs, for example, then technically
these should be regarded as an asset which will provide a benefit over the
next few years i.e. it is a capital expenditure which should be put on the
balance sheet and depreciated. However, if the cost of the chairs is only a
few hundred pounds the firm may write them off in one go i.e. treat them
as revenue expenditure and put the total expenditure on the profit and
loss this year (this is the concept of materiality, covered in 3.2)
In the case of items such as research and development some firms will
treat this as a revenue expenditure on the basis that the benefits of this
have been used up this period. Other firms will treat research and
development as capital expenditure on the basis that it will hopefully
provides a benefit in the future if the research is fruitful. This lack of
clarity about what is and what is not a capital expenditure gives some
firms increased scope for 'window dressing' their accounts so as to
present the firm in a particularly flattering way. For example, by deciding
to classify an item as a capital expenditure rather than as revenue
expenditure this year's costs will be reduced and profits increased simply
because of a change in accounting policy.
As a result, the accounting profession has developed a series of
regulations which state which items of expenditure can and which cannot
be capitalised on the balance sheet. These regulations are covered in
module 6. For example, in the case of Research and Development costs
'SSAP 13' states that R & D expenditure can only be capitalized if certain
conditions are met".
year - this means that it should show all the income earned and all the
expenses incurred for that year even if they have not all been paid and
received.
This idea is contained within the accruals (or matching) concept - that we
should account for income and expenses when they are incurred (i.e.
used up), not when they are paid and received. In other words, if an item
of income or an expense belongs to a period of time (e.g., car insurance
for a year) then it would appear as an income or expense for that period regardless of the amounts actually paid or received.
So far, we have only applied this concept to sales and purchases - sales
are included as income and purchases are included as an expense even
though they are usually on credit terms and the money from these
transactions may not be paid or received until the next accounting period.
For example, credit sales made on 20th December 2001 would count
towards the profits of the year ended 31 December 2001, but the cash
generated by this sale is unlikely to be received until 2002. The accruals
concept must also be applied for any expenses and any incomes. This
leads to some new definitions:
The implications of these for the profit and loss account is that this
account should show the income that should have been received and the
expenses that should have been paid when the transaction was originally
made, even if this does not correspond with the money paid in or
received.
If expenses are paid immediately when they are incurred and income is
received immediately when it is also earned, then we have no need for
accrual and prepayments. For example, if we assume the annual
electricity bill was 750 and commission received for the year of 2001
was 500, then the ledger accounts would appear as follows:
Electricity
2001
2001
2001
2001
Concepts covered
1. Accrued expenses (or accruals) are expenses incurred during a
financial period but not yet paid for, i.e. expenses owing
2. Prepayments are expenses paid in advance of the current financial
period (i.e. paid now for the next period).
3. Accrued revenue refers to income which is still owing to firm
(similar to debtors)
4. Prepaid revenue refers to income which the firm has received in
advance of when it was due
Balance sheets
On the balance sheet, only the amount that is either an accrual or a
prepayment should be included in current assets and current liabilities.
Normally, prepayments should appear in current assets after bank and
cash. Accruals should appear in current liabilities after creditors and bank
overdrafts.
Credit balances
Debit balances
Current liabilities
Current assets
Bad debts
Credit sales and credit purchases are normal business transactions, where
goods are exchanged between supplier and customer, but the money for
the transaction is exchanged at a later date. These credit terms offered
gives firms valuable 'breathing space' where they can pay for the goods at
a time when the firm may have more money available (most credit terms
expect payment within one month).
The business offering credit terms is taking the risk that some customers
may never pay for the goods sold to them on credit. Any debtor's
balances that remain unpaid (after a specified period of time has elapsed)
are classified as a bad debt.. The process of cancelling a debt because
payment is not expected to be received is known as 'writing off' the bad
debt. Bad debts are an unfortunate, but not unusual business expense,
and must be charged as an expense to the profit and loss account in the
period when the firm decides to cancel the debt from ledger accounts
Bad debts are a profit and loss expense in the period in which they
are written off
Firms would not offer credit to any firm they know would not pay, but
many firms will experience financial difficulty - and may have to close
down - thus making bad debts an inevitable part of the business world.
Debit
Credit
2005 -
- -
G Elliot
2005
2005 -
- -
2005
2005 -
- -
(N.B. The sales account would receive the credit entry for each of these
sales)
On the 31 December of that year it was decided that the following
accounts would be written off as bad debts:
G Flitcroft
G Elliot
At 31 December, P Krugman had been declared bankrupt during the year
and a payment of 25p in the was received by cheque in full settlement
of this account.
The debtor's account would now appear as:
G Flitcroft
2005
2005
2005
2005
2005
2005
160 -
40
160
have received 25p for every 1 owing to us - the other 75p in the is
rewritten off as a bad debt.
To complete the entries, the amounts are transferred to the debit side of
the bad debts account. This account is then transferred to the debit side
of the profit and loss account - as an expense.
Bad debts
2005
2005
Dec 31 G Flitcroft
750
Dec 31 G Elliot
490
1360 -
1360
In a trial balance, the entries for bad debts will always be in the debit
column.
This means that the bad debts have already been deducted from the
debtors figure in the trial balance and therefore you should not deduct the
bad debt from he debtors figure. Only if the bad debt has not been
recorded in the books would the debtors figure need to be reduced
because of bad debts.
debtors will become bad debts (surely it would not have given credit
terms to any customer who is unlikely to pay), but it will have to face up
the fact that bad debts are a common business occurrence. In most
cases, the debtors would be wiling to pay, but simply cannot (maybe
because the customer's firm has had to close). As a result, the debtors
figure on the balance sheet does not show a 'true and fair view' of the
actual amounts that will be collected by the firm from the customers.
Therefore to be prudent, the firm should try to aim to show a more
realistic figure for the amounts likely to be collected over the near future in other words, it should try to estimate the size of any future bad debts,
before they actually occur. This can be done by creating a provision for
doubtful debts.
This provision is supposed to reflect the likely size of the future bad debts
which means that this can be deducted form the debtors figure on the
balance sheet so to give a more realistic figure for the amounts likely to
be collected.
The provision for doubtful debts is not the same as the amount of bad
debts. Bad debts are actual sums of money that have been written off.
The provision for doubtful debts is an estimate of the size of future bad
debts - it has not happened. The firm may actually over or underestimate
the size of the future bad debts when creating this provision. This does
not matter, as long as the estimate is a reasonably realistic prediction of
what will happen then it does not matter if the actual bad debts in the
future are not exactly the same as the provision for doubtful debts.
become a bad debt. This can be seen in an aged debtors schedule which
ranks and classify amounts owing to the firm by the length of time that
they have been outstanding.
Example: Ageing Schedule for Doubtful Debts
Period debt
owing
Amount
30 days or less
10,000
100
1 month to 2
months
6,000
120
2 months to 6
months
800
40
6 months to 1
year
300
10
30
Over 1 year
180
50
90
Total debtors
amounts
17,280
380
This balance of 380 for the provision would then be deducted from the
value of the debtors figure on the balance sheet - giving us a more
realistic value of the amount that we will collect from the debtors.
As far, as most examination questions go, the provision for doubtful debts
is likely to be a percentage of the overall debtors figure. For example,
some firms may always maintain a provision for doubtful debts of 2 or 3%
of their outstanding debtors totals.
Balance sheet
Debit
Credit
2001
2001
2002
480 -
480
Debit
Credit
with the increase in the provision with the increase in the provision
Profit and Loss Account (extract) for the year ended 31 December
2002
Gross profit
xxx
Less Expenses:
30
Current assets
Debtors
16,000 -
480
15,520
2001
2002
480 -
480
2003
2003
Jan 1
480 -
480
2004
Jan 1
The entries needed for when the provision is to be reduced are as follows:
Debit
Credit
with the decrease in the provision with the decrease in the provision
Gross profit
xxx
Add
60
Current assets
Debtors
14,000 -
420
13,580
Balance sheet
Deduct full provision from debtors figure show workings in current assets
Debit
Credit
Debit
Credit
profit and loss account (as income)- it would be added on to the gross
profit
Normally, we try to match income to the period in which it was generated,
or the expense to when it was incurred. However, with bad debts
recovered this procedure is ignored. Rather than add the bad debt
recovered as income for the period in which the sale was made, we
include the income in the period in when it was recovered instead.
To summarise: Bad debts recovered
Added as income
Although related, it will be easier if you treat the bad debts and the
provision for any bad debts as completely separate items when making
calculations.
This topic can be integrated into the construction of the final accounts.
Meaning of depreciation
Fixed assets are those assets, which are:
1. of long life, and
2. to be used in the business, and
3. not bought with the main purpose of resale.
Although they represent an expense when they are purchased in the
sense that they cost money, purchases of fixed assets are items of capital
expenditure and therefore will not appear directly in the profit and loss
account during the period in which they are acquired. However, we still
need to show the effect of a fixed asset purchased in the final accounts
and this is achieved through the use of depreciation.
The main reason for charging depreciation to the profit and loss account is
to satisfy the accruals concept - that the profit and loss account should
reflect the expense incurred in that period of time. Therefore if an asset is
used over a period of time then there should be a charge in the profit and
loss account to reflect this usage. However, depreciation is not really a
'true' expense because it does not involve any cash being paid out by the
firm. Depreciation is actually a provision not an expense. This means that
it is supposed to represent an amount equal to the loss in value of the
asset.
Therefore, when a fixed asset is purchased we will not enter the full
purchase price of the asset as a profit and loss account expense. We will,
however, enter a proportion of the asset's charge as a depreciation
provision, for each year that we make use of the asset. This provision will
appear as an expense and will also be deducted from the value of the
asset on the balance sheet - in order to show the reduced value
Causes of depreciation
Why do assets lose value over time? The main reasons to explain a loss in
value are as follows:
1. Wear & tear
2. Obsolescence
3. Passage of time
4. Depletion
Obsolescence
Advances in technology will mean that assets will lose value. This is
because, as new innovations are launched into an industry, assets using
older technology will become out of date and therefore will have less
value. This does not mean that the equipment is worthless, some firms
may buy the older assets and use them because they cannot afford to buy
new up-to-date equipment.
Passage of time
Intangible assets are those which do not exist in a physical sense.
Leasehold property and goodwill are examples of intangible fixed assets.
These assets may have a legal life fixed in terms of years. For instance,
you may agree to rent some buildings for 20 years. This is normally called
a lease. After twenty years has elapsed the lease is worth nothing to you,
as it has finished. Whatever you paid for the lease is now of no value.
A patent allows the holder to exploit an innovation or invention for a fixed
period time (usually 16 years) without any threat of others copying. This
could also be considered a fixed asset - if it is purchased, as it is likely to
help the firm to generate more income in the future. Here though, instead
of using the term depreciation, the term amortisation is often used for
these intangible assets.
Depletion
Some assets, especially land, will lose value as they are used more and
more. For example, a mine will lose value the more the resources are
extracted from beneath the surface. Therefore it is the rate at which the
resources are depleted which will determine how quickly the asset loses
its value.
Appreciation
What about the assets that increase (appreciate) in value? It is normal
accounting procedure to ignore any such appreciation, as to bring
appreciation into account would be to contravene both the historical cost
concept and the prudence. Nevertheless, in certain circumstances
appreciation is taken into account in partnership and limited company
accounts, but this is left until partnerships and limited companies are
considered.
There is an intense and lasting debate on this issue within the accounting
profession. The profession appears generally to have accepted the use of
'current values' on the basis that this gives more meaningful information
to the users of the statements. The system used in the UK at present can
best be described as a 'hybrid' one which uses a mixture of historical cost
and revaluations. At present the choice is left to the preparers of the
statements.
Straight-line method
This method, also known as the fixed instalment method, is the most
commonly used method of depreciation. It is also the easiest method to
account for.
Once the annual depreciation provision has been calculated, this will
remain the same for each year the asset is in use. The formula for
calculating the annual rate of depreciation is as follows:
Example 1
A delivery vehicle was bought for 25,000 and we thought we would keep
it for five years and then trade it in for 3,000 (in effect the trade in value
becomes the scrap value).
Once you have had a go at this, check your answer against ours. If you
have made some mistakes, make sure you work out carefully where you
have gone wrong.
Straight-line as a percentage
It is fairly common to express straight-line depreciation as a percentage.
This simply means that a percentage of the original cost of the asset will
be charged as the deprecation. For example, if an asset cost 10,000 and
depreciation is to be calculated at 10% on cost - this would mean that we
should charge 10% x 10,000 (1,000) as the annual deprecation for
each year that we have the asset.
The percentage quoted under the straight-line method will also tell us
how long we expect the asset to last, for example:
10% - 10 years
25% - 4 years
20% - 5 years
Example 2
Equipment is bought for 15,000 and depreciation is to be
charged at 20 per cent per annum using the reducing balance
method
Remember, both methods can be quoted using percentages
for the depreciation.
Straight line is a percentage of the cost of the asset
Reducing balance is a percentage of the net book value of the
asset.
Choice of method
Notice that with the reducing balance method, the
depreciation provision per year will start off relatively large
and will gradually get smaller. It has been commented that
Example 3
A firm has just bought a machine for 30,000. It will be kept
in use for four years, and then it will be disposed of for an
estimated amount of 2,000. They ask for a comparison of
the amounts charged as depreciation using both methods.
Straight-line method: (30,000 - 2,000) ( 4 = 7,000 per
annum Reducing balance method: 50 per cent will be used.
Have a go at calculating the figures for both methods and
then follow the answer link below to see how you got on.
Credit
Example 1
On 1 January 2001, a firm purchases a machine for 10,000,
paying by cheque. It chooses to depreciate the machine at
25% on cost using the straight-line method.
Show the asset, the provision for depreciation account and
the extracts from the balance sheet for each of the four years,
the firm has the asset for.
Answer
The annual depreciation will be 25% x 10,000 = 2,500 (i.e.
the machine is expected to last for four years).
The entry in the asset account is easy, it will look as follows:
Machinery
2001 -
2001
2001
2001
2001
2001
2002
2002
Jan 1
5,000
2003
2003
Jan 1
7,500
2004
2004
10,000 -
5,000
7,500
10,000
Although the charge to the profit and loss account stays the
same at 2,500, the accumulated total on the above
'provision' account will increase each year. This is illustrated
on the balance sheet where the closing balance is deducted
from the cost of the asset to give the net book value of the
asset at that moment in time:
Fixed assets
Machinery
10,000 -
2,500
7,500
Fixed assets
Machinery
10,000 -
5,000
Balance sheet
(extract) as at 31
December 2003
Fixed assets
Machinery
10,000 -
5,000
Less Provision
7,500 2,500
for depreciation
Fixed assets
Machinery
10,000 -
10,000 0
Treated as:
Profit on
disposal
Credit
Income - added on to
profits
Loss on
disposal
Debit
Example 1
A machine was bought on 1 January 2001 for 9,000.
Depreciation was to be provided for at 20% on cost (straight
line method) on a monthly basis. On 30 June 2003 the
machine was sold for 5,000 cash.
Answer
The profit on the disposal is calculated as follows:
1. The annual deprecation provided on this machine is
20% of 9,000 = 1,800
2. The accumulated deprecation is the annual deprecation
over a 2 1/2 year period = 1,800 x 2 1/2 = 4,500
3. The net book value will be: cost - accumulated
depreciation, i.e. 9,000 - 4,500 = 4,500.
4. The profit on the asset disposal will therefore be:
5,000 - 4,500 = 500 profit.
This 500 profit would appear as income in the profit and loss
account for this period.
Example 1
A machine was bought on 1 January 2001 for 9,000.
Depreciation was to be provided for at 20% on cost (straight
line method) on a monthly basis. On 30 June 2003 the
machine was sold for 5,000 cash.
If we use bookkeeping, then we would need to see the state
of the relevant accounts at the moment of sale. These would
be as follows:
Machinery
2003 -
2003 -
- -
2003 - - 2003
-
2003 -
2003
2003
2003
2003
Jun
30
Machinery 9,000
2003
Jun
30
Machinery
deprecation
4,500
Notice that the disposal account is taking the other half of the
double entry for the entries made in the cost and provision
accounts. The cash received from the sale is also entered into
the disposal account. This is debited to the cashbook and
therefore is credited to the disposal account. This is shown
below:
Machinery disposal
2003
Jun
30
Machinery 9,000
2003
Jun
30
Machinery
deprecation
4,500
Jun
30
Cash
5,000
2003
2003
Jun
30
Machinery
9,000
Jun
30
Machinery
deprecation
4,500
Jun
30
Profit &
loss
500
Jun
30
Cash
5,000
9.500 -
9,500