calculate and comment on the effect on asset valuations of incorrect treatment

4.1 Capital and Revenue Expenditure and Receipts

Learning objective

Calculate and comment on the effect on profit and on asset valuation when a capital or revenue item is treated incorrectly.

Exam‑style definitions (Cambridge wording)

• Capital expenditure (CapEx) = out‑flow that creates a new non‑current asset or enhances an existing one, providing benefits for more than one accounting period.
• Revenue expenditure (RevEx) = out‑flow incurred to maintain the earning capacity of an asset within the current period.
• Capital receipt = cash inflow that relates to the acquisition, sale or disposal of a non‑current asset.
• Revenue receipt = cash inflow from ordinary operating activities (sales, interest, rent, etc.).

Classification of expenditure

Item	Capital or Revenue?	Reason (Cambridge criteria)
Purchase of a delivery van	Capital	Creates a new non‑current asset that will be used for several years.
Annual servicing of the van	Revenue	Maintains the van in its present condition; benefit is limited to the current year.
Installation of air‑conditioning in the van	Capital	Improves the van and extends its useful life.
Repair of a broken tyre	Revenue	Restores the van to its previous condition only.

Classification of receipts

Receipt	Capital or Revenue?	Reason (Cambridge criteria)
Proceeds from sale of old machinery	Capital	Cash from disposal of a non‑current asset.
Cash received from customers for goods sold	Revenue	Arises from ordinary trading activities.
Insurance claim for damaged equipment	Revenue	Compensates for loss of a revenue‑producing asset, not a disposal.

Key‑phrase reminder: Capital receipt = cash from disposal of a non‑current asset.

Correct journal entries

1. Purchase of a delivery van for $25 000

   Dr. Delivery Van (Asset)          $25,000
       Cr. Bank                                   $25,000
           

2. Annual servicing cost of $800

   Dr. Servicing Expense            $800
       Cr. Bank                                   $800
           

3. Depreciation of the van (straight‑line, 5 years, no residual value)

   Dr. Depreciation Expense          $5,000
       Cr. Accumulated Depreciation – Delivery Van   $5,000
           

4. Sale of old machinery – cost $12 000, accumulated depreciation $8 000, proceeds $5 000

   Dr. Bank                                   $5,000
   Dr. Accumulated Depreciation – Machinery   $8,000
       Cr. Machinery (Asset)                         $12,000
       Cr. Other income – gain on disposal            $1,000
           

Effect of incorrect treatment – profit and asset valuation

Example 1 – Capitalising a revenue cost (over‑capitalisation)

• Van cost: $20 000 (capital)
• Air‑conditioning: $2 500 (capital)
• Annual servicing: $1 000 (revenue – wrongly capitalised)
• Useful life: 5 years, straight‑line, no residual value

Correct depreciation per year

\[ \text{Depreciation}_{\text{correct}}=\frac{20\,000+2\,500}{5}= \$4\,500 \]

Depreciation if the $1 000 servicing cost is capitalised

\[ \text{Depreciation}_{\text{incorrect}}=\frac{20\,000+2\,500+1\,000}{5}= \$4\,700 \]

Year‑end	Correct carrying amount	Incorrect carrying amount	Difference
End of Year 1	$20 000 – $4 500 = $15 500	$23 500 – $4 700 = $18 800	+$3 300 (over‑statement)

Impact

• Balance sheet: asset value $3 300 too high.
• Profit‑and‑loss: depreciation expense $200 higher → profit $200 lower.
• Ratios: Return on assets (ROA) is understated; current ratio unchanged but asset‑turnover is overstated.

Example 2 – Expensing a capital cost (under‑capitalisation)

• Purchase of computer equipment: $5 000 (capital)
• Useful life: 5 years, straight‑line, no residual value
• Correct annual depreciation: $1 000

If the $5 000 is recorded as an expense in the year of purchase:

Dr. Computer Expense          $5,000
    Cr. Bank                               $5,000

Effect on the first year

• Profit reduced by $5 000 instead of $1 000 → profit understatement of $4 000.
• Asset omitted from the balance sheet → total assets $5 000 too low.
• Subsequent years: no depreciation charge, so profit is overstated by $1 000 each year.
• Ratios: ROA appears higher after the first year; asset turnover is inflated because assets are understated.

Example 3 – Treating a major improvement as revenue (under‑capitalisation of a capital cost)

• Re‑engineered production line – cost $30 000 (improves efficiency and extends life).
• Correct treatment: capitalise and depreciate over 10 years → depreciation $3 000 per year.

If the $30 000 is expensed immediately:

Dr. Production Line Expense   $30,000
    Cr. Bank                               $30,000

Result

• Profit in year of purchase is $30 000 lower instead of $3 000 lower → profit understated by $27 000.
• Asset value on the balance sheet is $30 000 too low.
• Future years show $3 000 higher profit (no depreciation), giving a cumulative profit distortion of $27 000.
• Ratios: ROA is artificially high after the first year; equity‑to‑assets ratio is also distorted.

How mis‑statements affect common ratios

• Return on assets (ROA) = Profit ÷ Total assets. Over‑stated assets lower ROA; understated assets raise ROA.
• Asset turnover = Revenue ÷ Total assets. Same direction of distortion as ROA.
• Current ratio is not directly affected by non‑current asset mis‑statements, but total assets are used in other solvency ratios.

Checklist for correct classification (Cambridge)

1. Does the out‑flow create a new asset or extend the life of an existing asset? → Capital expenditure
2. Is the out‑flow incurred to keep the asset in its present condition? → Revenue expenditure
3. Is the inflow from the sale or disposal of a non‑current asset? → Capital receipt
4. Is the inflow generated by ordinary trading activities? → Revenue receipt

Self‑test (3 questions)

1. Does the cost create a new non‑current asset or improve an existing one?
   Answer: Yes → Capital.
2. Is the out‑flow only to maintain the asset’s current condition?
   Answer: Yes → Revenue.
3. Is the cash inflow received because a non‑current asset has been sold?
   Answer: Yes → Capital receipt.

Link to accounting principles

Capitalising a cost follows the matching principle** – the expense is matched with the future periods that benefit from the asset. Treating a capital cost as revenue can breach the principle of prudence** because it may overstate profit in the current period and understate assets.

Summary

• Accurate classification of capital vs. revenue items is essential for:
  • Correct valuation of non‑current assets on the balance sheet.
  • Proper measurement of profit (depreciation vs. expense).
  • Reliable financial ratios and sound decision‑making.
  • Compliance with IGCSE Accounting (0452) and UK GAAP/IAS 16.
• Mis‑treatment leads to:
  • Over‑ or under‑statement of assets.
  • Distorted profit figures.
  • Mis‑leading ratio analysis.
  • Potential tax errors.