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Do you want to consolidate what you have learned about revenue and capital cost? Would you like to work through a practical scenario to prove to yourself the differences between the two costs? Use this simple exercise to help apply your learning. It will take you around 15 minutes to complete.
Task
- Read through the scenario below.
- Work through the data to answer the questions. Consider referring to the ‘How to Calculate Depreciation’ guide to help you.
- Compare your answers to the solution provided.
Suggested Resources
- pen and paper
- calculator
- solution – attached
Scenario
Your organization, Quick Drop, is a courier company that delivers packages all over the country. You are a regional manager putting together this year’s budget forecasts. You realize that your office needs a new van and this would cost £17,625 (which includes VAT of £2,625). Your current van is getting old and is on its last legs. Quick Drop bought it five years ago and you have been advised that it is currently worth £1,000. You have also been advised that if you purchase a new van you will be able to sell it on after five years for £2,000. If you do buy a new van, what will the effect on Quick Drop’s financial performance be?
Questions
- What is the effect on the balance sheet and profit and loss account of recording the van purchase as a revenue cost?
- What is the effect on the balance sheet and profit and loss account of recording the van purchase as a capital cost?
- Can the van purchase be treated as a capital cost?
Exercise: What Effect Does Capitalization Have? – Solution
Question 1
The net price of the van is £17,625 less VAT (i.e. £15,000). As a revenue cost, this would be recorded in the profit and loss account as an expense. This would have an overall effect of reducing profit (or increase the loss) by £15,000 in the year of purchase.
Question 2
Step 1 - Capitalization
Again, the net price of the van is £17,625 less VAT (i.e. £15,000). As a capital cost, this would be recorded in the balance sheet as a fixed asset of £15,000.
Step 2 – Depreciation
Identify the cost that is to be depreciated:
The net purchase price and the resale value are both given, so this can be calculated as £15,000 less £2,000 i.e. £13,000.
Identify the useful economic life of the asset:
You should check this with your firm’s accounting policy but the useful economic life of the van appears to be five years based on what you know about the old van and the information you have been given about selling the new van.
Calculate the depreciation:
Depreciation charge
=
Net purchase price - resale value
Number of years asset in use
=
13,000
5
=
£2,600 per year
At the end of year one, the annual depreciation charge is recorded as an expense in the profit and loss account. At the same time the balance sheet shows an increase in the fixed assets with a Net Book Value (NBV) of £15,000 less £2,600 i.e. £12,400.
In the subsequent four years the same depreciation charge will appear in the annual profit and loss account. The NBV of the fixed asset in the balance sheet will reduce by £2,600 each year, as the accumulated depreciation increases.
After five years of depreciating the asset, the NBV will be £2,000. The van will then be sold for £2,000 and the fixed asset taken out of the balance sheet altogether.
Question 3
The purchase of the new van will give Quick Drop ownership of an fixed asset that has a useful economic life of more than a year, giving benefit over the period of its useful economic life. Therefore, it should be classified as a capital cost.
