Avel-COVID19-BFN-ND2- Financial Accounting II – Liabilities&Equity, Capital&Revenue Expenditure.
INTRODUCTION TO FINANCIAL ACCOUNTING II
LONG-TERM LIABILITIES AND OWNERSHIP EQUITY
INTRODUCTION
Business entities carry out their business operations by using current assets and
non-current assets, a combination of which represents the asset structure in the
statement of financial position. But these assets are usually funded through long-term (long-
term liability and equity) and short-term (current liabilities) sources of fund.
These sources of fund combine to represent the financial structure of the statement of
financial position.
The long-term sources of fund, which also represents the capital structure of the statement of financial position. However, long-term sources of fund cannot be used interchangeably with long-term liabilities as the former comprises both long-term liabilities and proprietary or ownership interest.
èDistinguish between long-term liabilities and ownership equity.
è Explain the difference between long-term sources of fund and long-term liabilities.
è Explain what drawings mean and its effects on equity.
èDistinguish Between Long-Term Liabilities And Ownership Equity.
Long-term liabilities
Generally speaking, another name for liability is debt. A liability, according to the IASB’s
conceptual framework, is “a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity resources embodying
economic benefits.” Long-term liabilities comprise all long-term sources of fund other than
those contributed by or attributable to the owners of the business. The nature and size of the
entity will determine the different types of long-term liabilities it has in its statement of
financial position. A sole proprietorship form of business may not have any long-term
liabilities, while the ones that have may simply have long-term loan (probably from bank).
WHILE
Ownership Equity
Equity represents the ownership interest in a business entity. Generally, this refers to capital
which represents the amount contributed by or attributable to the owners of the business for
carrying out the business operations. For a sole proprietorship business, for example, the
ownership equity will comprise the capital plus net profit/(loss) less drawings (C + P/(L) –
D). For a partnership business, equity comprises the partners’ capital accounts plus partners’
current accounts. Equity of a company or corporate entity is more complex as it includes:
share capital, share premium, revenue and capital reserves, retained profit, different sinking
funds, and revaluation surplus reserve.
è Corporate entities (companies) usually have different types of long-
term liabilities, list and briefly explain?
i. Debenture: It is a term loan with a fixed rate of interest and long-term maturity date
and it is usually traded on the stock market.
ii. Mortgage loan: This is a long-term loan usually taken for the purpose of acquiring
properties (buildings).
iii. Other long-term loans: For example, long-term bank loans.
è List the features of long-term liabilities ?
Generally, these long-term liabilities have certain common features such as
- Long-term maturity/repayment period
- Fixed or fluctuating rate of interest.
è Some of these long-term debts or liabilities may be secured or unsecured, Explain?
A secured liability is one in which the debt is tied to certain asset(s) of the borrowing entity.
For example, a loan secured against a firm’s warehouse building. In the event that the firm is unable to repay the loan, the creditor takes possession of the warehouse building and sells it to recoup his money. Or, when the company is liquidated, the amount realised from the warehouse will first by applied in repaying the creditor whose credit facility is secured against the building before using the balance to pay other creditors.
Unsecured liability on the other hand means that the debt is not tied to any particular asset of the borrowing entity. This makes unsecured debt more risky to the lender than a secured one. Furthermore, long-term debts may also have the feature of convertibility.
Convertible debt is the one that can be converted into share capital of a company whereas
non-convertible debt does not have the option of convertibility. Moreover long-term
liabilities usually have redemption feature. This means that debts may be redeemable or in
rarity irredeemable. Redeemable debts are those that have a repayment (or redemption)
period, which may be 10, 20 or other years, depending on the agreed loan tenure.
Irredeemable debts are those debts that are perpetual and have no liquidation or repayment
date. However, if such debts are traded on the stock market, the debt holder could sell them
and transfer ownership (and risk) to the debt buyers.
Long-term debts are treated under long-term liabilities in the statement of financial position
distinct from equity.
è Explain what drawings mean and its effects on equity.
Drawings
Drawings are basically found in the books of sole proprietorship and partnership as a result of
owners’ withdrawal of goods, cash or other assets from the business for private use. If owners
withdraw any form of assets from the business, this invariably reduces its capital or
ownership equity/interest in the business. However, because the capital account is a
permanent account, the drawings are not directly charged against or deducted from the capital
account, instead, a drawings account is created as a debit account while the corresponding
assets are credited with the value withdrawn. The drawings are then deducted from the equity
section in the statement of financial position. Accounting entries for assets withdrawn from
business for private use are:
a. Cash: Dr Drawings a/c and Cr Cash/Bank a/c
b. Goods: Dr Drawings a/c and Cr Purchases a/c
c. Non-current assets: Dr Drawings a/c and Cr Non-current assets a/c
Although drawings are evident in the books of sole proprietorship and partnership, it is subtle
with respect to companies. A sole proprietor may withdraw cash for personal use because he
is self-employed and not paid any salary by the business. If the proprietor converts that
business to a limited company for example, he can pay himself salary as a director without
the remuneration been regarded as drawings. He can also be entitled to dividend, that is, the
income he receives as a result of shares he holds in the company. But when a sole
proprietorship withdraws from its profit, the drawings are not charged to profit the way
dividend is deducted from net profit. You will appreciate this subtle and intricate situation in
a higher level course. So never worry at this time!
REVENUE EXPENDITURE AND CAPITAL EXPENDITURE
Expenditure is the amount of money an entity spends to achieve a particular purpose,
especially for generating revenues. No entities generate income or revenue without making
expenditure. That is why every business entity commences operation with investment seed
(capital) contributed by the business owner(s) to provide the resources the entity can draw on
to make expenditure it can use to generate revenue. This Unit focuses on two broad
categories of expenditure namely, capital and revenue, which have long-term and short-term
implications for the entity’s quest to achieving objectives of survival and profit maximisation.
è Differentiate capital expenditure from revenue expenditure.
è Identify and segregate capital expenditure from revenue expenditure from a list of business expenses as well as how they are treated in the income statement and statement of financial position.
è Differentiate Capital Expenditure From Revenue Expenditure.
Capital Expenditure
This is an expenditure incurred by an entity and the benefit of which transcends one
accounting year. This means that even though the expenditure is made in a particular
accounting year, the benefits are not consumed in that year only. For the purpose of not
charging too much cost to the profit or loss for that year, a portion of the capital expenditure
estimated to have been consumed are charged to each of the periods over which the benefits
are expected to cover. Capital expenditure or long-term expenditure is an investment in non-
current assets, whether tangible or intangible. Examples are investment in tangible assets
such as land and building, motor vehicle, equipment, plant and machinery, furniture.
Examples of intangible assets include trademark, patent, copyright, development cost,
mineral right, and mining license. As these assets generate benefits to the entity in more than
one accounting period, they are expensed to the income statement through a process called
depreciation, amortisation or depletion.
It is important for students to understand the accounting treatments of the costs of non-current
assets. For example, having mentioned that land and buildings, motor vehicles, equipment,
machineries are examples of non-current assets, the composition of the cost is usually more
than the purchase price. The following are things that will constitute the cost of non-current
assets that would be capitalised (regarded as capital expenditure rather than revenue
expenditure:
· Cost price
· Alteration/improvement cost
· Incidental freight cost
· Installation cost
· Incidental legal fees
· For asset built by the firm
o Material cost
o Labour cost
o Overhead cost (attributed expenses)
o Financing cost
The accounting entries for capital expenditure are similar to how expenses are generally
entered into the books of accounts. When capital expenditure investment is made, say, for
equipment, you Dr Equipment A/c and Cr Cash or Bank A/c. When a portion of the
expenditure on equipment is expensed to the profit or loss, the asset A/c is not affect, instead
you Dr Profit or loss A/c and Cr Allowance for depreciation A/c with the depreciation
chargeable to income in that accounting period (See Units 9 & 10). The allowance for
depreciation is not credited to the asset account but only subtracted from the asset cost in the
statement of financial position.
Revenue Expenditure
This is an expenditure incurred by an entity in the day-to-day running of the activities of the
entity. Its benefits expire in the year it is incurred and therefore is charged in whole to the
profit or loss A/c in the year of occurrence. Examples of such expenses are wages and
salaries, motor running expenses, electricity, advertising, repairs, travelling and
transportation, discounts allowed and interest expense. When revenue expenditure is made,
you debit the particular revenue expenditure A/c and credit cash/bank A/c.
Identify grey areas of capital and revenue expenditures
However, students sometimes find it confusing as to how to treat certain expenditures that are
associated with some non-current assets such as motor vehicle running expenses,
repairs/refurbishment to non-current assets and replacement of parts. Motor vehicle running
expense is not a capital expenditure but revenue expenditure and so must be kept separate
from acquisition cost of motor vehicle. Repairs or refurbishment of non-current assets are
usually revenue expenditure if they are meant to maintain the operating capacity of the assets
or keep the assets in their productive state. But where the repairs/refurbishment are done to
increase or enhance the operating capacity of the non-current assets which invariably benefits
more than one accounting period, that expenditure will be capitalised. Similarly, the cost
incurred in replacing a part of a plant to increase its productive capacity or extend the useful
life of the asset will be regarded as a capital expenditure; but if the replacement is only to
maintain the functionality of the asset the related cost is revenue expenditure.
Question 1
Group the following expenditure as capital or revenue expenditure:
(i) Purchase of machinery for business use
(ii) The cost of maintaining machinery
(iii)The cost of installing a new machinery
(iv)The cost of increasing the interior of new van to increase its carrying capacity
(v) The cost of acquiring mining license
(vi)The cost of acquiring copyrights
(vii) Cost of extending office building
Question 2
The following data relate to Babatunde Ventures which engages in internet, printing and
designing business:
(i) Purchase of six new computers at N20,000 each for N110,000 (net of quantity
discount)
(ii) Purchase of cables for cabling the computer networking at N6,000
(iii)Installation charge N8,000
(iv)Acquisition of software for the computers N38,000
(v) Purchases 2 printers at N15,000 each
(vi)Computer consumables N7,500
(vii) Computer servicing N3,500
Required:
(a) What is the amount of capital expenditure to be found in the statement of financial
position?
(b) What is the amount of revenue expenditure chargeable to the statement of
comprehensive income?
