Cambridge IGCSE0452

Capital and revenue expenditure and receipts

Accounting 0452 Chapter Notes

What this chapter covers

Capital and revenue expenditure and receiptsAccounting for depreciation and disposal of non-current assetsOther payables and other receivablesIrrecoverable debts and allowance for irrecoverable debtsValuation of inventory
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In this chapter

  1. 1Capital Expenditure: Buying Long-Term Assets
  2. 2Revenue Expenditure: Day-to-Day Running Costs
  3. 3Capital vs. Revenue Receipts
  4. 4Impact of Incorrect Treatment

1. Capital Expenditure: Buying Long-Term Assets

Capital expenditure is the money a business spends to buy, upgrade, or extend the life of its non-current assets. Non-current assets are items that will be used in the business for more than one year, such as property, vehicles, or machinery. It's not just the purchase price; it includes all costs necessary to get the asset into a working condition and location for its intended use. This includes costs like delivery charges, installation fees, legal costs for property purchase, and costs of improving an asset to increase its efficiency or capacity. Since these assets provide a long-term benefit, their cost is not treated as an expense in the year of purchase. Instead, it is recorded on the statement of financial position as a non-current asset, and its value is gradually reduced over its useful life through depreciation (which is a revenue expense).

Total Capital Expenditure = Purchase Price + Delivery Costs + Installation Costs + Legal Fees + Improvement Costs

Key term

Capital Expenditure: Expenditure on acquiring or improving non-current assets, which will benefit the business for more than one accounting period.

Examiner insight

Examiners reward students who can identify all associated costs of acquiring a non-current asset, not just the sticker price, as capital expenditure.

Common pitfall

Forgetting to capitalise costs like installation, delivery, and legal fees associated with the purchase of a non-current asset. Students often just record the purchase price.

Fun fact

When a film studio like Disney produces a major movie like 'Avatar', the multi-million dollar production costs are treated as capital expenditure, creating an 'intangible asset' that generates revenue for many years.

Worked example 13 marks

A-Star Printing buys a new printing press. The following costs were incurred:

  • List price of the machine: $50,000
  • Delivery from manufacturer: $1,500
  • Installation and testing by specialist engineers: $2,500
  • Cost of a five-year maintenance contract: $5,000
  • Repainting the factory room to match the new machine: $800

Calculate the total capital expenditure for the new printing press.

  1. 1

    Step 1: Identify costs directly related to acquiring the asset and getting it ready for use.

  2. 2

    Step 2: The list price of the machine is a core part of the acquisition cost: $50,000.

  3. 3

    Step 3: The delivery cost is necessary to get the machine to the business's premises: $1,500.

  4. 4

    Step 4: The installation and testing costs are essential to make the machine operational: $2,500.

  5. 5

    Step 5: The maintenance contract is a running cost for future periods, not a cost to acquire the asset. It is revenue expenditure, spread over five years.

  6. 6

    Step 6: Repainting the room is a general maintenance cost (revenue expenditure), not a cost of the machine itself.

  7. 7

    Step 7: Sum the capital expenditure items: $50,000 (Price) + $1,500 (Delivery) + $2,500 (Installation) = $54,000.

  8. 8

    Answer: The total capital expenditure to be recorded in the statement of financial position is $54,000.

Recap

  • Capital expenditure is for buying or significantly improving non-current assets.
  • It includes all costs to bring the asset to its required location and condition for use.
  • The benefit from this spending lasts for more than one accounting period.
  • It is recorded as a non-current asset on the statement of financial position.
  • Examples include buying a building, a delivery van, or adding an extension to a factory.

Quick check

  1. A business buys a new van for $25,000 and pays $600 to have its logo painted on it before use. What is the total capital expenditure?1 mark
  2. Are legal fees paid to purchase a new office building classified as capital or revenue expenditure?1 mark

2. Revenue Expenditure: Day-to-Day Running Costs

Revenue expenditure is the money spent on the day-to-day operations of a business. These are short-term costs where the benefit is used up within the current accounting period (less than one year). This category also includes costs for maintaining the existing earning capacity of non-current assets, such as repairs. Common examples include rent, salaries, utility bills, inventory purchases, and vehicle running costs like fuel and annual insurance. Unlike capital expenditure, revenue expenditure is charged as an expense in the income statement for the period it is incurred. This means it directly reduces the gross profit and ultimately the profit for the year. The key distinction is 'maintaining' (revenue) versus 'improving' (capital).

Key term

Revenue Expenditure: Expenditure on the day-to-day running of the business or maintaining non-current assets, which is consumed within one accounting period.

Examiner insight

A clear distinction between 'maintaining' an asset (revenue expenditure) and 'improving' or 'upgrading' it (capital expenditure) is crucial for high marks.

Common pitfall

Incorrectly classifying the cost of repairing a non-current asset as capital expenditure. Repairs simply maintain an asset's current state; they do not improve it.

Worked example 14 marks

Hayden's business incurred the following costs in May:

  • Purchase of goods for resale: $12,000
  • Wages and salaries: $8,000
  • Purchase of a new office computer: $900
  • Repair of a broken window: $150
  • Annual vehicle insurance premium: $720
  • Upgrade to the main server to double its capacity: $4,000

Calculate the total revenue expenditure for May.

  1. 1

    Step 1: Analyse each item to determine if it is a day-to-day running cost or a long-term asset purchase/improvement.

  2. 2

    Step 2: Purchase of goods for resale ($12,000) is a key running cost (cost of sales). This is revenue expenditure.

  3. 3

    Step 3: Wages and salaries ($8,000) are a routine operational expense. This is revenue expenditure.

  4. 4

    Step 4: Purchase of a new computer ($900) is the acquisition of a non-current asset. This is capital expenditure.

  5. 5

    Step 5: Repair of a broken window ($150) maintains an existing asset. This is revenue expenditure.

  6. 6

    Step 6: Annual vehicle insurance ($720) is a running cost. This is revenue expenditure.

  7. 7

    Step 7: The server upgrade doubles capacity, which is a significant improvement, not just maintenance. This is capital expenditure.

  8. 8

    Step 8: Sum the revenue expenditure items: $12,000 + $8,000 + $150 + $720 = $20,870.

  9. 9

    Answer: The total revenue expenditure for May is $20,870.

Recap

  • Revenue expenditure relates to the daily operations of the business.
  • Its benefit is consumed within one year.
  • It includes costs to maintain non-current assets, such as repairs.
  • It is recorded as an expense in the income statement.
  • Examples include rent, wages, electricity bills, and fuel for vehicles.

Quick check

  1. Is the cost of replacing a single broken tile on an office floor capital or revenue expenditure?1 mark
  2. A business pays its monthly electricity bill. Is this capital or revenue expenditure?1 mark

3. Capital vs. Revenue Receipts

Receipts are funds flowing into the business. Just like expenditure, they are classified as either revenue or capital.

Revenue Receipts are generated from the normal, everyday trading activities of the business. They are recurring in nature. The main example is sales revenue from selling goods or services. Other examples include rent received from a tenant, commission received, and discounts received from suppliers. Revenue receipts are recorded in the income statement and are a key component in calculating the profit for the year.

Capital Receipts are funds received from sources other than the normal course of business. They are usually one-off, non-recurring events. The most common example is the money received from selling a non-current asset (e.g., selling an old delivery van). Other examples include receiving a long-term bank loan, the owner investing more capital into the business, or issuing shares. The proceeds from selling a non-current asset (the capital receipt itself) are used to remove the asset from the statement of financial position. However, any profit or loss made on the sale is calculated and shown in the income statement.

Profit on Disposal = Disposal Proceeds (Capital Receipt) - Net Book Value of Asset

Loss on Disposal = Net Book Value of Asset - Disposal Proceeds (Capital Receipt)

Key term

Capital Receipt: Money received by a business from sources other than its normal trading activities, such as the sale of a non-current asset or obtaining a loan.

Examiner insight

Students often forget that while the proceeds from selling an asset are a capital receipt, any resulting profit or loss on that sale is a revenue item that must be included in the income statement.

Common pitfall

Treating the entire amount from the sale of a non-current asset as revenue in the income statement, instead of just the profit or loss on disposal.

Worked example 14 marks

A retail business had the following inflows of cash during the year:

  • Cash sales from customers: $250,000
  • Loan received from a bank, repayable in 5 years: $50,000
  • Sale of an old office desk for $100 (its net book value was $80)
  • Commission received for selling tickets on behalf of another company: $1,200

Classify each item as a capital receipt or a revenue receipt.

  1. 1

    Step 1: Cash sales ($250,000) are the primary source of income from normal trading. This is a revenue receipt.

  2. 2

    Step 2: The bank loan ($50,000) is an injection of long-term finance, not from trading. This is a capital receipt.

  3. 3

    Step 3: The sale of the old office desk ($100) is the disposal of a non-current asset. This is a capital receipt.

  4. 4

    Step 4: Commission received ($1,200) is income earned from a business activity. This is a revenue receipt.

  5. 5

    Answer: Revenue Receipts are Cash Sales and Commission Received. Capital Receipts are the Bank Loan and Sale of the office desk.

Worked example 22 marks

Using the information from the previous example, calculate the amount that would be shown in the income statement relating to the sale of the office desk.

  1. 1

    Step 1: Identify the capital receipt (disposal proceeds) from the sale: $100.

  2. 2

    Step 2: Identify the net book value (NBV) of the asset sold: $80.

  3. 3

    Step 3: Calculate the profit or loss on disposal. Profit = Disposal Proceeds - NBV.

  4. 4

    Step 4: Calculation: $100 - $80 = $20 profit.

  5. 5

    Answer: A profit on disposal of $20 would be shown as 'Other Income' in the income statement.

Recap

  • Revenue receipts come from the main trading activities of a business, like sales.
  • Revenue receipts are recorded in the income statement and increase profit.
  • Capital receipts are one-off inflows, typically from selling non-current assets or raising finance.
  • The proceeds from selling an asset are a capital receipt.
  • The profit or loss on the sale of a non-current asset is a revenue item, affecting the income statement.

Quick check

  1. A business receives $5,000 from cash sales. Is this a capital or revenue receipt?1 mark
  2. The owner invests an additional $10,000 of their own money into the business. Is this a capital or revenue receipt?1 mark

4. Impact of Incorrect Treatment

Correctly classifying expenditure and receipts is vital. Getting it wrong is called an 'Error of Principle' and it distorts the financial statements, giving a misleading view of the business's performance and position. The effects are a chain reaction impacting both the income statement and the statement of financial position.

Scenario 1: Capital Expenditure wrongly treated as Revenue Expenditure (e.g., Buying a new computer but recording it as 'Office Expenses')

  • Effect on Income Statement: An expense account is debited incorrectly. This overstates the total expenses for the year. Therefore, the Profit for the year is understated.
  • Effect on Statement of Financial Position: The new non-current asset is not recorded. Therefore, the value of Non-Current Assets is understated.

Scenario 2: Revenue Expenditure wrongly treated as Capital Expenditure (e.g., Paying for vehicle repairs but adding the cost to the 'Vehicles' asset account)

  • Effect on Income Statement: An expense that should have been recorded is missed. This understates the total expenses for the year. Therefore, the Profit for the year is overstated.
  • Effect on Statement of Financial Position: The value of a non-current asset is incorrectly increased. Therefore, the value of Non-Current Assets is overstated.

Key term

Error of Principle: An accounting error where a transaction is recorded in the wrong class of account, such as treating a capital expenditure item as a revenue expenditure item.

Examiner insight

Examiners frequently test the dual effect of these errors. Always state the impact on both the profit for the year and the non-current asset valuation to gain full marks.

Common pitfall

Only stating the effect on profit and forgetting to mention the corresponding effect on the value of non-current assets in the statement of financial position.

Worked example 12 marks

On 1 June, a business paid $3,000 for a major upgrade to a machine which extended its useful life. The bookkeeper incorrectly debited the 'Repairs and Maintenance' account. State the effect of this error on the profit for the year and the value of non-current assets at the year-end.

  1. 1

    Step 1: Identify the correct treatment. An upgrade that extends useful life is capital expenditure. It should have been added to the value of non-current assets.

  2. 2

    Step 2: Identify the incorrect treatment. It was treated as a revenue expense ('Repairs and Maintenance').

  3. 3

    Step 3: Analyse the impact on profit. An expense of $3,000 was recorded when it shouldn't have been. This overstates expenses, which means the profit for the year will be understated by $3,000.

  4. 4

    Step 4: Analyse the impact on non-current assets. The value of machinery was not increased by $3,000 as it should have been. This means the total value of non-current assets will be understated by $3,000.

  5. 5

    Answer: The profit for the year is understated by $3,000, and non-current assets are understated by $3,000.

Worked example 23 marks

A business has a draft profit of $50,000. It is then discovered that $400 paid for the annual office cleaning service was mistakenly debited to the 'Office Buildings' asset account. Calculate the correct profit for the year.

  1. 1

    Step 1: Identify the error. A revenue expense ($400 for cleaning) was treated as capital expenditure (added to 'Office Buildings').

  2. 2

    Step 2: Determine the effect of the error on the draft profit. Because the $400 expense was missed, the total expenses are too low, and therefore the draft profit of $50,000 is too high.

  3. 3

    Step 3: Correct the profit. The missed expense must be deducted from the draft profit.

  4. 4

    Step 4: Calculation: Correct Profit = Draft Profit - Missed Expense = $50,000 - $400 = $49,600.

  5. 5

    Answer: The correct profit for the year is $49,600.

Recap

  • Treating capital expenditure as revenue understates both profit and non-current assets.
  • Treating revenue expenditure as capital overstates both profit and non-current assets.
  • These mistakes are called errors of principle and violate accounting rules.
  • Correcting these errors ensures the financial statements are true and fair.
  • Always consider the dual effect: one impact on the income statement and one on the statement of financial position.

Quick check

  1. If the purchase of a new machine is wrongly recorded as a repair expense, will the year's profit be overstated or understated?1 mark
  2. If a rent payment is incorrectly added to the value of Buildings, are non-current assets overstated or understated?1 mark

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Which of the following is an example of capital expenditure?1 mark
  2. A business paid $500 for repairs to its delivery van and incorrectly debited the Motor Vehicles asset account. How did this error affect the financial statements?2 marks
  3. Ravi is a retailer. Complete the table by indicating how each item would be classified. | Item | Capital Receipt | Revenue Receipt | Capital Expenditure | Revenue Expenditure | |---|---|---|---|---| | Proceeds of sale of vehicle | | | | | | Purchase of goods for resale | | | | | | Legal fees on purchase of property | | | | | | Rent received from sub-letting part of the store | | | | |4 marks
  4. A company purchased a new machine for $80,000. It also paid $2,000 for delivery, $3,500 for installation, and $1,200 for the first year's insurance on the machine. Calculate the total capital expenditure and the total revenue expenditure.3 marks
  5. Define the following terms: (i) Capital Receipt, (ii) Revenue Expenditure.2 marks
  6. A business calculated a draft profit of $75,000. Later, it was discovered that the purchase of a new computer for $1,500 had been incorrectly included in the 'Office Stationery' expense account. Calculate the correct profit for the year.3 marks
  7. Explain the effect on profit for the year and non-current assets if the sale proceeds of $5,000 from a non-current asset are treated as sales revenue. The asset had a net book value of $4,000 at the time of sale.4 marks
  8. A business bought a second-hand van for $10,000. Before it could be used, the business spent $2,000 on an engine overhaul to improve its performance, $300 on replacing worn tyres, and $500 to paint the company logo on it. What is the total cost that should be capitalised?2 marks
  9. On 31 May, a business paid $900 for the annual rent of its warehouse. The bookkeeper mistakenly debited the 'Land and Buildings' asset account. State the journal entry required to correct this error of principle.3 marks
  10. For each of the following errors, state whether profit for the year and non-current assets are Overstated or Understated. (a) Cost of installing a new machine was treated as a repair expense. (b) A payment for office rent was added to the cost of office furniture.4 marks

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