🚀 Capital and Revenue: The Accounting Detective Work 🕵️♀️
Hello IGCSE students! This chapter is one of the most important (and sometimes trickiest!) in Accounting. Why? Because getting this distinction right is the difference between calculating your true profit and having a completely wrong valuation of your business.
Don't worry if this seems complex at first. We are simply learning how to sort the big, long-term investments from the small, everyday bills. Let's dive in!
1. Understanding Expenditure: Capital vs. Revenue
What is Expenditure?
Expenditure simply means money spent by the business. However, not all spending is treated the same way in the accounts. We divide all expenditure into two major categories: Capital Expenditure and Revenue Expenditure.
(A) Capital Expenditure (CAPEX)
Capital Expenditure (CAPEX) is spending money on items that will benefit the business for more than one year. This spending is intended to acquire, improve, or extend the life or earning capacity of Non-Current Assets (also known as fixed assets).
- Purpose: To acquire assets or to increase the value/efficiency of existing assets.
- Time Frame: Long-term benefit (years).
- Accounting Treatment: The cost is recorded in the Statement of Financial Position (SFP) as an Asset (it is capitalized). It is then gradually expensed over its useful life through Depreciation.
Real-World Examples of Capital Expenditure:
- Buying a new factory building or land.
- Purchasing new machinery or delivery vehicles.
- Adding an extension to the existing office building (a significant improvement).
- Initial costs incurred to get a non-current asset ready for use (e.g., delivery charges, installation costs).
💡 Analogy Time: The Car Purchase
Think of buying a new car for your personal use. The cost of the car itself is a major, long-term investment. This is Capital Expenditure.
(B) Revenue Expenditure (REVEX)
Revenue Expenditure (REVEX) is spending money on items that are consumed or used up within the current accounting period (usually one year). This spending is necessary to keep the business running day-to-day and maintain its current earning capacity.
- Purpose: To maintain non-current assets or to cover the costs of running the business operations (generating revenue).
- Time Frame: Short-term benefit (within the year).
- Accounting Treatment: The cost is treated as an Expense and appears in the Income Statement, reducing the profit for the current year.
Real-World Examples of Revenue Expenditure:
- Paying wages, salaries, and rent.
- Buying raw materials or inventory (goods for resale).
- Fuel, electricity, and insurance premiums.
- Small, routine repairs and maintenance (e.g., changing the oil in the delivery van).
💡 Analogy Time: The Car Maintenance
Continuing the car analogy: the cost of petrol, oil changes, insurance, and routine cleaning are Revenue Expenditure. They keep the car running, but they don't increase its value or lifespan significantly beyond the regular wear and tear.
🧠 Key Takeaway (Expenditure):
CAPEX = Adds to assets (SFP).
REVEX = Reduces profit (Income Statement).
2. The Tricky Distinction: Repairs and Maintenance
The biggest confusion often comes when dealing with repairs and improvements. You must judge the purpose of the spending:
- If the spending MAINTAINS the asset's current state: It is Revenue Expenditure (Expense). Example: Replacing a broken window pane.
- If the spending SIGNIFICANTLY IMPROVES the asset or EXTENDS its life: It is Capital Expenditure (Asset). Example: Replacing the entire roof to last another 20 years, or adding air conditioning to a building that didn't have it.
Common Mistake to Avoid: Simply because an amount is large does NOT automatically make it Capital Expenditure. If you pay a year's rent in advance (a large sum), it is still Revenue Expenditure because the benefit (housing the business) lasts less than one year.
3. Understanding Receipts: Capital vs. Revenue
Just as spending is classified, money coming into the business (receipts) must also be classified based on its source.
(A) Revenue Receipts
Revenue Receipts are inflows of cash that arise from the normal, day-to-day running of the business. These are regular and recurring.
- Source: Core trading activities.
- Accounting Treatment: Recorded in the Income Statement as Revenue/Income, increasing the profit.
Examples:
- Sales of goods or services.
- Commission received.
- Rent received from a tenant renting part of your building.
(B) Capital Receipts
Capital Receipts are inflows of cash that are irregular and non-recurring, usually arising from reducing the size or funding structure of the business.
- Source: Selling non-current assets or introducing new capital.
- Accounting Treatment: Recorded in the Statement of Financial Position (SFP), usually affecting Non-Current Assets or Owner's Equity (Capital).
Examples:
- Selling an old delivery van.
- The owner introducing more capital into the business.
- Taking out a long-term bank loan.
🧠 Key Takeaway (Receipts):
Revenue Receipts = Regular sales/income (affects Profit).
Capital Receipts = Irregular sources (affects SFP assets/capital).
4. The Critical Impact of Incorrect Treatment
This is where the exam marks are often found! If an accountant mixes up Capital and Revenue items, the financial statements will show misleading figures.
You need to be able to calculate and comment on the effect of misclassification on two main figures:
- Profit for the Year (from the Income Statement)
- Asset Valuations (from the Statement of Financial Position)
Scenario 1: Treating Capital Expenditure as Revenue Expenditure
Example: A business buys a new computer (a Non-Current Asset) for $1,000 but records it mistakenly as a "General Expense."
Effect on Profit:
When Capital Expenditure is treated as Revenue Expenditure, it means you have recorded an asset purchase ($1,000) as an immediate expense in the Income Statement.
- The Expense is OVERSTATED (too high).
- Profit for the Year is UNDERSTATED (too low).
(Note: This error is often partially corrected over time by depreciation, but for the current year, the initial profit is definitely too low.)
Effect on Asset Valuation:
Since the computer was recorded as an expense, it never made it onto the Statement of Financial Position as a Non-Current Asset.
- Non-Current Assets are UNDERSTATED (too low).
Scenario 2: Treating Revenue Expenditure as Capital Expenditure
Example: A business pays $500 for routine painting and repairs (a Revenue Expense) but mistakenly records it by adding it to the value of the Building account.
Effect on Profit:
When Revenue Expenditure is treated as Capital Expenditure, you failed to record a necessary operating expense ($500) in the Income Statement.
- The Expense is UNDERSTATED (too low).
- Profit for the Year is OVERSTATED (too high).
Effect on Asset Valuation:
Since the repair cost ($500) was added to the Building account, the asset value is inflated.
- Non-Current Assets are OVERSTATED (too high).
📈 Quick Review: The Impact Chart
This chart is essential for your revision. Memorise how these errors impact the two key financial figures.
| Type of Error | Effect on Profit | Effect on Non-Current Assets |
|---|---|---|
| CAPEX recorded as REVEX | UNDERSTATED (Too Low) | UNDERSTATED (Too Low) |
| REVEX recorded as CAPEX | OVERSTATED (Too High) | OVERSTATED (Too High) |
Did you know? This misclassification is one of the ways businesses can try to illegally 'window dress' their accounts. If a manager wants to look more profitable, they might hide expenses by treating Revenue Expenditure as Capital Expenditure (Scenario 2)! This inflates both profit and asset values, making the company look stronger than it really is.
5. Accounting for the Correction
When a misclassification error is discovered, it must be corrected using a Journal Entry. This shifts the amount from the wrong ledger account (e.g., Expense) to the correct ledger account (e.g., Non-Current Asset).
Step-by-step Correction (Using Scenario 1: $1,000 computer treated as Expense)
- Identify the error: $1,000 was debited to the General Expenses Account (which reduced profit).
- Identify the required correction: The $1,000 should have been debited to the Non-Current Asset Account (e.g., Machinery/Equipment).
- Move the item out of the wrong account: Credit the General Expenses Account by $1,000 to reverse the incorrect expense entry.
- Move the item into the correct account: Debit the Non-Current Asset Account by $1,000.
Journal Entry to Correct Scenario 1:
Debit: Non-Current Assets Account ($1,000)
Credit: General Expenses Account ($1,000)
(Narration: Being correction for the purchase of computer wrongly treated as an expense.)
This correction will increase the Non-Current Assets in the SFP and decrease the General Expenses in the Income Statement, thereby increasing the profit by $1,000.
✅ Chapter Summary & Review
To succeed in this chapter, remember the core concept: CAPITAL items are long-term (Non-Current Assets) and go to the SFP, while REVENUE items are short-term (Expenses/Income) and go to the Income Statement. Getting this distinction right ensures a true and fair view of the business's performance and position.