Cambridge AS & A Level9706

Capital and revenue income and expenditure

Accounting 9706 Chapter Notes

What this chapter covers

Capital and revenue income and expenditureChanging asset values
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In this chapter

  1. 1Understanding Capital vs. Revenue Expenditure
  2. 2Identifying Capital Expenditure
  3. 3Identifying Revenue Expenditure
  4. 4Distinguishing Capital and Revenue Income
  5. 5How Expenditure Choices Affect Financial Statements

1. Understanding Capital vs. Revenue Expenditure

In accounting, not all spending is treated the same. We split expenditure into two main types: capital and revenue. Capital expenditure is money spent to buy or significantly upgrade a non-current asset (like a building, vehicle, or machine) that will help the business earn money for more than one year. Think of it as a long-term investment. Revenue expenditure is the money spent on day-to-day running costs, like electricity bills, staff wages, or routine maintenance for those assets. This is the cost of 'keeping the lights on'.

Key term

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

Examiner insight

Examiners reward students who can clearly justify their classification of an item with reference to its purpose and its impact on the asset's earning capacity or lifespan.

Common pitfall

Confusing a repair with an improvement. Repainting a van in the same colour is a revenue expense (maintenance), but adding a refrigeration unit to it is a capital expense (improvement).

Fun fact

The concept of capitalising costs isn't just for big businesses. When you renovate your kitchen to sell your house, you're treating that cost as a 'capital improvement' to increase the asset's value, just like a company does!

Worked example 13 marks

A delivery company buys a new van for $30,000. In the first month, it also pays $150 for road tax and $200 for fuel. Classify these three items of expenditure.

  1. 1
    1. Van ($30,000): This is a non-current asset that will be used for several years to generate income. This is Capital Expenditure.
  2. 2
    1. Road Tax ($150): This is a recurring, annual running cost required to use the van legally. It does not improve the van. This is Revenue Expenditure.
  3. 3
    1. Fuel ($200): This is a day-to-day running cost consumed in the process of making deliveries. It is a Revenue Expenditure.

Recap

  • Capital expenditure is for buying or improving long-term assets.
  • Revenue expenditure is for day-to-day running costs.
  • Capital expenditure is recorded as a non-current asset on the Statement of Financial Position.
  • Revenue expenditure is recorded as an expense on the Statement of Profit or Loss.
  • The key difference is whether the spending provides a benefit for more than one year (capital) or not (revenue).

Quick check

  1. What is the main difference between capital and revenue expenditure in terms of the time period they benefit?2 marks

2. Identifying Capital Expenditure

When a business buys a non-current asset, its 'cost' is more than just the price on the invoice. According to accounting rules (IAS 16), the total capital cost includes all expenditure necessary to bring the asset to the location and condition required for it to be used as intended. This means you must 'capitalise' (add to the asset's cost) items like delivery charges, installation fees, legal costs for property purchase, site preparation, and even the cost of initial testing to ensure it works correctly.

Total Capitalised Cost = Purchase Price + All costs to bring the asset to its location and condition for use

Key term

Capitalised: The process of recording expenditure as a non-current asset on the Statement of Financial Position rather than as an expense in the Statement of Profit or Loss.

Examiner insight

Students who include all relevant costs (delivery, installation, legal fees) in the initial cost of a non-current asset demonstrate a thorough understanding and score higher marks.

Common pitfall

Forgetting to include costs like delivery, installation, and legal fees in the total cost of the asset. The capital cost is not just the sticker price.

Worked example 14 marks

A bakery buys a new industrial oven. The list price is $25,000. They also pay $500 for delivery, $1,200 for installation and electrical wiring, and $300 to a specialist to test it. What is the total capital expenditure for the oven that should be recorded?

  1. 1
    1. Start with the purchase price of the oven: $25,000.
  2. 2
    1. Add the delivery cost, as the oven cannot be used without it being at the bakery: $25,000 + $500 = $25,500.
  3. 3
    1. Add the installation and wiring cost, as this is essential to make the asset operational: $25,500 + $1,200 = $26,700.
  4. 4
    1. Add the testing cost, as this ensures the asset is in a usable condition: $26,700 + $300 = $27,000.
  5. 5
    1. The total capital expenditure to be capitalised is $27,000. This amount will be recorded as a non-current asset.

Recap

  • The cost of a non-current asset includes more than just its purchase price.
  • All costs to get an asset ready for its intended use should be capitalised.
  • Examples include delivery, installation, legal fees, and site preparation.
  • Expenditure that significantly improves or extends the life of an existing asset is also capital expenditure.

Quick check

  1. List three costs, other than the purchase price, that should be capitalised as part of a new machine's cost.3 marks

3. Identifying Revenue Expenditure

Revenue expenditure relates to the costs of running the business on a daily basis and maintaining the current condition of non-current assets. These costs don't increase the value or earning capacity of an asset; they simply keep it running as it should. Common examples include repairs (e.g., fixing a broken part), servicing, insurance, fuel, and redecoration to maintain appearance. These costs are treated as expenses and are deducted from income in the Statement of Profit or Loss for the period they are incurred.

Key term

Revenue Expenditure: Expenditure on the day-to-day running of the business or the maintenance of non-current assets, charged as an expense in the Statement of Profit or Loss.

Examiner insight

Examiners often test the distinction between a repair (revenue) and an improvement (capital). For example, replacing a broken window is a repair, but upgrading all single-glazed windows to double-glazing is an improvement.

Common pitfall

Incorrectly capitalising routine repair and maintenance costs. A repair just restores the asset to its previous condition; it doesn't improve its performance beyond its original state.

Worked example 13 marks

Using the bakery example from before (oven capitalised at $27,000), in its first year of use the bakery spends $400 on a service contract, $150 to replace a broken door handle, and $5,000 on flour to bake bread. Classify these costs.

  1. 1
    1. Service Contract ($400): This is a routine maintenance cost to keep the asset in good working order. It is Revenue Expenditure.
  2. 2
    1. Replacing Door Handle ($150): This is a repair that restores the oven to its previous working condition. It does not improve the oven. It is Revenue Expenditure.
  3. 3
    1. Flour ($5,000): This is a raw material, a day-to-day cost of producing goods for sale. It is a Revenue Expenditure (specifically, Cost of Sales).

Recap

  • Revenue expenditure is for day-to-day running costs.
  • It includes repairs, maintenance, insurance, and fuel.
  • These costs are charged as expenses in the Statement of Profit or Loss.
  • Revenue expenditure does not increase an asset's value or lifespan.
  • It maintains the asset's current earning capacity.

Quick check

  1. A business repaints its office building. When would this be capital expenditure and when would it be revenue expenditure?2 marks

4. Distinguishing Capital and Revenue Income

Just as with expenditure, income is also classified as either capital or revenue. Revenue income is the main income of the business, generated from its normal trading activities like selling goods or providing services. For a non-profit club, this would be subscriptions or event ticket sales. Capital income is different; it's the money received from selling a non-current asset. The entire amount received is not profit. We calculate a separate profit or loss on disposal by comparing the sale proceeds with the asset's value in the books (its Net Book Value).

Profit / Loss on Disposal = Sale Proceeds - Net Book Value (Cost - Accumulated Depreciation)

Key term

Revenue Income: Income generated from the principal trading activities of a business, such as sales revenue or fees earned.

Common pitfall

Treating the entire cash received from selling a non-current asset as profit. You must deduct the asset's carrying value (net book value) first.

Worked example 14 marks

A business sells an old computer that had an original cost of $1,200 and accumulated depreciation of $900. They sell it for $250 cash. Is this capital or revenue income, and what is the result of the transaction?

  1. 1
    1. The income is from the sale of a non-current asset, so it is Capital Income.
  2. 2
    1. Calculate the Net Book Value (NBV) of the computer: NBV = Cost - Accumulated Depreciation = $1,200 - $900 = $300.
  3. 3
    1. Compare the sale proceeds to the NBV: Sale Proceeds ($250) - NBV ($300) = -$50.
  4. 4
    1. The result is a Loss on Disposal of $50. This loss is recorded as an expense in the Statement of Profit or Loss.

Recap

  • Revenue income is from normal business activities (e.g., sales).
  • Capital income is from the sale of non-current assets.
  • The full amount from selling an asset is not profit.
  • Profit or loss on disposal is calculated by comparing sale proceeds to the Net Book Value.
  • A profit on disposal is shown as 'other income', while a loss on disposal is an expense.

Quick check

  1. A shop sells a new t-shirt for $20 and its old cash register for $100. Which is revenue income and which is capital income?2 marks

5. How Expenditure Choices Affect Financial Statements

The decision to classify spending as capital or revenue has a major impact on the financial statements and key performance indicators. Correctly classifying expenditure is essential for the accounts to be true and fair. If you incorrectly capitalise a revenue expense (e.g., a repair), you overstate your non-current assets on the Statement of Financial Position and you overstate your profit for the year because the expense has not been correctly deducted. Conversely, if you incorrectly expense a capital item, you understate your assets and your profit.

Key term

Matching Concept: The accounting principle that requires expenses to be matched with the revenues they helped to generate in the same accounting period.

Examiner insight

Top-level answers explain the consequences of misclassifying expenditure, showing an understanding of its impact on both profit and asset valuation.

Common pitfall

Thinking that capitalising expenditure is a way to 'hide' costs. The cost is simply recognised over time through depreciation, rather than all at once.

Worked example 14 marks

A business spends $50,000 on a major machine upgrade. The accountant is unsure whether to capitalise it or treat it as a repair (revenue expenditure). Explain the effect on the profit for the year and non-current assets in the Statement of Financial Position if it is incorrectly treated as revenue expenditure.

  1. 1
    1. Correct Treatment (Capital Expenditure): The $50,000 would be added to non-current assets. Profit would be reduced only by the first year's depreciation (e.g., 10% = $5,000).
  2. 2
    1. Incorrect Treatment (Revenue Expenditure): The full $50,000 would be treated as an expense in the Statement of Profit or Loss.
  3. 3
    1. Effect on Profit: By incorrectly expensing the full $50,000 instead of just the depreciation charge of $5,000, the profit for the year will be understated by $45,000 ($50,000 - $5,000).
  4. 4
    1. Effect on Non-Current Assets: By not adding the $50,000 upgrade to the asset's value, the total value of non-current assets on the Statement of Financial Position will be understated by $50,000 (before considering depreciation).

Recap

  • Capital expenditure increases assets on the Statement of Financial Position.
  • Revenue expenditure increases expenses on the Statement of Profit or Loss.
  • Capitalising an item spreads its cost over time via depreciation.
  • Incorrectly capitalising a revenue cost overstates profit and assets.
  • Incorrectly expensing a capital cost understates profit and assets.

Quick check

  1. If a business wrongly treats a $2,000 repair as capital expenditure, will the profit for that year be overstated or understated?1 mark

End-of-chapter exercise

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

  1. Define capital expenditure and revenue expenditure, giving one example of each.4 marks
  2. List two examples of capital expenditure and two examples of revenue expenditure for a restaurant.4 marks
  3. A company buys a machine for $80,000. It pays $1,500 for delivery and $3,000 for installation. In the first year, it also pays $800 for an annual service. Calculate the total capital expenditure and total revenue expenditure related to the machine in the first year.4 marks
  4. Explain the difference between a repair and an improvement to an asset, using an example for a building. How would each be treated in the accounts?4 marks
  5. A business sells a machine for $5,000. Its original cost was $20,000 and the accumulated depreciation was $16,000. Calculate the profit or loss on disposal.3 marks
  6. Why are legal fees paid when buying a new office building treated as capital expenditure?2 marks
  7. Jahendra purchased a building for $320,000 with legal costs of $14,000. She spent $27,500 on repairs and decorating to make it usable and $41,000 installing new energy-efficient windows. Two years later, she spent $18,700 replacing worn-out carpets. Calculate the total initial capital cost of the premises and identify the revenue expenditure.5 marks
  8. A business spends $10,000 on an item of equipment. Explain the impact on the profit for the year and the statement of financial position if this is (a) correctly treated as capital expenditure with depreciation at 20% straight line, versus (b) incorrectly treated as revenue expenditure. Use figures in your answer.6 marks
  9. Explain the 'materiality' concept in the context of deciding whether to treat the purchase of a $50 office printer as capital or revenue expenditure for a large multinational company.3 marks
  10. A business incorrectly capitalised $6,000 of routine vehicle repairs at the start of its financial year. The business depreciates vehicles at 25% per annum on a straight-line basis. Calculate the effect of this error on the reported profit for the year.5 marks

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