IGCSE Accounting 0452 - 4.1 Capital and Revenue Expenditure and Receipts

Objective: Calculate and comment on the effect on asset valuations of incorrect treatment

Understanding Capital and Revenue Expenditure

In accounting, it's crucial to distinguish between capital and revenue expenditure. This distinction significantly impacts how assets are treated on the balance sheet.

Capital Expenditure

Capital expenditure is expenditure that provides a lasting benefit to the business. It increases the value of an asset and is typically shown on the balance sheet as a capital asset (e.g., property, plant, and equipment).

• Examples: Purchase of a new machine, building a new factory, purchasing land.
• Effect on the balance sheet: Increases the value of the relevant asset.
• Accounting treatment: Capital expenditure is not expensed in the income statement in the period it is incurred. Instead, it is depreciated over its useful life.

Revenue Expenditure

Revenue expenditure is expenditure incurred to maintain the normal running of the business. It does not provide a lasting benefit and is expensed in the income statement in the period it is incurred.

• Examples: Salaries, rent, utilities, repairs and maintenance.
• Effect on the balance sheet: Does not directly affect asset valuations.
• Accounting treatment: Revenue expenditure is deducted from profit in the income statement.

Incorrect Treatment and its Effects on Asset Valuations

Incorrectly classifying expenditure as either capital or revenue can have a significant impact on a company's financial statements, particularly on the valuation of its assets.

Overstating Capital Expenditure (Incorrectly classifying revenue as capital)

If revenue expenditure is incorrectly treated as capital expenditure, it will lead to an overstatement of asset values on the balance sheet.

Example: A company spends £5,000 on routine repairs to a machine. If this is incorrectly treated as capital expenditure, the value of the machine on the balance sheet will be artificially inflated by £5,000.

Effect:

• Balance Sheet: Assets are overstated, leading to an overstatement of total assets.
• Profit and Loss Account: Profit is understated because the £5,000 should have been expensed.
• Depreciation: Depreciation will be calculated on a higher asset value, leading to lower depreciation charges in subsequent periods.

Understating Capital Expenditure (Incorrectly classifying capital as revenue)

If capital expenditure is incorrectly treated as revenue expenditure, it will lead to an understatement of asset values on the balance sheet.

Example: A company purchases a new piece of equipment for £10,000. If this is incorrectly treated as revenue expenditure, the value of the equipment on the balance sheet will be understated by £10,000.

Effect:

• Balance Sheet: Assets are understated, leading to an understatement of total assets.
• Profit and Loss Account: Profit is overstated because the £10,000 should have been capitalised.
• Depreciation: Depreciation will be calculated on a lower asset value, leading to higher depreciation charges in subsequent periods.

Table Summarising the Effects

Incorrect Treatment	Effect on Asset Valuation (Balance Sheet)	Effect on Profit and Loss Account
Revenue Expenditure treated as Capital Expenditure	Assets are overstated	Profit is understated
Capital Expenditure treated as Revenue Expenditure	Assets are understated	Profit is overstated

Conclusion

Accurate classification of expenditure as either capital or revenue is fundamental to presenting a true and fair view of a company's financial position. Incorrect treatment can significantly distort asset valuations, leading to misleading financial statements and potentially impacting business decisions.