Mwangaza Traders: Depreciation Policy and the Capital/Revenue Boundary
Mwangaza Traders is a sole trader in Nakuru operating three delivery vehicles. On 1 January 2023 the business bought a van for KSh 1,800,000. The owner estimated a residual value of KSh 300,000 and a useful life of five years, and straight-line depreciation has been charged since. On 1 January 2024 the van's engine was replaced at a cost of KSh 240,000. The replacement extended the van's remaining useful life, and the accountant has revised the remaining life to five years with the same residual value. The KSh 240,000 has been debited to Repairs and Maintenance. The owner now wants every vehicle depreciated on a reducing-balance basis at 30% per year, arguing that vehicles lose value fastest in their early years and that the change will lower reported profit and therefore the tax payable. The 2024 accounts are not yet finalised.
1. Advise whether the KSh 240,000 engine replacement is capital or revenue expenditure, and compute the correct 2024 depreciation charge on the van under the existing straight-line policy. Show the effect of the accountant's current treatment on the 2024 profit.
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Classification. The engine is a major component whose replacement restores and extends the van's ability to generate income, and the remaining useful life has been re-assessed as a result. It is therefore capital expenditure and must be added to the carrying amount of the van, not written off to Repairs and Maintenance.
Correct charge for 2024 (straight line, prospective revision):
| Step | KSh |
|---|---|
| Cost, 1 Jan 2023 | 1,800,000 |
| Less 2023 depreciation (1,800,000 − 300,000) ÷ 5 | (300,000) |
| Carrying amount, 1 Jan 2024 | 1,500,000 |
| Add capitalised engine replacement | 240,000 |
| Revised carrying amount | 1,740,000 |
| Less residual value | (300,000) |
| Depreciable amount | 1,440,000 |
| ÷ revised remaining life of 5 years | 288,000 p.a. |
Effect of the current (wrong) treatment: the accounts carry 240,000 + 300,000 = KSh 540,000 of expense instead of KSh 288,000. 2024 profit is therefore understated by KSh 252,000, while the van's carrying amount at 31 December 2024 is understated by KSh 240,000 less the depreciation that should have been charged on it.
2. Compute the 2024 charge that would arise if the owner's proposed 30% reducing-balance basis were adopted from 2024 onwards (engine capitalised), and quantify the effect on 2024 profit of making the switch.
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A change of method is applied prospectively: the carrying amount brought forward is unaffected by what a reducing-balance charge would have been in 2023.
| Step | KSh |
|---|---|
| Carrying amount, 1 Jan 2024 (after 2023 straight-line charge) | 1,500,000 |
| Add capitalised engine | 240,000 |
| Depreciable base at 1 Jan 2024 | 1,740,000 |
| × 30% reducing balance | 522,000 |
Profit effect of the switch: 522,000 − 288,000 = KSh 234,000 extra charge, so 2024 profit falls by KSh 234,000. (Note the residual value of KSh 300,000 is not deducted first under the reducing-balance method; it acts only as a floor on the carrying amount.)
3. Would you support the proposed change of depreciation method? Justify your answer with reference to accounting principles and to the owner's stated motives.
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The case for the change: a change of depreciation method is a change in accounting estimate, not a change in policy, and is permitted where it better reflects the pattern in which the asset's future economic benefits are consumed. Vehicles and machinery genuinely do lose a larger share of their service potential in early years, so a reducing-balance basis can be defensible. If adopted, it is applied prospectively, disclosed in the notes, and applied consistently to all assets of the same class.
The case against, on the stated reasoning: the owner's motive - 'lower profit, therefore lower tax' - is not an acceptable basis for choosing a method. Accounting depreciation does not determine taxable profit; capital allowances are set by tax statute, so the switch would not reduce the tax bill. Choosing a method to manage reported profit also undermines neutrality and comparability, and could breach loan covenants or mislead a lender reading the accounts.
Recommendation: decide the method on the merits of benefit consumption, not on the profit effect. If reducing balance is adopted, the KSh 234,000 additional charge must be disclosed together with the reason for the change, and prior-year figures are not restated. The KSh 240,000 misclassification must be corrected in any case, since it is an error, not an estimate.