Resources | Subject Notes | Accounting | Lesson Plan
It's crucial to distinguish between capital and revenue expenditure as this directly impacts how assets are treated on the balance sheet. Capital expenditure is expenditure that increases the value of an asset or extends its useful life. It is typically capitalised, meaning it's recorded as an asset on the balance sheet.
Revenue expenditure is expenditure incurred to maintain the asset in its current working condition. It does not increase the asset's value or extend its useful life. It is typically expensed in the income statement in the period it is incurred.
Here's a table illustrating common examples:
| Expenditure | Type | Explanation |
|---|---|---|
| Purchase of a new machine | Capital | Increases the factory's productive capacity and extends its useful life. |
| Repairs to an existing machine | Revenue | Maintains the machine in its current working condition but doesn't increase its value or lifespan. |
| Extension of a building | Capital | Increases the building's size and value. |
| Routine cleaning of office equipment | Revenue | Maintains the equipment but doesn't increase its value or lifespan. |
| New safety lights in a factory | Capital | Improves safety and potentially extends the life of the factory. |
| Replacement of a worn-out component in a machine | Revenue | Maintains the machine's current working condition. |
Incorrectly classifying expenditure as either capital or revenue has a significant impact on asset valuations and the overall financial position of a business.
If revenue expenditure is incorrectly treated as capital expenditure, it leads to an overstatement of asset values on the balance sheet. This means the value of assets is higher than it should be.
Example: If a company spends £500 on routine repairs to a machine but records it as capital expenditure, the carrying value of that machine on the balance sheet will be inflated by £500. This will also affect depreciation calculations in future periods, as depreciation is calculated on the asset's carrying value.
Impact on Financial Statements:
Conversely, if capital expenditure is incorrectly treated as revenue expenditure, it results in an understatement of asset values on the balance sheet. This means the value of assets is lower than it should be.
Example: If a company purchases a new machine for £10,000 but records it as revenue expenditure, the machine will not appear as an asset on the balance sheet. This will also mean that no depreciation will be recorded on this asset in future periods.
Impact on Financial Statements:
The effect on asset valuations is directly the amount of the incorrectly classified expenditure. Overstating capital expenditure increases the asset's carrying value by the amount of the wrongly recorded capital expenditure. Understating capital expenditure decreases the asset's carrying value by the amount of the wrongly recorded revenue expenditure.
Formula:
Change in Asset Value = Amount of Expenditure (Incorrectly Classified)
Accurate classification of expenditure as either capital or revenue is fundamental to presenting a true and fair view of a company's financial performance and position. Incorrect treatment can significantly distort asset valuations, leading to misleading financial statements and potentially impacting decision-making by stakeholders.