FRA Misc Questions

What is a capital expenditure versus a revenue expenditure?

Definition of Capital Expenditure

A capital expenditure is an amount spent to acquire or significantly improve the capacity or capabilities of a long-term asset such as equipment or buildings. Usually the cost is recorded in a balance sheet account that is reported under the heading of Property, Plant and Equipment. The asset's cost (except for the cost of land) will then be allocated to depreciation expense over the useful life of the asset. The amount of each period's depreciation expense is also credited to the contra-asset account Accumulated Depreciation.

Examples of Capital Expenditures

Examples of capital expenditures include the amounts spent to acquire or significantly improve assets such as land, buildings, equipment, furnishings, fixtures, vehicles. The total amount spent on capital expenditures during an accounting year is reported under investment activities on the statement of cash flows.

Definition of Revenue Expenditure

A revenue expenditure is an amount that is spent for an expense that will be matched immediately with the revenues reported on the current period's income statement.

Examples of Revenue Expenditures

Examples of revenue expenditures include the amounts spent on repairs and maintenance, selling, general and administrative expenses.

What is financial leverage?

Definition of Financial Leverage

Financial leverage which is also known as leverage or trading on equity, refers to the use of debt to acquire additional assets.

The use of financial leverage to control a greater amount of assets (by borrowing money) will cause the returns on the owner's cash investment to be amplified. That is, with financial leverage:

• an increase in the value of the assets will result in a larger gain on the owner's cash, when the loan interest rate is less than the rate of increase in the asset's value
• a decrease in the value of the assets will result in a larger loss on the owner's cash

Examples of Financial Leverage

Mary uses $500,000 of her cash to purchase 40 acres of land with a total cost of $500,000. Mary is not using financial leverage.

Sue uses $500,000 of her cash and borrows $1,000,000 to purchase 120 acres of land having a total cost of $1,500,000. Sue is using financial leverage to own/control $1,500,000 of property with only $500,000 of her own money. Let's also assume that the interest on Sue's loan is $50,000 per year and it is paid at the beginning of each year.

Effects of Using Financial Leverage

For our examples let's assume that after one year, the land owned by Mary and the land owned by Sue increased in value by 20% and both Mary and Sue sold their land investments at the market values. As a result:

• Mary's land will sell for $600,000 which results in a gain of $100,000 (selling price of $600,000 minus the land's cost of $500,000). The $100,000 gain on Mary's cash of $500,000 results in a gain of 20% on Mary's $100,000
• Sue's land will sell for $1,800,000 which results in a gain of $250,000 (selling price of $1,800,000 minus $1,550,000, which is the land's cost of $1,500,000 and interest of $50,000). The $250,000 gain on Sue's $550,000 of cash is a gain of 45% instead of a gain of 20% without the use of leverage

Now let's assume that after one year, the land owned by Mary and and the land owned by Sue decreased in value by 20% and that both Mary and Sue sold their land investments at the market values. As a result:

• Mary's land will sell for $400,000 which means a $100,000 loss on the land's cost of $500,000. The $100,000 loss on Mary's cash of $500,000 results in a 20% loss on Mary's money
• Sue's land will sell for $1,200,000 which results in a loss of $350,000 (selling price of $1,200,000 minus the land's cost of $1,500,000 and interest of $50,000). The $350,000 loss on Sue's cash of $550,000 results in a 63.6% loss on Sue's money instead of a loss of 20% without the use of leverage

What is the debt to total assets ratio?

Definition of Debt to Total Assets Ratio

The debt to total assets ratio is an indicator of a company's financial leverage. It tells you the percentage of a company's total assets that were financed by creditors. In other words, it is the total amount of a company's liabilities divided by the total amount of the company's assets.

Note: Debt includes more than loans and bonds payable. Debt is the total amount of all liabilities (current liabilities and long-term liabilities).

Example of Debt to Total Assets Ratio

Let's assume that a corporation has $100 million in total assets, $40 million in total liabilities, and $60 million in stockholders' equity. This corporation's debt to total assets ratio is 0.4 ($40 million of liabilities divided by $100 million of assets), 0.4 to 1, or 40%. This indicates 40% of the corporation's assets are being financed by the creditors, and the owners are providing 60% of the assets' cost. Generally, the higher the debt to total assets ratio, the greater the financial leverage and the greater the risk.

How To Be Used

As with all financial ratios, it is best for a company to compare its debt to total assets ratio to:

• its ratio at an earlier date
• its targeted ratio...its goal
• the ratios at companies in the same industry

What is included in cash and cash equivalents?

Examples of Cash

In accounting, a company's cash includes the following:

• currency and coins
• checks received from customers but not yet deposited
• checking accounts
• petty cash

Definition of Cash Equivalents

Cash equivalents are short-term, highly liquid investments with a maturity date that was 3 months or less at the time of purchase. In other words, there is very little risk of collecting the full amount being reported.

Examples of Cash Equivalents

Examples of cash equivalents include:

• money market accounts
• U.S. Treasury Bills
• commercial paper

Typically, the combined amount of cash and cash equivalents will be reported on the balance sheet as the first item in the section with the heading current assets.

Why is depreciation on the income statement different from the depreciation on the balance sheet?

Definition of Depreciation

Depreciation is the systematic allocation of an asset's cost to expense over the useful life of the asset.

Example of Depreciation

Let's assume that a retailer purchased displays for its store at a cost of $120,000. The displays have a useful life of 10 years and will have no salvage value. The straight-line method of depreciation will result in depreciation of $1,000 per month ($120,000 divided by 120 months). The monthly journal entry to record the depreciation will be a debit of $1,000 to the income statement account Depreciation Expense and a credit of $1,000 to the balance sheet contra asset account Accumulated Depreciation.

Depreciation on the Income Statement

The depreciation reported on the income statement is the amount of depreciation expense that is appropriate for the period of time indicated in the heading of the income statement.

Using our example, the monthly income statements will report $1,000 of depreciation expense. The quarterly income statements will report $3,000 of depreciation expense, and the annual income statements will report $12,000 of depreciation expense. Each month $1,000 of depreciation expense is being matched to the 120 monthly income statements during which the displays are used to generate sales revenues.

Depreciation on the Balance Sheet

The depreciation reported on the balance sheet is the accumulated or the cumulative total amount of depreciation that has been reported as depreciation expense on the income statement from the time the assets were acquired until the date of the balance sheet.

Using our example, after one month of use the accumulated depreciation for the displays will be $1,000. After 24 months of use, the accumulated depreciation reported on the balance sheet will be $24,000. After 120 months, the accumulated depreciation reported on the balance sheet will be $120,000. At that point, the depreciation will stop since the displays' cost of $120,000 has been fully depreciated. If the displays continue to be used in the 11th year, there will be no depreciation expense in the 11th year and the accumulated depreciation will continue to be $120,000.