0452 · 4.1Capital and revenue expenditure and receipts

Assets, revenue and financial statements

0:00Nadia’s Bakery pays for a new oven and repairs an existing one. Both payments reduce its bank balance, but they belong in different places in the records. This video covers the distinction between capital expenditure and revenue expenditure, and how to account for each. We will also distinguish capital receipts from revenue receipts and calculate the effects of incorrect treatment on profit and asset valuations. Assets are resources owned or controlled by a business that bring future benefit.

0:25The bakery’s oven is one of them. Non-current assets are assets held for continuing use in the business rather than for resale, so the oven belongs in this category. Money spent acquiring that equipment has a different purpose from money spent operating it. Revenue is the income a business earns from its main activity, such as selling goods or providing services. At Nadia’s Bakery, bread sales provide revenue. Expenses are the costs used up in running the business and earning revenue during a period.

0:52Electricity used for baking is one of the bakery’s expenses. A payment’s purpose determines its treatment, rather than simply the fact that money leaves the bank. Financial statements are summaries that show a business’s profit or loss for a period and what it owns and owes at a date. The statement of profit or loss is the financial statement that shows the revenue, expenses and profit or loss for a period.

1:12Liabilities are amounts the business owes to others. Owner’s equity, also called capital, is the owner’s investment in the business, or the amount the business owes the owner. A statement of financial position shows assets, liabilities and owner’s equity at a particular date. The oven appears there as a non-current asset, while the electricity is shown in the statement of profit or loss as an expense. For every payment, we must decide whether it belongs in the period’s expenses or in the cost of a resource still held.

Capital and revenue expenditure

1:40Capital expenditure is spending on buying or improving non-current assets, including costs needed to bring them into use. Buying an oven creates a resource that the bakery will use over several periods. Delivery and installation are also necessary before that oven can operate. Those amounts therefore form part of the equipment’s cost, rather than separate running expenses. Revenue expenditure is spending on the day-to-day running of the business and maintaining its assets.

2:05Repairs restore an oven’s existing working condition, while fuel allows the bakery’s delivery vehicle to operate. Neither payment acquires a new resource or improves an asset beyond its previous condition. Wages, rent and insurance are also revenue expenditure because they pay for running the business. An extension to the bakery’s premises is capital expenditure because it increases the space available for business use. Routine painting of the existing premises is revenue expenditure because it maintains their condition.

2:33Legal fees directly connected with purchasing premises form part of their acquisition cost, so they are capital expenditure. Classify the work by what it achieves, rather than by the size of the invoice. A large repair bill remains revenue expenditure when it only restores an asset’s existing condition. Conversely, a small installation charge can be capital expenditure when it brings new equipment into use. The same type of payment can be treated differently in other circumstances.

2:58Installation wages directly attributable to a new oven form part of its cost, whereas ordinary baking wages are revenue expenditure. Inventory means goods held for resale. Goods bought for resale are revenue expenditure rather than equipment acquired for continuing use. Cost of sales is the cost of inventory sold during a period. Goods still unsold at the year end remain an asset, so only the cost of inventory sold is charged as cost of sales.

Recording expenditure and matching costs

3:22Nadia’s Bakery buys an oven for four thousand dollars and pays three hundred dollars for delivery. Installation costs another seven hundred dollars, and all three amounts are paid through the bank. Four thousand plus three hundred plus seven hundred equals five thousand dollars. The equipment account receives the whole five thousand dollars because all these costs bring the oven into use. Double entry means every transaction is recorded as a debit in one account and a credit of the same amount in another.

3:47For the oven, debit the equipment account and credit the bank account with five thousand dollars. The debit records an increase in equipment, while the credit records a reduction in money at the bank. The equipment cost appears under non-current assets in the statement of financial position. The bakery also pays six hundred dollars through the bank for a routine repair to an existing oven. Debit the repairs account and credit the bank account with six hundred dollars.

4:11Repairs expense rises because the work maintains existing equipment, while the bank asset decreases. This expense appears in the statement of profit or loss, not as an addition to equipment. The accruals concept, also called the matching concept, means income and expenses are recorded in the period to which they relate, not when cash is received or paid. Charging the entire oven cost immediately would place several periods’ equipment cost into one period’s expenses.

4:35Depreciation is the loss in value of a non-current asset over its useful life. It is an estimate that is charged as an expense in each year of use. You will see its calculation in the video on accounting for depreciation and disposal of non-current assets.

Capital and revenue receipts

4:48Here a receipt means money received by the business, rather than the written proof that money has been received. Money received from sources other than normal trading is a capital receipt. Examples are capital introduced by the owner, loans and sales of non-current assets. Revenue receipts are income arising from normal trading activities, such as sales, rent received and commission received. The source of each receipt determines its classification, rather than its amount or payment method.

5:15When Nadia introduces personal money, the bakery receives a capital receipt. Suppose she pays eight thousand dollars into the business bank account. Debit the bank account and credit the capital account with eight thousand dollars. Money at the bank increases, and the owner’s equity rises. This receipt does not appear as sales in the statement of profit or loss because the bakery has not earned it from customers. The bakery separately receives a loan of six thousand dollars into its bank account.

5:39A loan is also a capital receipt, but it creates a liability rather than owner’s equity. Record a debit in the bank account and a credit in the loan account for six thousand dollars. The business now has more money at the bank, but its obligation to repay the lender also rises. Borrowing therefore changes assets and liabilities without creating trading income. Selling an oven previously used by the bakery produces a capital receipt because the business is disposing of a non-current asset.

6:05A disposal account collects the entries needed when a non-current asset is removed from the records. Suppose the old oven is sold for nine hundred dollars, paid into the bank. Debit the bank account and credit the disposal account with nine hundred dollars because bank funds rise and the disposal account collects the proceeds. This money is not sales revenue, and any profit or loss on disposal is covered in the video on depreciation and disposal.

6:27Bread sales paid directly into the bank bring in fifteen hundred dollars. Debit the bank account and credit the sales account with that amount because the bank asset grows and sales revenue rises. Sales are revenue receipts because selling bread is the bakery’s main activity. The sales revenue belongs in the statement of profit or loss. Other income is income from activities other than the main one, such as rent received or discount received.

6:49Nadia’s Bakery receives four hundred dollars for letting a spare room and two hundred and fifty dollars commission for selling a local farm’s eggs. Debit the bank account with each amount, and credit rent received with four hundred dollars and commission received with two hundred and fifty dollars. Bank funds increase, and other income rises in both accounts. Rent received and commission received are revenue receipts, but they appear as other income rather than sales revenue.

Correcting classification errors

7:12Incorrect classification changes what the records report, even though the actual bank payment stays the same. An error of principle records a transaction in the wrong class of account. Recording a routine repair as equipment is an example because an expense has been placed in a non-current asset account. The debit and credit can still be equal, so equal totals do not prove that classification is correct. Profit for the year is the amount by which revenue exceeds expenses over one financial year.

7:38When capital expenditure is treated as revenue expenditure, expenses are overstated and profit for the year is understated. Non-current assets are also understated because their cost has been omitted. These effects arise from the same mistake, not from two separate transactions. For revenue expenditure treated as capital expenditure, the correct expense is missing, so profit for the year is overstated. Non-current assets are overstated because expenditure already used up has been included in their valuation.

8:05This also breaks the matching concept, because the cost is not charged in the period to which it relates. The bank balance is still correct if the payment itself was properly recorded. We will assume no depreciation adjustments in the following calculations. A routine repair costing twelve hundred dollars has incorrectly been included in equipment. Reported profit for the year is eighteen thousand four hundred dollars, and reported non-current assets are thirty-two thousand six hundred dollars.

8:30The repair should be an expense, so the reported profit is too high. Subtracting twelve hundred from eighteen thousand four hundred gives correct profit of seventeen thousand two hundred dollars. The same repair must also be removed from equipment because it created no additional non-current asset. Thirty-two thousand six hundred minus twelve hundred equals thirty-one thousand four hundred dollars. Both reported profit for the year and non-current assets were overstated by twelve hundred dollars.

8:55The correction changes their classification without changing the amount originally paid. Receipts can be misclassified too, so check the account that should receive the credit. Money introduced by the owner belongs in the capital account, while borrowing belongs in a loan account, which is a liability. Recording either as sales would overstate revenue and profit for the year. The capital account or the loan liability would then be understated by the same amount.

9:17The bank balance stays correct because the debit to the bank account was recorded properly. Paper One contains forty multiple-choice questions, while Paper Two contains five compulsory structured questions. You may need to classify expenditure, record receipts or calculate the effects of an error. Identify means name or select, and explain means give reasons why and how, supported by evidence. Calculate means work out from given figures, so show the adjustment as well as the corrected amount.

9:44Examiners also reward the direction of each effect, overstated or understated. Consider equipment costing two thousand four hundred dollars that was incorrectly charged to repairs. Reported profit for the year is thirteen thousand seven hundred dollars, and non-current assets are twenty-two thousand one hundred dollars. Identify the expenditure and calculate the corrected figures, with no depreciation adjustment. The purchase is capital expenditure because it acquires equipment for continuing business use.

10:11Expenses are overstated by two thousand four hundred dollars, so profit for the year is understated by that amount. Thirteen thousand seven hundred plus two thousand four hundred equals sixteen thousand one hundred dollars. Non-current assets are understated by two thousand four hundred dollars. Twenty-two thousand one hundred plus two thousand four hundred gives a correct asset valuation of twenty-four thousand five hundred dollars. Capital expenditure acquires or improves non-current assets, including costs needed to bring them into use.

10:38Revenue expenditure pays for running the business and maintaining existing assets. Capital receipts come from the owner’s capital, loans or selling non-current assets, while revenue receipts arise from normal trading activities. For any classification error, follow the misplaced amount into expenses, profit and asset valuation, then calculate the correction.