Chapter 7 Solutions: Preparation of Financial Statements of Sole Trading and Partnership Firms
Answers to the Chapter 7 exercises. Each answer is as long as its marks call for: a sentence or two for 1 mark, five clear points or a five-row table for 5 marks, and full working for numerical problems.
Group A: Very Short Answer Questions (1 Mark Each)
1. Distinguish between Capital Expenditure and Revenue Expenditure in one sentence.
Capital Expenditure is incurred to acquire or improve fixed assets whose benefit lasts for more than one accounting year and is shown as an asset in the Balance Sheet, whereas Revenue Expenditure is incurred on the day-to-day running of the business, its benefit is used up within the current year, and it is charged to the Trading or Profit and Loss Account.
2. What is Deferred Revenue Expenditure? Give one example.
Deferred Revenue Expenditure is a heavy expenditure that is revenue in nature but whose benefit extends over 3 to 5 years, so only the current year’s share is written off to the Profit and Loss Account and the balance is shown temporarily on the Assets side of the Balance Sheet. Example: a massive initial advertising campaign to launch a new product.
3. Give two examples of Capital Receipts.
Two examples are capital contributed by the owner and a loan taken from a bank; the sale proceeds of fixed assets are also a capital receipt.
4. How is Goods Lost by Fire (partially insured) treated in Final Accounts?
The full cost of the goods lost is deducted from Purchases in the Trading Account. The insurance claim admitted is shown under Current Assets in the Balance Sheet, and the uninsured loss (cost of goods lost - claim admitted) is debited to the Profit and Loss Account.
5. What is meant by Marshalling of Balance Sheet?
Marshalling of the Balance Sheet means arranging its assets and liabilities in a definite order, either in the Order of Permanence (fixed assets and long-term capital first, liquid items last) or in the Order of Liquidity (cash first, fixed assets last).
Group B & C: Short and Long Numerical Questions (5 / 8 Marks)
1. Distinguish between Capital Expenditure and Revenue Expenditure on any five bases.
Capital expenditure builds up the fixed assets that earn for the business over several years, while revenue expenditure keeps the business running from day to day. They differ as follows:
| Basis of Difference | Capital Expenditure | Revenue Expenditure |
|---|---|---|
| Purpose | Incurred to acquire, install or upgrade fixed assets, which increases the earning capacity of the business | Incurred on the day-to-day running and maintenance of the business, which only maintains the existing earning capacity |
| Duration of benefit | The benefit lasts for more than one accounting period (long-term) | The benefit is used up within the current accounting year (short-term) |
| Recurrence | Non-recurring and irregular in nature | Recurring and regular in nature |
| Accounting treatment | Capitalized and shown as an asset in the Balance Sheet; only the yearly depreciation on it is charged to the Profit and Loss Account | Shown as an expense on the Debit side of the Trading or Profit and Loss Account |
| Examples | Purchase price of machinery, freight and installation wages on a new machine, legal fees for buying land, cost of a building extension | Purchase of goods for resale, routine repairs, whitewashing a building, salaries, wages, rent, electricity |
Treating one as the other is an Error of Principle: it misstates the Net Profit in the Profit and Loss Account and the assets in the Balance Sheet.
2. State whether the following are Capital or Revenue Expenditures with reasons:
- (a) Freight and cartage paid on purchase of a new printing machine.
- (b) Legal expenses incurred in defending a suit for breach of contract to supply goods.
- (c) Cost of overhauling and painting a second-hand delivery van just purchased.
- (d) Whitewashing and routine repair of the factory building.
- (e) Cost of constructing an additional room in the office building.
| Item | Nature | Reason |
|---|---|---|
| (a) Freight and cartage on a new printing machine | Capital Expenditure | Freight and cartage are paid to bring the new machine into the business and make it ready for use, so they are part of the machine’s cost. They are debited to the Printing Machine Account, not to an expense account. |
| (b) Legal expenses in defending a suit for breach of contract to supply goods | Revenue Expenditure | The suit arises from the ordinary business of supplying goods. The expense is a normal cost of carrying on that trade and creates no asset, so it is charged to the Profit and Loss Account as legal charges. |
| (c) Overhauling and painting a second-hand delivery van just purchased | Capital Expenditure | The van has just been bought, and this cost puts it into working condition before use. It is part of the cost of acquiring the asset, its benefit lasts for years, and it is added to the Delivery Van Account. |
| (d) Whitewashing and routine repair of the factory building | Revenue Expenditure | It only maintains the existing building in its present condition and adds nothing to its earning capacity. It recurs regularly, so it is charged to the Profit and Loss Account as repairs. |
| (e) Constructing an additional room in the office building | Capital Expenditure | The new room extends the building and increases its size and value, and its benefit lasts for many years. The cost is added to the Building Account in the Balance Sheet. |
Answer: Capital Expenditure: (a), (c) and (e); Revenue Expenditure: (b) and (d).
The rule behind each answer: an expense that acquires an asset, makes a newly bought asset ready for use, or adds to an asset is capital; an expense that only keeps the business or an existing asset running is revenue.