distinguish between and account for capital expenditure and revenue expenditure

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Topic 4.1 – Capital and Revenue Expenditure and Receipts

Learning Objectives (AO)

  • AO1: Distinguish between capital and revenue expenditure, and between capital and revenue receipts.
  • AO2: Record the appropriate journal entries for each type of outlay or receipt.
  • AO3: Explain the impact of each transaction on profit and on the balance sheet.

Key Definitions (AO1)

  • Capital Expenditure (CapEx) – An outlay that creates a new non‑current asset or enhances an existing one, providing economic benefits for more than one accounting period.
  • Revenue Expenditure (RevEx) – An outlay incurred in the normal course of business and wholly consumed within the current accounting period.
  • Capital Receipt – Money received that relates to the acquisition or disposal of non‑current assets, the issue of share capital, or the receipt of a loan. (Only the gain or loss on disposal of an asset affects profit; the receipt itself does not.)
  • Revenue Receipt – Money received from ordinary trading activities such as sales, interest, rent, commissions, or donations/grants to a non‑trading entity.

Comparison of Capital and Revenue Expenditure (AO1)

Aspect Capital Expenditure Revenue Expenditure
Purpose Acquire or improve a non‑current asset Maintain or run the business in the current period
Benefit period More than one accounting period Within the current accounting period
Accounting treatment Added to the asset’s cost on the balance sheet; depreciated over its useful life Charged to the profit‑and‑loss account immediately
Effect on profit No immediate effect; profit is affected later through depreciation (or gain/loss on disposal) Reduces profit in the period incurred
Typical examples Purchase of machinery, building extensions, major overhaul that extends life, legal fees to acquire a patent Wages, utilities, routine repairs, advertising, consumables, insurance paid in advance (pre‑payment)

Comparison of Capital and Revenue Receipts (AO1)

Receipt type Typical source Accounting treatment Effect on profit
Capital receipt
  • Sale of a non‑current asset
  • Issue of share capital (e.g., £5 000 ordinary shares)
  • Loan received from a bank
  • Grant or donation to a club (non‑trading entity) – recorded as a capital receipt when it is used to acquire a non‑current asset
 Recorded on the balance sheet (cash + corresponding liability or equity). Any gain or loss on disposal of an asset is recognised in the profit‑and‑loss account, not the receipt itself. No direct effect on profit, except for the gain/loss on disposal of an asset.
Revenue receipt Sales revenue, interest received, rent received, commission earned, donation to a club that is used for day‑to‑day running Recorded in the profit‑and‑loss account as income. Increases profit.

When a Repair or Maintenance Cost Should Be Capitalised (AO2)

A repair is treated as capital expenditure when it meets **any** of the following criteria:

  • It substantially increases the future economic benefits of the asset.
  • It extends the useful life of the asset.
  • It results in a material increase in the asset’s carrying amount (materiality is judged relative to the asset’s cost – typically < 5 % of the asset’s cost).

Otherwise the cost is revenue expenditure.

Depreciation Methods (AO1)

Straight‑line:
Depreciation = (Cost – Residual value) ÷ Useful life.

Reducing‑balance:
Depreciation = Carrying amount at start of year × Depreciation rate (the rate is chosen so that the asset is fully written‑off by the end of its useful life).
(Used when the asset’s economic benefits are higher in early years.)

Journal Entries (AO2)

Capital Expenditure

  1. Purchase of a non‑current asset 
    Dr. Asset (e.g., Machinery)          XXX
   Cr. Bank / Creditors               XXX
  2. Depreciation – Straight‑line 
    Dr. Depreciation Expense             XXX
   Cr. Accumulated Depreciation – Asset   XXX
  3. Depreciation – Reducing‑balance 
    Dr. Depreciation Expense             XXX
   Cr. Accumulated Depreciation – Asset   XXX
    (XXX = Opening carrying amount × rate)
  4. Disposal of a non‑current asset (capital receipt) 
    Dr. Bank / Cash                       Sale proceeds
Dr. Accumulated Depreciation          XXX
   Cr. Asset (original cost)          XXX
   Cr. Gain on Disposal*              XXX   (if sale price > carrying amount)
   Dr. Loss on Disposal*              XXX   (if sale price < carrying amount)
    *Gain or loss is recognised in the profit‑and‑loss account; the receipt itself is a capital receipt.
  5. Issue of share capital (capital receipt) 
    Dr. Bank                              £5 000
   Cr. Share Capital                  £5 000
  6. Receipt of a loan (capital receipt) 
    Dr. Bank                              £10 000
   Cr. Loan Payable (Liability)       £10 000

Revenue Expenditure

  1. Utility bill paid 
    Dr. Utilities Expense                 XXX
   Cr. Bank                           XXX
  2. Routine repair of equipment 
    Dr. Repairs & Maintenance Expense     XXX
   Cr. Bank / Creditors               XXX
  3. Pre‑paid expense (e.g., 12‑month insurance) 
    Dr. Prepaid Insurance                 XXX
   Cr. Bank                           XXX
    (Each month: Dr. Insurance Expense / Cr. Prepaid Insurance)
  4. Accrued expense (e.g., wages earned but not yet paid) 
    Dr. Wages Expense                     XXX
   Cr. Accrued Wages Payable          XXX
    (When paid: Dr. Accrued Wages Payable / Cr. Bank)

Sample Problem (AO2 & AO3)

A company purchases a delivery van for £30 000 on 1 January. At the end of the first year it spends £2 000 on a full engine overhaul that extends the van’s useful life by three years. The company uses the straight‑line method and estimates the van’s original useful life as 5 years with no residual value.

  1. Classify the £30 000 purchase – capital or revenue?
  2. Classify the £2 000 overhaul – capital or revenue?
  3. Prepare the journal entry for the purchase.
  4. Prepare the journal entry for the overhaul.
  5. Calculate the depreciation expense for the first year (straight‑line).
  6. Explain how the classification of the overhaul influences (a) profit for the first year and (b) the carrying amount of the van at year‑end.

Answers

  1. The £30 000 purchase is capital expenditure.
  2. The £2 000 overhaul is capital expenditure because it extends the van’s useful life.
  3. Purchase entry: 
    Dr. Delivery Van                     £30 000
   Cr. Bank                          £30 000
  4. Overhaul entry: 
    Dr. Delivery Van                     £2 000
   Cr. Bank                          £2 000
  5. Re‑calculated useful life = 5 years + 3 years = 8 years.
    Total depreciable amount = £30 000 + £2 000 = £32 000.
    Depreciation per year (straight‑line) = £32 000 ÷ 8 = £4 000.
    Depreciation expense for the first year = £4 000.

  6. (a) Profit impact: Because the overhaul is capitalised, the £2 000 cost is not deducted from profit in the year incurred. Only the depreciation charge (£4 000) reduces profit, spreading the cost over the extended 8‑year life.

    (b) Carrying amount: At 31 December the van’s carrying amount is:

    Cost (including overhaul)          £32 000
Less: Depreciation (year 1)        £4 000
Carrying amount at year‑end        £28 000

    If the overhaul had been treated as revenue expenditure, profit would have been lower by £2 000 and the carrying amount would have been £30 000 – £4 000 = £26 000.

Key Points to Remember (AO1 & AO3)

  • Apply the matching principle: costs are matched with the periods that benefit from them.
  • Capital expenditure is added to the cost of an asset and depreciated; revenue expenditure is expensed immediately.
  • Capital receipts increase assets or equity/liabilities; only the gain or loss on disposal of an asset affects profit.
  • When deciding whether a repair is capitalised, consider:
    • Future economic benefit
    • Extension of useful life
    • Material increase in carrying amount (generally ≥ 5 % of the asset’s cost)
  • Depreciation methods required by the syllabus:
    • Straight‑line – most common.
    • Reducing‑balance – used when the asset’s benefits are higher in early years.
  • Pre‑payments and accruals are part of revenue‑type adjustments and must be recorded to give a true picture of profit for the period.
  • Loans and share issues are capital receipts; they affect the balance sheet but not profit (except for any associated interest expense).
  • Grants or donations to clubs that are used to purchase a non‑current asset are treated as capital receipts.

Decision Flowchart – Capital vs. Revenue Expenditure (AO2)

Flowchart showing the decision process for classifying an outlay as capital or revenue expenditure
Start with the outlay → Does it create or enhance a non‑current asset? → Yes → Is the benefit expected to last more than one period and is the cost material (≥ 5 % of asset cost)? → Yes = Capital Expenditure (add to asset, depreciate).
No → Revenue Expenditure (expense immediately). Apply the matching principle throughout.

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