Resources | Subject Notes | Accounting
This section focuses on the distinction between capital and revenue expenditure, and how the incorrect classification of these expenditures, as well as receipts, can significantly impact a business's reported profit. Understanding this distinction is crucial for accurate financial reporting.
Capital Expenditure is an expenditure that provides a benefit to the business for more than one accounting period. It is typically an investment in fixed assets such as property, plant, and equipment (PP&E). Capital expenditure is not expensed in the period it is incurred; instead, it is capitalised and shown on the balance sheet as an asset. It is then depreciated over its useful life.
Revenue Expenditure is an expenditure that provides a benefit to the business only for the current accounting period. It is typically an expense such as salaries, rent, utilities, and repairs. Revenue expenditure is expensed in the period it is incurred and is shown on the income statement.
The incorrect classification of expenditure as either capital or revenue has a direct impact on a business's reported profit. Capital expenditure, when incorrectly treated as revenue expenditure, will reduce profit in the current period, leading to an underestimation of the true profitability of the business. Conversely, revenue expenditure incorrectly treated as capital expenditure will overstate profit in the current period.
Here's a table summarizing the impact:
| Incorrect Treatment | Effect on Profit | Effect on Assets | Effect on Equity |
|---|---|---|---|
| Capital Expenditure treated as Revenue Expenditure | Profit is understated | Assets are understated | Equity is understated |
| Revenue Expenditure treated as Capital Expenditure | Profit is overstated | Assets are overstated | Equity is overstated |
A business purchases a new machine for £10,000. If this is incorrectly treated as a revenue expenditure, the full £10,000 would be expensed in the current period, reducing profit. Correctly, it should be capitalised as an asset and depreciated over its useful life, with depreciation expense being recorded each period.
A business spends £5,000 on repairs to an existing building. If this is incorrectly treated as a capital expenditure (e.g., adding an extension), it will overstate profit. Correctly, it should be treated as revenue expenditure and expensed in the current period.
A business buys office furniture for £2,000. This is typically capitalised as an asset. If incorrectly treated as revenue expenditure, profit will be understated.
The correct classification of receipts is also important. Receipts can be classified as either revenue or capital, depending on their nature.
Revenue Receipts are income generated from the normal course of business activities, such as sales of goods or services. They are recorded as income on the income statement.
Capital Receipts are income received from non-operating activities, such as the sale of assets or a loan from a bank. Capital receipts are not recorded on the income statement; instead, they are shown on the balance sheet as an increase in capital or a reduction in liabilities.
Incorrectly classifying receipts can also affect profit. For example, if the sale of an asset is incorrectly treated as a revenue receipt, profit will be overstated. Conversely, if a loan is incorrectly treated as a revenue receipt, profit will be understated.
Accurate classification of capital and revenue expenditure, and receipts, is fundamental to producing a reliable profit figure. Incorrect treatment can lead to a distorted view of a business's financial performance and position. Therefore, it is essential to understand the difference between these classifications and apply the correct accounting principles.