Income Determination

1. Income Determination Capital income vs Revenue income Capital expenditure vs Revenue expenditure

2. Learning outcome • State the basic principle of ‘recognition’ • State the nature of income • Distinguish capital income and revenue income • State the nature of expense • State the nature of asset • Distinguish capital expenditure and revenue expenditure • Discuss the effects on balance sheet and net profit for incorrect treatment of capital expenditure and revenue expenditure

3. An element should be recognized if • Future economic benefit associated with the item will flow to or from the enterprise; and • The item has a cost or value that can be measured with reliability.

4. Nature of Income • Increase in economic benefits • Inflow of assets • Decrease in liabilities • Increase in equity

5. Capital Income • Gain on assets not acquired on resale • e.g. profit on sale of fixed asset

6. Revenue Income • Gain on sale of goods acquired for resale • Income from ordinary business of the enterprise

7. Capital vs Revenue expenditure • Buying a van • Petrol costs for van • Repairs to van • Putting extra headlights on van • Buying machinery • Electricity costs of using machinery • Painting outside of new building • Three years later – repainting outside the same building

8. Think it over XYZ Co purchased a new machine at the list price of $250,000. The supplier offered a trade discount of 10%. The supplier also provided that if the company settled the balance within 10 days, a further 10% cash discount would be given. XYZ Co promptly settled the debt, taking the advantage of both discounts. In addition, the company Incurred installation costs of $4,500. The total transportation and insurance cost incurred for the shipment of the machine amounted to $3,000 and $6,000 respectively. $1,200 was paid to the supplier for the maintenance charge for the current year. Explain how each of the above figures should be accounted for by the company. (HKAL 1998)

9. Nature of Expense • Decrease in economic benefits • Outflow of assets • Incurrence of liabilities • Decrease in equity

10. Nature of asset • An asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. • Substance over form

11. Future economic benefits • Used singly or with other assets in the production of goods or services to be sold by the enterprise; • Exchanged for other assets; • Used to settle a liability; or • Distributed to the owners of the enterprise

12. Capital Expenditure • Money spent on acquisition of fixed asset • Money spent on addition of value to the existing asset

13. Recognition of an asset • An asset is recognized in the balance sheet when it is probable that the future economic benefits will flow to the enterprise and the asset has a cost or value that can be measured reliably.

14. Revenue Expenditure • Money spent on daily operating activities • An asset is not recognized in the balance sheet when expenditure has been incurred for which it is considered improbable that economic benefits will flow to the enterprise.

15. Recognition of expenses • Expenses are recognized in the profit and loss account when • - a decrease in an asset • - an increase of a liability • - the value can be measured reliably • Expenses are recognized in the profit and loss account on the basis of a direct association between the costs incurred and the earning of specific items of income. (i.e. matching of costs with revenues)

16. Incorrect treatment of expenditure • Capital expenditure is incorrectly treated as revenue expenditure • Revenue expenditure is incorrectly treated as capital expenditure

17. Capital expenditure is treated as revenue expenditure • Value of fixed asset is understated • Net profit is understated

18. Revenue expenditure is treated as capital expenditure • Value of fixed asset is overstated • Net profit is overstated