Capital or Revenue: Van Refrigeration, Overhaul and Repairs
Nsanje Foods bought a second-hand delivery van on 1 July 2024 for MWK 8,500,000. During the year it spent: MWK 1,200,000 on a refrigeration unit fitted to the van so that it can carry frozen products; MWK 450,000 on an engine overhaul completed on 1 September 2024 that extends the van's useful life by two years; MWK 180,000 replacing a windscreen broken in an accident; MWK 90,000 on the annual service; and MWK 350,000 painting the company logo on the van. The accountant expensed all these amounts. The company policy is to capitalise items costing more than MWK 500,000 that enhance earning capacity or extend useful life. Depreciation is 20% per year on a straight-line basis, charged from the month the asset is available for use. The year end is 31 December 2024. The van was available for use on 1 July 2024.
1. Classify each of the five amounts as capital or revenue, giving a reason for each.
Read the worked answer
- Refrigeration unit 1,200,000: capital. It changes the van's capacity to carry frozen products and enhances earning capacity; it is above the 500,000 threshold.
- Engine overhaul 450,000: capital in substance even though below the threshold. It extends useful life by two years, which is an enhancement; the policy threshold should not override the substance. The amount is material in relation to the van and should be capitalised.
- Windscreen 180,000: revenue. It restores the van to its previous condition after an accident; it does not enhance capacity or extend life.
- Annual service 90,000: revenue. Routine maintenance.
- Logo painting 350,000: revenue. It is advertising and branding and does not enhance the asset's capacity; it is also below the threshold. If the policy were applied strictly it would be expensed.
2. Calculate depreciation for 2024 and the adjusted profit effect of the corrections.
Read the worked answer
Capitalised cost = 8,500,000 + 1,200,000 + 450,000 = 10,150,000. Depreciation: van and refrigeration available 1 July: (8,500,000 + 1,200,000) x 20% x 6/12 = 970,000. Overhaul completed 1 September: 450,000 x 20% x 4/12 = 30,000. Total depreciation = 1,000,000.
Originally expensed: 1,200,000 + 450,000 + 180,000 + 90,000 + 350,000 = 2,270,000. Correct expense: 180,000 + 90,000 + 350,000 + 1,000,000 = 1,620,000. Profit was understated by 2,270,000 - 1,620,000 = 650,000. Assets were understated by capitalised cost 1,650,000 less accumulated depreciation 1,000,000 = 650,000. The corrections increase profit and net assets by 650,000.
3. Evaluate whether the company's MWK 500,000 capitalisation threshold is acceptable under accounting standards.
Read the worked answer
A 500,000 threshold is a practical materiality policy, not an accounting standard. It can be acceptable if it is applied consistently and the resulting balances are not materially misstated. But it cannot be used to expense an item that clearly enhances capacity or extends life, such as the 450,000 overhaul, if the effect is material. The company should consider the nature of the item and the cumulative effect of items below the threshold. It should also disclose the policy. A strict rule that ignores substance may breach the requirement to present a true and fair view. The policy should be reviewed so that capital items below the threshold are capitalised when material in aggregate or in substance.