Packaging machine overhaul, doubtful debt and legal claim
Għajnuna Ltd, a Maltese food-processing company, prepares accounts to 31 December. Its main packaging machine was bought on 1 January 2020 for €180,000 and is depreciated at 10% a year on cost, with no residual value. On 1 January 2024 the company spent €45,000 on a major overhaul that extended the machine's useful life by four years and raised its output; a further €6,000 was spent on routine servicing in September. The directors are also reviewing two year-end items. A customer owing €22,000 has been in liquidation since November and the liquidator advises that unsecured creditors will receive about 20c in the euro. A former employee has sued for €60,000; the company's lawyers put the probable loss at €25,000 but the directors want to ignore it because the case 'could still be won'. The managing director has asked the accountant to capitalise both the overhaul and the servicing and to leave the claim out of the accounts in order to protect the bank covenant.
1. Compute the depreciation charge on the packaging machine for the year ended 31 December 2024 and the carrying amount at that date. Show clearly how you treat the €45,000 overhaul and the €6,000 servicing.
Read the worked answer
Carrying amount at 1 January 2024
Cost €180,000; accumulated depreciation 4 years × €18,000 = €72,000; carrying amount €108,000.
The €45,000 overhaul is capitalised. It extends the useful life by four years and increases output, so it enhances the asset rather than merely restoring it. New carrying amount €108,000 + €45,000 = €153,000. At 1 January 2024 the original remaining life was 6 years; the overhaul adds 4 years, giving a revised remaining life of 10 years. Depreciation for 2024 = €153,000 ÷ 10 = €15,300.
The €6,000 servicing is revenue expenditure. It maintains the machine in working order but does not add to its life or output, so it is expensed in 2024.
Closing carrying amount = €153,000 − €15,300 = €137,700.
If the overhaul had been expensed instead, 2024 depreciation would have been €18,000, and profit would have been lower by €45,000 − (€18,000 − €15,300) = €42,300. The classification therefore has a large effect on profit and on the bank covenant.
2. Show the adjusting journal entries at 31 December 2024 for the doubtful debt and the legal claim, and explain how each item will appear in the financial statements.
Read the worked answer
Doubtful debt
Expected recovery = 20% × €22,000 = €4,400. Irrecoverable amount = €17,600.
Dr Irrecoverable debts expense €17,600 Cr Trade receivables €17,600
Receivables will be reported at the €4,400 expected to be recovered. If the company maintains an allowance account, the debit is to expense and the credit to the allowance for doubtful debts for €17,600. The write-down is supported by the liquidator's estimate, so it is a specific allowance rather than a general guess.
Legal claim
There is a present obligation from a past event, an outflow is probable, and the amount can be estimated reliably at €25,000. This meets the definition of a provision:
Dr Legal claim expense €25,000 Cr Provision for legal claim €25,000
The €25,000 is charged to profit or loss and shown as a liability. The remaining €35,000 of the €60,000 claimed is a contingent liability and is disclosed in the notes, not accrued. The directors' hope that the case 'could still be won' does not override the lawyers' assessment that a €25,000 loss is probable.
3. Evaluate the managing director's proposals. Your answer should refer to capital and revenue expenditure, prudence, accruals and the true and fair view, and should quantify the effect on profit.
Read the worked answer
Capital versus revenue
The overhaul is capital expenditure because it enhances the asset's life and output. The servicing is revenue expenditure because it only maintains the asset. Capitalising the servicing would overstate non-current assets and profit: €6,000 would be removed from expenses, while depreciation would rise by only €600 (€6,000 ÷ 10), so profit would be overstated by €5,400. The error would reverse over the asset's life, but each year's accounts would still be wrong.
Prudence and accruals
Omitting the legal claim overstates profit by €25,000 and understates liabilities. The accruals concept requires the expense to be recognised when the obligation arises, not when it is paid. Prudence requires probable losses to be recognised; it does not permit deliberate understatement, but it does forbid leaving out a known probable liability.
Combined effect
The two proposals would overstate 2024 profit by about €30,400 (€25,000 + €5,400) and overstate net assets by €31,000 (the €25,000 liability plus the €6,000 wrongly capitalised servicing). That is not a true and fair view. Protecting a bank covenant is not a valid accounting reason; it is a misstatement that could mislead the bank and may amount to fraud. The accountant should refuse, record the advice in writing, and escalate the matter to the board or the auditors.