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Explain The Causes of Depreciation.: Capital Expenditure and Revenue Expenditure

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Muminah Doray
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37 views2 pages

Explain The Causes of Depreciation.: Capital Expenditure and Revenue Expenditure

Uploaded by

Muminah Doray
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Explain the causes of depreciation.

Non-current assets provide a benefit to the business over several years. The non-current asset will lose
value/depreciate as it is used up. The business will have to estimate this annual depreciation and record it as an
expense in the Income Statement / Statement of Profit or Loss. Depreciation is caused by: obsolescence - the asset
becoming out of date due to improvements in technology; wear and tear/physical deterioration - the asset
becomes less useful as it becomes older and less reliable; erosion, rust, rot and decay - equipment eroded or
wasting away due to forces of nature; excessive use - over time the asset may lose value due to being used
intensively; inadequacy - the growth or size of the business makes the asset unsuitable eg larger vehicles resulting
in businesses selling off their smaller vehicles; time factor - some assets have a legal life fixed in terms of years eg a
lease where a proportion of the lease is depreciated each year until it’s value is nil; depletion - some assets are of a
wasting nature such as the extraction of raw materials from mines or quarries.

Distinguish between straight line and reducing balance methods of depreciation.

Annual depreciation is treated as an expense in the Income Statement / Statement of Profit or Loss. It represents a
reduction in the value of the non-current asset. Rather than placing the full cost of the asset as an expense, the
business only charges the amount of the asset used up this year to this year’s Statement of Profit or Loss.

only two methods of depreciation. Straight line depreciation depreciates the asset by the same amount every year.
The depreciation is spread evenly over the expected life of the asset. This can be worked out in two ways: using
the formula (cost price - disposal value) / number of years of use OR the annual depreciation is a given percentage
of the cost price.

You should know which method is appropriate for which type of non-current asset. Eg the reason why a business
uses the reducing balance method is because motor vehicles bring more benefits to the business in the early years
and, therefore, in order to match revenue with related expenses (matching concept) the business has to use the
reducing balance method which gives high depreciation charges in the early years.

Capital expenditure and revenue expenditure

a) Explain the terms:

● capital expenditure

● revenue expenditure.

Capital expenditure is spending on: non-current assets; additions to non-current assets;


expenses incurred in acquiring non-current assets and getting them ready for use. Examples
include: buying a non-current asset; delivery or installation costs associated with buying a
non-current asset; legal fees associated with buying property; carriage inwards costs
associated with buying non-current assets; costs of building an extension to property.
Revenue expenditure is spending on the day to day running costs/expenses for services a
business uses. These expenses are associated with the current accounting period and are
shown in the Statement of Profit or Loss. They include wages, repair and maintenance
costs, depreciation.
You could be given a list of transactions with two columns entitled capital and revenue
expenditure and they have to decide how to categorise the spending.
b) Explain the importance of the correct treatment of capital expenditure and
revenue expenditure.
Correctly identifying spending as either capital expenditure or revenue expenditure is important in order to
calculate the correct profit for the year and the correct value of the assets in the Statement of Financial Position.
Incorrectly treating capital expenditure as revenue expenditure means that it will be recorded as an expense in the
Statement of Profit or Loss which means that the profit will be understated. Non-current assets will also be
understated eg. if the purchase of a vehicle was wrongly posted to the motor expenses account instead of the
motor vehicle account. Conversely, if revenue spending is posted as capital spending, profit for the year and non-
current assets would both be overstated.

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