Capital expenditure and revenue expenditure - Accounting - Pearson IGCSE

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Welcome to Capital & Revenue Expenditure!

Hi there! This chapter is one of the most fundamental (and sometimes confusing!) parts of introductory accounting. Don't worry if it seems tricky at first—we'll break it down using simple steps and real-world examples.

What are we learning? We are learning how businesses decide whether a cost is an ongoing, everyday expense (like paying rent) or a long-term investment (like buying a building). Getting this classification right is essential, as it directly affects how we calculate profit and how the company's value is reported!

Why This Classification is Crucial (The Accountant's Sorting Hat)

Imagine you are sorting laundry. You wouldn't put a brand new sofa in the washing machine, right? And you wouldn't keep buying a new washing machine every time you needed detergent. Accounting is similar! We must sort costs into two main categories so that our final reports make sense:

Costs that help us today (daily running costs).
Costs that benefit us for many years (investments).

These two categories are called Capital Expenditure and Revenue Expenditure.

Section 1: Understanding Capital Expenditure (CE)

Capital Expenditure (CE) involves spending money to buy, improve, or extend assets that the business will use for a long period (more than one year).

Characteristics of Capital Expenditure

Duration: The benefit lasts for a long time (multiple accounting periods).
Purpose: To acquire, install, or enhance Non-current Assets (also known as Fixed Assets).
Effect on Assets: It either creates a new asset or significantly increases the earning capacity or useful life of an existing asset.

The House Analogy

Think of your home. Capital Expenditure is like spending money on the structure or foundation of the house:

Buying a new plot of land.
Building an extension.
Installing a brand new kitchen that increases the house's value.

These are big investments that provide value for many years.

Real-World Business Examples of CE

CE includes all costs needed to get the asset ready for use:

Purchasing a new machine, vehicle, or computer system.
Installation costs for new machinery.
Legal fees associated with buying land or buildings.
Significant modifications or upgrades that increase production capacity. (e.g., adding a powerful robotic arm to an existing factory machine).

Accounting Impact of Capital Expenditure

CE is NOT charged to the Income Statement (Profit and Loss Account) immediately. Instead, it is recorded as an asset on the Statement of Financial Position (Balance Sheet).

Did you know? Although the full cost of the asset is a Capital Expenditure, a portion of its cost (called depreciation) is charged as a Revenue Expenditure each year to reflect the asset's wear and tear.

Quick Review: Capital Expenditure

Capital expenditure = Create or Contribute to a Non-current Asset. (Long-lasting benefit)

Section 2: Understanding Revenue Expenditure (RE)

Revenue Expenditure (RE) involves spending money on the day-to-day running of the business or maintaining the efficiency of existing assets. The benefit of this spending is usually used up within one accounting period (one year).

Characteristics of Revenue Expenditure

Duration: The benefit is short-term (used up quickly).
Purpose: To generate sales revenue, maintain assets, or cover general administrative costs.
Effect on Assets: It does not create a new asset or substantially improve an existing asset; it simply keeps things running.

The House Analogy Revisited

If CE was the foundation, Revenue Expenditure is the money you spend keeping the house running and tidy:

Paying the electricity bill.
Hiring a cleaner (salary/wages).
Changing a broken lightbulb.
Painting a room (general maintenance).

These costs are necessary but don't increase the long-term value of the house.

Real-World Business Examples of RE

Cost of goods purchased for resale (stock).
Rent, rates, and insurance premiums.
Wages and salaries for employees.
General repair and maintenance costs (e.g., servicing a company car, replacing a worn part).
Selling and distribution costs (e.g., advertising).

Accounting Impact of Revenue Expenditure

RE is vital for calculating profit. It is directly charged to the Income Statement (Trading and Profit and Loss Account) as an expense, reducing the business's Profit for that year.

Quick Review: Revenue Expenditure

Revenue expenditure = Running costs. (Short-term benefit, charged against profit)

Section 3: The Tricky Part – Distinguishing Maintenance from Improvement

This is where students often make mistakes. Sometimes a repair can look like a Capital Expenditure, but it’s actually RE. We need to look closely at the effect of the spending.

Key Rule: Is the Asset Made BETTER or just RESTORED?

1. General Repairs and Maintenance (RE)

If the cost simply restores the asset to its original working condition or maintains its current state of efficiency, it is Revenue Expenditure.

Example: A company car has a flat tyre. Replacing the tyre is RE. The car is no better or faster than it was when it was new—it's just working again.
Example: Changing the oil filter on a machine. (Maintenance)

2. Additions and Improvements (CE)

If the cost significantly extends the asset's useful life OR increases its efficiency or capacity (so the business can earn more revenue), it is Capital Expenditure.

Example: Installing a special new engine in the company car that doubles its fuel efficiency and speed. This improvement adds permanent, long-term value and increases performance.
Example: Converting the ground floor of a factory into two floors, significantly increasing storage capacity. (Improvement/Extension)

Memory Aid: If you spend money and the old asset is suddenly SUPER efficient, think Capital. If you spend money and the old asset is just OKAY again, think Revenue.

Common Mistake to Avoid!

When a company buys a new non-current asset (like a machine), the initial costs of bringing it into use—such as delivery, installation, and testing—are all treated as part of the asset's cost. They are Capital Expenditure. They are not treated as everyday expenses (RE).

Example: Buying Machine X for $10,000 + Delivery $500 + Installation $200 = Total CE of $10,700.

Section 4: Why Classification Accuracy Matters

Incorrectly classifying an expenditure is known as an Error of Principle, and it seriously distorts a business’s financial performance and position.

What Happens If We Get It Wrong?

Misclassification affects both the Income Statement (Profit) and the Statement of Financial Position (Assets).

Case 1: Treating Capital Expenditure (CE) as Revenue Expenditure (RE)

(You buy a new machine, but treat it like a repair bill.)

Effect on Income Statement: Expenses are recorded as being too high.
Result: Profit is understated (too low).
Effect on Statement of Financial Position: The value of Non-current Assets is not recorded correctly.
Result: Non-current Assets are understated (too low).

Case 2: Treating Revenue Expenditure (RE) as Capital Expenditure (CE)

(You pay the electricity bill, but treat it as buying a new asset.)

Effect on Income Statement: Expenses are recorded as being too low (they should have reduced profit, but didn't).
Result: Profit is overstated (too high).
Effect on Statement of Financial Position: The expense has been mistakenly recorded as an asset.
Result: Non-current Assets are overstated (too high).

Key Takeaway: Getting CE and RE right ensures the calculated profit is accurate and that the business's true worth (assets) is correctly shown to investors and banks.

Chapter Summary: Capital vs. Revenue Expenditure

Here is a final table to help you summarise the key differences:

	Capital Expenditure (CE)	Revenue Expenditure (RE)
Benefit Period	Long-term (more than 1 year)	Short-term (within 1 year)
Purpose	Acquiring or substantially improving Non-current Assets	Day-to-day running, maintenance, and revenue generation
Example	Purchase of a new building, installation costs	Wages, rent, small repairs, fuel
Reporting Location	Statement of Financial Position (Asset)	Income Statement (Expense)

You did great making it through this core concept! Remember, practice makes perfect. Keep asking yourself: "Is this expense for the foundation of the business (CE) or for the daily running costs (RE)?"