Capital Expenditure and Revenue Expenditure

Definition and Distinction

In financial accounting, it is essential to distinguish between capital expenditure and revenue expenditure due to their differing impacts on financial statements. Capital expenditure relates to the acquisition or improvement of non-current assets, while revenue expenditure pertains to the day-to-day running costs and maintenance of assets.

• Capital Expenditure: Spending that results in the acquisition of non-current assets or enhances their earning capacity.

• Revenue Expenditure: Spending on the running costs of the business or maintaining the existing earning capacity of non-current assets.

• Owner's Capital vs Capital Expenditure: Owner's capital refers to the owner's investment in the business, whereas capital expenditure refers to spending on non-current assets. These are distinct concepts.

Example: Buying a delivery van is capital expenditure; buying petrol for the van is revenue expenditure.

Characteristics of Non-Current Assets

Non-current assets possess three key characteristics:

• Long-life assets

• Used in the business (not for resale)

• Not bought for the purpose of resale

Examples: Land, buildings, machinery, equipment, fixtures & fittings, motor vehicles, computers.

Components of Capital Expenditure

Capital expenditure includes all costs incurred to bring a non-current asset into use and improve its earning capacity.

• Purchase price (net of discounts)

• Delivery costs

• Non-reclaimable taxes (e.g., import duty, stamp duty)

• Assembly, installation, and testing costs

• Professional fees (e.g., legal, architects’ fees)

• Site preparation costs (e.g., demolition)

• Direct wages for construction

• Planning permission costs

Example: If a business buys equipment for £8,900, pays £700 for delivery, and £1,600 for installation, the total capital expenditure is £11,200.

Revenue Expenditure Explained

Revenue expenditure is incurred in the normal operations of the business or in maintaining the existing capacity of non-current assets.

• Purchasing goods for resale

• Wages and salaries

• Utilities (electricity, water, gas)

• Rent, advertising

• Repairs, maintenance, servicing of assets

Example: Repairing a warehouse roof is revenue expenditure; building an extension is capital expenditure.

Distinguishing Capital and Revenue Expenditure

Correct classification is crucial for accurate financial reporting. The following table illustrates common examples:

Additional info: When expenditure is split, only the portion that improves the asset is capitalised; maintenance is expensed.

Accounting Treatment

• Capital Expenditure: Debited to the non-current asset account; increases asset value in the balance sheet.

• Revenue Expenditure: Debited to the relevant expense account; appears in the income statement as an expense.

• Capitalisation: The process of adding expenditure to the cost of a non-current asset in the balance sheet.

Impact of Incorrect Classification

• If revenue expenditure is treated as capital expenditure: Non-current assets and net profit are overstated.

• If capital expenditure is treated as revenue expenditure: Net profit and non-current assets are understated.

Replacement of Major Parts in Complex Assets

For complex assets (e.g., aircraft), replacement of major parts (e.g., seats) can be capitalised if the old part is removed from the books. Otherwise, follow the general rule: restoration is revenue expenditure.

Interest Costs on Construction of Non-Current Assets (IAS 23)

Interest costs incurred in financing the construction of a non-current asset may be capitalised if:

• The asset takes a long time to get ready for use.

• The borrowing costs are directly attributable to the construction.

• Capitalisation occurs only during the construction period.

Formula for Capitalised Interest:

Example: £1.5m loan at 6% for 8 months:

Total cost of factory: £1,740,000 (construction) + £60,000 (interest) = £1,800,000

Summary Flowchart: Capital vs Revenue Expenditure

Use the following logic to classify expenditure:

• Was the expenditure incurred in bringing a non-current asset into use for the first time and will benefit the business in the long term? Yes: Capital expenditure.

• Did the expenditure improve an existing non-current asset beyond its original level? Yes: Capital expenditure.

• If neither, it is revenue expenditure.

Learning Outcomes

• Capital expenditure results in acquisition or improvement of non-current assets.

• Acquisition cost includes all costs to bring asset into use.

• Revenue expenditure covers running costs and maintenance.

• Incorrect classification affects profit and asset values.

• Interest costs on self-constructed assets may be capitalised under IAS 23.