XII ACCOUNTING REGULAR / PRIVATE. S.Hussain

Transcription

1 The workings under the heading of Additional Working are not required according to the requirement of the examiner. These are only for understanding the solutions. For more help, visit XII ACCOUNTING REGULAR / PRIVATE Compiled and Solved by: S.Hussain

2 ACCOUNTING 1996 REGULAR / PRIVATE Compiled & Solved by: S.Hussain Q.No.1 SINGLE ENTRY MIXED GIVEN Mr. Fahad maintains his accounting records on single entry basis. His financial position at the beginning and at the end of the year 1995 was as under:- January 1 December 31 Cash in hand Rs.4,500 Rs.13,000 Cash at bank 5,000 4,500 Accounts receivable 25,000 22,000 Merchandise inventory 15,000 20,000 Furniture 10,000 12,000 Equipment 7,000 10,000 Accounts payable 11,000 15,000 Fahad, Capital 55,500? Summary of his cash transactions during 1195 was as under:- Receipts Payments Collection from customers Rs.30,500 Purchase for cash Rs.10,000 Cash sales 25,000 Payment to suppliers 22,000 Salaries expense 2,500 Rent expense 3,500 Advertising expense 1,500 Insurance expense 2,000 Fahad, Drawings 1,000 REQUIRED (i) Compute the amount of total purchases and total sales. (ii) Prepare STATEMENT FO PROFIT & LOSS for the year ending December 31, (iii) Prepare STATEMENT OF AFFAIRS (i.e. balance sheet) as of December 31, SOLUTION 1 (i) Computation of Total Purchases: Accounts payable (ending) 15,000 Add: Cash payments to the suppliers 22,000 37,000 Less: Accounts payable (beginning) (11,000) Total credit purchases 26,000 Add: Cash purchases 10,000 Total purchases 36,000 Computation of Total Sales: Accounts receivable (ending) 22,000 Add: Cash collection from customers 30,500 52,500 Less: Accounts receivable (beginning) (25,000) Total credit sales 27,500 Add: Cash sales 25,000 Total sales 52,500 X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 2

3 SOLUTION 1 (ii) MR. FAHAD STATEMENT OF PROFIT & LOSS FOR THE PERIOD ENDED 31 DECEMBER 1995 Sales 52,500 Less: Cost of Goods Sold: Merchandise inventory (beg) 15,000 Add: Net purchases 36,000 Merchandise available for sale 51,000 Less: Merchandise inventory (end) (20,000) Cost of goods sold (31,000) Gross profit 21,500 Less: Operating Expenses: Salaries expense 2,500 Rent expense 3,500 Advertising expense 1,500 Insurance expense 2,000 Total operating expenses (9,500) Net profit 12,000 SOLUTION 1 (iii) MR. FAHAD STATEMENT OF AFFAIRS AS ON 31 DECEMBER 1995 ASSETS EQUITIES Current Assets: Liabilities: Cash in hand 13,000 Accounts payable 15,000 Cash at bank 4,500 Total liabilities 15,000 Accounts receivable 22,000 Merchandise inventory 20,000 Owner s Equity: Total current assets 59,500 Capital 55,500 Add: Net profit 12,000 Fixed Assets: 67,500 Furniture 12,000 Less: Drawings (1,000) Equipment 10,000 Total owner s equity 66,500 Total fixed assets 22,000 Total assets 81,500 Total equities 81,500 Computation of Capital at End: Cash in hand 13,000 Cash at bank 4,500 Accounts receivable 22,000 Merchandise inventory 20,000 Furniture 12,000 Equipment 10,000 Total assets 81,500 Less: Accounts payable (15,000) Capital at end 66,500 X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 3

4 Q.No.2 PARTNERSHIP ADMISSION GIVEN The following is the balance sheet of M/s. Amir, Mushtaq and Hanif who share profits and losses in the ratio of 5:3:2 respectively. Balance Sheet As of January 1, 1996 Assets Equities Cash 80,000 Accounts payable 25,000 Accounts receivable 40,000 Amir, Capital 100,000 Merchandise inventory 100,000 Mushtaq, Capital 75,000 Machinery 30,000 Hanif, Capital 50, , ,000 They agreed to admit Ismail as partner on REQUIRED Give necessary entries in the General Journal of the firm under each of the following cases separately:- Case (a): If Ismail invests Rs.75,000 for one-fifth (1/5) interest in the business. (Record bonus). Case (b): Case (c): If Ismail invests Rs.85,000 for one-fourth (1/4) interest in the business. (Record goodwill) If Ismail invests Rs.65,000 for one-fifth (1/5) interest in a total capital of the firm, Rs.300,000. SOLUTION 2 Case (a): Computation: (Bonus Method): Old partners capital (100, , ,000) 225,000 Add: Ismail s investment 75,000 Total capital of firm 300,000 For 1/5 interest, Ismail s capital (300,000 x 1/5) 60,000 Less: Ismail s investment (75,000) Bonus to old partners 15,000 PARTNERSHIP 1 Cash 75,000 Amir Capital (15,000 x 5/10) 7,500 Mushtaq Capital (15,000 x 3/10) 4,500 Hanif Capital (15,000 x 2/10) 3,000 Ismail Capital 60,000 (To record the investment of Ismail) Case (b): Check Goodwill: Ismail s investment 85,000 X 4/1 X 4/1 Total capital of firm 340,000 Less: Old partners capital (100, , ,000) (225,000) Less: Ismail s investment (85,000) Positive value means goodwill to old partners 30,000 X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 4

5 Computation: (Goodwill Method): For 1/4 interest, Ismail s investment 85,000 Therefore total capital of firm (85,000 x 4/1) 340,000 For 3/4 interest, old partners capital (340,000 x 3/4) 255,000 Less: Old partners capital before admission (100, , ,000) (225,000) Goodwill to old partners 30,000 PARTNERSHIP 1 Cash 85,000 Ismail Capital 85,000 (To record the investment of Ismail) 2 Goodwill 30,000 Amir Capital (30,000 x 5/10) 15,000 Mushtaq Capital (30,000 x 3/10) 9,000 Hanif Capital (30,000 x 2/10) 6,000 (To record the distribution of goodwill) Case (c): Computation: For 1/5 interest, Ismail capital (300,000 x 1/5) 60,000 Less: Ismail s investment (65,000) Bonus to old partners (5,000) For 4/5 interest, old partners capital (300,000 x 4/5) 240,000 Less: Old partners capital before admission of Ismail (100,000+75,000+50,000) (225,000) 15,000 Goodwill to old partners 10,000 PARTNERSHIP 1 Cash 65,000 Amir Capital (5,000 x 5/10) 2,500 Mushtaq Capital (5,000 x 3/10) 1,500 Hanif Capital (5,000 x 2/10) 1,000 Ismail Capital 60,00 (To record the investment of Ismail) 2 Goodwill 10,000 Amir Capital (10,000 x 5/10) 5,000 Mushtaq Capital (10,000 x 3/10) 3,000 Hanif Capital (10,000 x 2/10) 2,000 (To record the distribution of goodwill) X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 5

6 Q.No.3 PARTNERSHIP LIQUIDATION GIVEN On December 31, 1995, the balance sheet of M/s. Amjad, Nasir, Khursheed partners, who shares profits and losses in the ratio of 4:3:2 respectively, showed as under:- Assets Equities Cash 50,000 Accounts payable 30,000 Accounts receivable 60,000 Notes payable 10,000 Merchandise inventory 75,000 Amjad, Capital 90,000 Equipment 30,000 Nasir Capital 60,000 Furniture 15,000 Khursheed Capital 40, , ,000 On this date they liquidate their business. All the accounts receivable were collected and all assets other than cash and furniture were sold out for cash, total amount being Rs.147,000. The furniture was taken over by Amjad at agreed market price of Rs.12,300. The liabilities and partner s capital accounts were settled with the available cash. REQUIRED (i) Give necessary entries in the General Journal of the firm to record the above process of liquidation. (ii) Prepare partner s capital accounts and also cash account. SOLUTION 3 (i): PARTNERSHIP 1 Cash 147,000 Realization 18,000 Merchandise inventory 75,000 Equipment 30,000 Accounts receivable 60,000 (To record the sale of other assets and collection of receivable) 2 Amjad Capital 12,300 Realization 2,700 Furniture 15,000 (To record the furniture taken up by Amjad) 3 Accounts payable 30,000 Notes payable 10,000 Cash 40,000 (To record the payment of liabilities) 4 Amjad Capital (20,700 x 4/9) 9,200 Nasir Capital (20,700 x 3/9) 6,900 Khursheed Capital (20,700 x 2/9) 4,600 Realization 20,700 (To record the distribution of loss among partners) 5 Amjad Capital (90,000 12,300 9,200) 68,500 Nasir Capital (60,000 6,900) 53,100 Khursheed Capital (40,000 4,600) 35,400 Cash (50, ,000 40,000) 157,000 (To record the distribution of remaining cash) X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 6

7 SOLUTION 3 (ii): GENERAL LEDGER Cash Balance 50,000 3 Liabilities 40,000 1 Sale of other assets 147,000 5 Partners Capital 157, , ,000 Amjad Capital 2 Furniture 12,300 Balance 90,000 4 Realization 9,200 5 Cash 68,500 90,000 90,000 Nasir Capital 4 Realization 6,900 Balance 60,000 5 Cash 53,100 60,000 60,000 Khursheed Capital 4 Realization 4,600 Balance 40,000 5 Cash 35,400 40,000 40,000 Q.No.4 CORPORATION ISSUE OF SHARES GIVEN On January 1, 1996, Jansher Company Ltd. was registered with an authorized capital of Rs.1,200,000 divided into 6,000 10% preference shares of Rs.100 each and 60,000 ordinary shares of Rs.10 each. On January 15, 1996, the company offered 4,000 10% preference shares and 50,000 ordinary shares, payable in full with application. On January 25, 1996, the company s banker reported that Rs.500,000 on 5,000 10% preference shares and Rs.400,000 on 40,000 ordinary shares were received with applications. The remaining ordinary shares which were not taken up by the public were taken up by the underwriters under the agreement. On January 31, 1996, the directors of the company finalized the allotment of 4,000 10% preference shares and 40,000 ordinary shares to the public and 10,000 ordinary shares to the underwriters and directed the banker to refund the excess of application money. On February 10, 1996, the company allotted 4,000 ordinary shares of Rs.10 each inconsideration of purchase price of machinery. The shares were issued at market price of Rs each. REQUIRED (i) Give dated entries in the General Journal of the Company for the above transactions. (ii) Prepare initial balance sheet of the company on February 29, X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 7

8 SOLUTION 4 (i): JANSHER COMPANY LTD. 25 Jan Bank (500, ,000) 900, % preference shares application 500,000 Ordinary shares application 400,000 (To record the preference shares and ordinary shares applications received at par) 31 Jan 10% preference shares application 400, Ordinary shares application 400,000 10% preference shares capital (4,000 x 100) 400,000 Ordinary shares capital (40,000 x 10) 400,000 (To record the allotment of preference shares and ordinary shares to the public at par) 31 Jan Bank (10,000 x 10) 100, Ordinary shares capital (10,000 x 10) 100,000 (To record the ordinary shares taken up by underwriters as per agreement) 31 Jan 10% preference shares application 100, Bank (1,000 x 100) 100,000 (To record the refund of excess money to the public) 10 Feb Machinery (4,000 x 12.50) 50, Ordinary shares capital (4,000 x 10) 40,000 Shares premium (4,000 x 2.50) 10,000 (To record the purchase of machinery by issuing shares at premium) SOLUTION 4 (ii): JANSHER COMPANY LTD. BALANCE SHEET AS ON 29 FEBRUARY 1996 EQUITIES ASSETS Authorized Capital: Fixed Assets: 6,000 10% preference Machinery 50,000 Rs.100 each 600,000 Total fixed assets 50,000 60,000 ordinary Rs.10 each 600,000 Current Assets: Total authorized capital 1,200,000 Bank 900,000 Shareholders Equity: Total current asset 900,000 4,000 10% preference each 400,000 54,000 ordinary Rs.10 each 540,000 Add: Shares premium 10,000 Total shareholders equity 950,000 Total equities 950,000 Total assets 950,000 X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 8

9 Q.No.5 CORPORATION FINANCIAL STATEMENTS GIVEN Mardan Company Ltd. was registered with an authorized capital of Rs.2,000,000 divided into 100,000 ordinary shares of Rs.10 each and 1,000 9% preference shares of Rs.100 each. Before closing, the following balances of accounts were extracted from the books of the company on December 31, 1995:- Debit Balances:- Cash on hand Rs.100,000; Cash at bank Rs.300,000; Merchandise inventory ( ) Rs.20,000; Prepaid insurance Rs.6,000; Accounts receivable Rs.75,000; Machine cost Rs.300,000; Purchases Rs.250,000; Transportation on purchases Rs.12,000; Salaries expense Rs.20,000; Advertising expense Rs.10,000; Auditor s fee expense Rs.5,000; Director s fee expense Rs.2,000. (Total Rs.1,100,000). Credit Balances:- Accounts payable Rs.48,000; Allowance for depreciation Machine Rs.50,000; Allowance for bad debts Rs,2,000; Mortgage notes payable Rs.70,000; Sales revenue Rs.320,000; Retained earnings Rs.10,000; Share capital - paid-up preference shares Rs.475,000; ordinary shares Rs.125,000. (Total Rs.1,100,000). Supplementary data for adjustments on December 31, 1995: (i) Merchandise inventory was valued on December 31, 1995 at Rs.32,000. (ii) Insurance expired Rs.4,000. (iii) Accrued salaries Rs.5,000. (iv) Allowance for depreciation on machinery to be provided for the year was estimated at Rs.5,000. (v) Allowance for bad debts to be increased by Rs.1,000. (vi) The company decided to appropriate Rs.5,000 for reserve for contingencies and to appropriate Rs.8,000 for reserve for plant expansion. REQUIRED (a) Prepare INCOME STATEMENT for the year ended December 31, 1995 in classified report form and also STATEMENT OF RETAINED EARNINGS on the same date. (b) Prepare BALANCE SHEET as of December 31, 1995 in classified report form or account form. SOLUTION 5 (a): MARDAN COMPANY LTD. INCOME STATEMENT FOR THE PERIOD ENDED 31 DECEMBER 1995 Sales 320,000 Less: Cost of Goods Sold: Merchandise inventory (beg) 20,000 Add: Net purchases: Purchases 250,000 Add: Transportation on purchases 12,000 Net purchases 262,000 Merchandise available for sale 282,000 Less: Merchandise inventory (end) (32,000) Cost of goods sold (250,000) Gross profit 70,000 Less: Operating Expenses: Salaries expense (20, ,000) 25,000 Advertising expense 10,000 Director s fee expense 2,000 Auditor s fee expense 5,000 Insurance expense 4,000 Depreciation expense 5,000 X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 9

10 Bad debts expense 1,000 Total operating expenses (52,000) Net profit 18,000 MARDAN COMPANY LTD. STATEMENT OF RETAINED EARNINGS FOR THE PERIOD ENDED 31 DECEMBER 1995 Retained earnings (opening balance) 10,000 Add: Net income for the period 18,000 Total retained earning 28,000 Less: Reserves: Reserve for plant expansion 8,000 Reserve for contingencies 5,000 Total reserves (13,000) Retained earnings (ending balance) 15,000 SOLUTION 5 (b) MARDAN COMPANY LTD. BALANCE SHEET AS ON 31 DECEMBER 1995 Equities Assets Shareholder s Equity: Fixed Assets: Authorized Capital: Machine 300,000 1,000 9% preference Less: All for depreciation (55,000) Rs.100 each 1,000,000 Total fixed assets 245, ,000 ordinary Rs.10/- each 1,000,000 Current Assets: Total authorized capital 2,000,000 Prepaid insurance 2,000 Merchandise inventory 32,000 Issued & Paid-up Capital: A/c receivable 75,000 4,750 9% preference shares Less: all for b/d (3,000) Rs.100/- each 475,000 Cash at bank 300,000 12,500 ordinary shares Cash on bank Rs.10/- each 125,000 Total current assets 506,000 Retained earnings 15,000 Reserves for contingencies 5,000 Reserve for plant expansion 8,000 Total shareholder s equity 628,000 Liabilities: Mortgage notes payable 70,000 Accounts payable 48,000 Salaries payable 5,000 Total liabilities 123,000 Total equities 751,000 Total assets 751,000 X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 10

11 Additional Working: MARDAN COMPANY LTD. ADJUSTING ENTRIES FOR THE PERIOD ENDED 31 DECEMBER Merchandise inventory 32,000 Expense and revenue summary 32,000 (To adjust the merchandise inventory ending) 2 Insurance expense 4,000 Prepaid insurance 4,000 (To adjust the insurance expense) 3 Salaries expense 5,000 Salaries payable 5,000 (To adjust the unpaid salaries) 4 Depreciation expense 5,000 Allowance for depreciation Machine 5,000 (To adjust the depreciation expense) 5 Bad debts expense 1,000 Allowance for bad debts 1,000 (To adjust the bad debts expense ) 6 Retained earnings 13,000 Reserve for contingencies 5,000 Reserve for plant expansion 8,000 (To adjust the reserves for contingencies and plant expansion) Q.No.6 ACCOUNTING FOR DEPRECIATION GIVEN The following account balances were extracted from the books of M/s. Muzaffar & Co. as on December 31, 1995, before making any adjustments for the year:- Machine Cost (Purchased on January 1, 1993) Rs.50,000 Machine Allowance for depreciation Rs.9,500. The company uses the Diminishing balance Method for computing depreciation charge using a rate of 10% on reduced balance every year. The accounting year closes on December 31. REQUIRED (a) What will be the amount of depreciation expense for 1995? Show your computation. (b) Give adjusting entries to record depreciation expense on December 31, 1993 and Show your computation. (c) Give closing entry for depreciation expense on December 31, (d) Prepare allowance for depreciation account for the accounting years ended December 31, 1993 and (e) Show machine cost in partial balance sheet as of December 31, X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 11

12 SOLUTION 6 (a) Computation of Depreciation Expense by Diminishing Balance Method: Annual depreciation = Cost/Book value x Rate (%) Book value = Cost Allowance for depreciation Year Cost/Book Value Rate Depreciation Expense Book Value ,000 10% 5,000 50,000 5,000 = 45, ,000 10% 4,500 45,000 4,500 = 40, ,500 10% 4,050 40,500 4,050 = 36,450 SOLUTION 6 (b) MUZAFFAR & CO. ADJUSTING ENTRIES 31.Dec Depreciation expense 5, Allowance for depreciation 5,000 (To record the depreciation expense) 31.Dec Depreciation expense 4, Allowance for depreciation 4,500 (To record the depreciation expense) SOLUTION 6 (C) MUZAFFAR & CO. CLOSING ENTRIES 31.Dec Expense and revenue summary 4, Depreciation expense 4,500 (To close the depreciation expense) SOLUTION 6 (d) GENERAL LEDGER Allowance for Depreciation 31 Dec 93 c/d balance 5, Dec 93 Depreciation exp. 5,000 5,000 5,000 1 Jan 94 b/d balance 5, Dec 94 c/d balance 9, Dec 94 Depreciation exp. 4,500 9,500 9,500 1 Jan 95 b/d balance 9,500 SOLUTION 6 (e) MUZAFFAR & CO. BALANCE SHEET AS ON 31 DECEMBER 1995 Assets Machine 50,000 Less: Allowance for depreciation (13,550) 36,450 Equities X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 12

13 Q.No.7 RESERVES AND FUNDS (a) GIVEN The following reserves appear on the balance sheet of Adnan Company Ltd. as of December 31, 1995:- (i) Allowance for depreciation Building Rs. 20,000 (ii) Reserve for income tax 5,000 (iii) Reserve for contingencies 10,000 REQUIRED (i) Classify each of the above reserves into three categories:- Valuation reserve, Liability reserve and Surplus reserve. (ii) Give the journal entries that must have been made to create each of the three reserves. (iii) Give the entries that will be made dispose of each of the three reserves. (b) : (i) From the viewpoint of accounting distinguish between a Reserve and a Fund. (ii) Give the necessary journal entries in skeleton form to record the creation and disposal of a fund. (c) Prepare a partial balance sheet showing a reserve representing retained earnings and a fund. SOLUTION 7 (a) Allowance for deprecation Building --- Valuation reserve. Reserve for income tax --- Liability reserve. Reserve for contingencies --- Surplus reserve. ADNAN COMPANY LTD. CREATION OF RESERVES 1 Depreciation expense 20,000 Allowance for depreciation Building 20,000 (To record the depreciation expense) 2 Income tax expense 5,000 Reserve for income tax 5,000 (To record the reserve for income tax) 3 Retained earnings 10,000 Reserve for contingencies 10,000 (To record the reserve for contingencies) ADNAN COMPANY LTD. DISPOSAL OF RESERVES 1 Allowance for depreciation Building 20,000 Building 20,000 (To record the disposal of building) 2 Reserve for income tax 5,000 Cash/Bank 5,000 (To record the income tax paid) 3 Reserve for contingencies 10,000 Retained earnings 10,000 (To record the disposal of reserve for contingencies) X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 13

14 SOLUTION 7 (b) RESERVE FUND 1. It is created out of retained earnings. 1. It is created out of cash. 2. Reserve is a voluntary provision made out of net income. 2. A provision is a change expense and revenue. 3. Reserve is part of owner s equity. 3. Fund is an asset. 4. It is shown on the credit side of the balance sheet under owner s equity. 4. It is shown on the debit side of the balance sheet among assets. 5. It represents a portion of profits or 5. It represents on assets. liability. 6. Reserve has normally credit balance. 6. Fund has normally debit balance. 7. It is part of retained earnings. 7. It is not part of retained earnings. CREATION OF FUND 1 Sinking fund DR. Cash CR. (To record the creation of sinking fund) DISPOSAL OF FUND 1 Bonds payable DR. Sinking fund CR. (To record the disposal of sinking fund) SOLUTION 7 (c) Equities Issued & Paid-up Capital: ordinary Rs.xx each Add: Retained earnings Add: Reserves for contingencies Total shareholder s equity Assets Liabilities: Long-Term Liabilities: Debentures payable Total long-term liabilities Current Liabilities: Cash dividend payable Stock dividend payable Reserve for income tax Total current liabilities Total equities Total assets X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 14

15 Q.No.8 WRITE ANSWERS TO ANY FOUR OF THE FOLLOWING QUESTIONS:- (i) How a statement of affairs does differ from a balance sheet? (ii) Distinguish between capital expenditure and revenue expenditure. Why is this distinction between the two necessary? (iii) State the misconceptions generally associated with depreciation accounting. (iv) Should salaries to partners be treated as an expense of the business or as a partial distribution of profit? (v) List some weakness in general of the form of balance sheet used by public companies in Pakistan. (vi) What are the misconceptions generally associated with reserve accounts? SOLUTION 8 (i) Differences between Balance Sheet and Statement of Affairs: Balance sheet is prepared on the basis of double entry system of book-keeping. Statement of affairs is prepared on the basis of incomplete records. Balance sheet is prepared to present financial position of the business. Statement of affairs is prepared to find out either the amounts of opening capital or closing capital. Balance sheet shows the true financial position of the business. Statement of affairs does not show the true financial position of the business. Statement of affairs is the statement of assets and liabilities (including capital) prepared under the single entry system. Balance sheet is the statement of assets and liabilities (including capital) prepared under the double entry system. Statement of affairs is prepared partly from a trader s book, partly from other sources of information like cash book and sometimes from memory. Balance sheet is prepared with data available from the books of accounts only. Statement of affairs is compiled from an incomplete books and information, the accuracy of which cannot be relied upon. Balance sheet is prepared from a set of books kept according to the double entry system, the arithmetical accuracy of which can be proved. (ii) Difference Between Capital and Revenue Expenditure: BASIS OF DIFFERENCE CAPITAL EXPENDITURE REVENUE EXPENDITURE 1. Purpose It is incurred for the purchase of fixed assets. It is incurred for the maintenance of fixed assets. 2. Earning Capacity It increases the earning capacity of the business. It does not increase the earning capacity of the business. 3. Periodicity of Benefit Its benefits are spread over a number of years. Its benefit is only for one accounting period. 4. Placement in Financial Statements It is an item of balance sheet and is shown as an asset. It is an item of trading and profit and loss account and is shown on the debit side of either of the two. The expenditure incurred for acquiring a fixed asset or which results in increasing the earning capacity of the business is known as capital expenditures. The benefits of capital expenditures are generally availed in several accounting years. An expenditure incurred in the course of regular business a transaction of a concern is availed in the same accounting year is known as revenue expenditure. X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 15

16 (iii) Misconceptions generally associated with depreciation accounting are: Since depreciation is an allocation of cost over accounting periods, it is not directly connected to market value or the amount that the asset would be worth if it was sold. The book value of an asset, computed as the actual cost minus the accumulated depreciation, is simply the unallocated cost of the item. The pattern of depreciation is fixed, and does not respond to changing market conditions. Depreciation does not involve any cash flow. This is clearest in the simple case of an asset acquired entirely by cash payment. Although the initial purchase is a cash flow, the subsequent allocation of part of the cost as a period expense involves only an accounting entry. Depreciation is not intended as a mechanism to provide for replacement of the asset. There are no cash flows associated with depreciation, and there is no connection with any cash accumulated for replacement of the asset. The asset may or may not be replaced this is a capital budgeting decision that is immaterial to the recognition of expense. Because depreciation is an expense but has no associated cash flow, it is sometimes described as being "added back" to arrive at cash flow for the firm. This gives the impression that depreciation is somehow a source of cash flow. The "adding back," however, is simply recognition that no cash flow occurred, and depreciation cannot supply cash. (iv) Partners salary should net be treated in the profit or loss account because it is not an expense. It is part of profit sharing scheme. It must be deducted from profit at the time of distribution of profits. (v) In the balance sheet of public companies, equities are listed on the left had side and assets are listed on right hand side of the balance sheet. This is not in keeping with the basic accounting equation Assets = Liabilities + Owner s equity. (vi) The misconceptions are (1) that the reserves for depreciation account represents an amount set-aside each year to help replace the assets and (2) the reserve for bad debts account represents an amount set-aside each year to meet bad debts when they actually materialized. Actually no amount is set-aside. Both of these accounts came into existence as a result of expense recognition. X I I A c c o u n t i n g ( R e g u l a r / P r i v a t e ) Page 16