Devon's Cycle Repairs: Capital, Revenue, Drawings or Liability?
Devon Ramlogan runs a bicycle repair shop in San Fernando. On 1 January he opened a business bank account with $48,000 of his own money and transferred his van, valued at $36,000, to the business. In December he announced a profit of $21,400, which is simply the increase in the business bank balance. His records show the following: $2,400 paid from the business account for his son's school fees; bicycle parts costing $1,850 taken home for personal use; $9,600 spent replacing the leaking workshop roof, which the landlord required him to renew; $600 for one year's fire insurance; $3,200 for a wheel-truing machine expected to last four years; and $5,000 borrowed from his uncle, which he entered in the capital account. Devon argues that because the loan money is in the business and he must repay it, the treatment makes no difference to profit.
1. Classify each of the six items as capital expenditure, revenue expenditure, drawings or a liability, giving a reason for each classification.
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Capital expenditure: the $9,600 roof - it is a structural renewal providing benefit for many years, not a repair of the leak; and the $3,200 wheel-truing machine - a non-current asset to be used to earn income for four years. Both are recorded as assets.
Revenue expenditure: the $600 fire insurance - it covers one year only and is consumed in this period, so it is an expense of the year.
Drawings: the $2,400 school fees and the $1,850 of parts taken home. Both are payments for Devon's private benefit, so they reduce capital and are never charged against profit.
Liability, not capital: the $5,000 from his uncle. There is a legal obligation to repay, so it is a loan; only the owner's own stake is capital.
The test is not where the cash came from, but what the business received and whether a future benefit remains at the year end.
2. Calculate Devon's corrected profit for the year and his capital at 31 December. Assume the wheel-truing machine is depreciated at 25% per annum on cost.
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Corrected profit = $21,400 + $2,400 + $1,850 + $9,600 + $3,200 − $800 = $37,650.
Reasoning: the cash increase of $21,400 has been reduced by payments that are not expenses. Add back drawings of $4,250 because they are appropriations of capital, and add back the $12,800 of capital expenditure because it bought assets. The roof is not depreciated in this calculation. Then charge one year's depreciation on the machine: $3,200 × 25% = $800. The $600 insurance is a genuine expense of the year and stays deducted.
Capital at 31 December:
| Item | $ |
|---|---|
| Cash introduced | 48,000 |
| Van introduced | 36,000 |
| Add corrected profit | 37,650 |
| Less drawings (2,400 + 1,850) | (4,250) |
| Closing capital | 117,400 |
The $5,000 loan is excluded from capital.
3. Explain why recording the $5,000 loan as capital does not change reported profit but does misstate two items in the statement of financial position.
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Profit measures income earned less expenses incurred. Receiving loan money is not income, and the obligation to repay is not an expense (only any interest charged would be). So the $5,000 leaves profit unchanged - which is why Devon's error is easy to miss.
The statement of financial position is a different matter. Capital is overstated by $5,000 and current liabilities are understated by $5,000. The statement still balances, because the bank balance is correct, but the business appears to be financed by the owner when in fact $5,000 must be repaid. Anyone reading the accounts - a bank considering a loan, a supplier granting credit, a prospective buyer - would overestimate Devon's stake and underestimate his obligations.
The correct entry is: Dr Bank $5,000; Cr Loan from uncle $5,000.