calculate and comment on the effect on profit of incorrect treatment

4.1 Capital and Revenue Expenditure and Receipts

Learning Objective

Calculate and comment on the effect on profit (and on the balance‑sheet) when a capital or revenue item is treated incorrectly.

1. Key Definitions

• Capital Expenditure (CapEx) – Outlay that creates or enhances a non‑current asset. It is recorded as an asset on the balance sheet and written‑off over its useful life (depreciation or amortisation).
• Revenue Expenditure (RevEx) – Cost incurred in the ordinary running of the business. It is charged to the profit‑and‑loss account in the period it is incurred.
• Capital Receipt
  • Proceeds from the sale/disposal of a non‑current asset – recorded in the cash‑flow statement; only the gain or loss on disposal affects profit.
  • Proceeds from borrowing (bank loan, debentures) – a financing activity, not part of profit.
  • Proceeds from issuing shares (ordinary or preference) – also a financing activity, not part of profit.
• Revenue Receipt – Cash inflow from ordinary sales, services, interest, rent etc. Included in turnover and profit.

2. Classification Checklist (AO1)

Before recording any transaction, ask the two questions below. Write “Capital” or “Revenue” in the margin and then decide “Receipt” or “Expenditure”.

1. Will the economic benefit last **more than one accounting period**?
   
   • Yes → Capital
   • No → Revenue
2. Is the cash flow **inward** or **outward**?
   
   • Inward → Receipt
   • Outward → Expenditure

3. Typical Classification Examples

4. Effect on Profit of Incorrect Treatment

4.1 Error 1 – Capital Expenditure Charged as Revenue Expense

Correct treatment: Record the asset, then depreciate over its useful life.

Example: Equipment cost $10,000; useful life 5 years; straight‑line depreciation $2,000 per year.

One‑line comment template: “Profit is understated by $8,000 in year 1 because the whole cost was expensed instead of being depreciated.”

4.2 Error 2 – Revenue Expenditure Capitalised

Correct treatment: Expense the cost in the period incurred.

Example: Advertising cost $3,000 recorded as a fixed asset and depreciated over 3 years ($1,000 per year).

Asset‑valuation effect: The balance‑sheet asset is overstated by $3,000 until fully depreciated.

One‑line comment template: “Profit is overstated by $2,000 in year 1 because the advertising cost was capitalised rather than expensed.”

4.3 Error 3 – Capital Receipt (Loan) Treated as Revenue

Correct treatment: Record as a liability; no impact on profit.

Example: Loan of $15,000 mistakenly entered as “Sales Revenue”.

One‑line comment template: “Profit is overstated by $15,000 because the loan proceeds were recorded as revenue rather than as a liability.”

5. Effect on Asset Valuation of Incorrect Classification

6. Practical Examination Steps (AO2)

1. Read the transaction description carefully.
2. Apply the **Classification Checklist** (section 2) and write “Capital/Revenue” and “Receipt/Expenditure”.
3. Record the appropriate journal entry using the formats in section 3.
4. If you suspect a mis‑classification:
   • Adjust the expense/depreciation amount (or liability/equity).
   • Re‑calculate profit for the current year.
   • Show the difference and write a one‑line comment (see templates above).
   • State any effect on the balance‑sheet (asset, liability or equity).
5. Conclude with a concise statement of the overall impact on profit and on the financial position.

7. Common Pitfalls (AO3)

• Confusing large one‑off repairs with improvements – only improvements that **extend life** or **increase capacity** are capitalised.
• Treating interest on a loan as a capital receipt – interest is a revenue expense.
• Including proceeds from the sale of an asset in turnover – it is a capital receipt; only the gain/loss affects profit.
• Recording borrowing as sales revenue – inflates profit and hides a liability.
• Capitalising advertising, research or staff training costs – these are revenue expenses.

8. Suggested Diagram

9. Key Take‑away

Correct classification of capital and revenue items determines both the profit reported for the period and the accuracy of the balance sheet. Mis‑treatment can under‑ or over‑state profit, distort asset values, or hide liabilities, leading to wrong decisions by managers, investors, and examiners.