distinguish between and account for capital receipts and revenue receipts

4.1 Capital and Revenue Expenditure and Receipts

Learning Objective

By the end of this section you will be able to:

• Distinguish between capital expenditure, revenue expenditure, capital receipts and revenue receipts (AO1).
• Explain how incorrect classification affects profit and asset values (AO1 + AO2).
• Record the appropriate journal entries for each type of transaction (AO1 + AO2).
• Explain depreciation and how a capital expense is turned into a revenue expense (AO1 + AO2).
• Identify financing activities as capital receipts and describe their effect on the balance sheet (AO1).
• Apply the classification flow‑chart to decide whether a cash flow is capital or revenue (AO2).

Quick‑Check Table – Syllabus Terminology

Key Definitions

• Capital Expenditure: Expenditure that creates, acquires or enhances a non‑current asset, or extends its useful life. It is recorded on the balance sheet and depreciated (or amortised) over the asset’s useful life.
• Revenue Expenditure: Expenditure 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: Inflow of cash that relates to financing activities (share issue, loan) or to the disposal of a non‑current asset. It does not form part of profit.
• Revenue Receipt: Inflow of cash from the core operating activities of the business (sales, interest, rent, fees). It is recognised as revenue in the profit‑and‑loss account.

Comparison – Expenditure

Comparison – Receipts

Effect of Mis‑classification – Numeric Illustration

Assume a business purchases a computer for $5 000.

• If recorded **correctly** as capital expenditure:
  • Balance sheet: Computer (asset) $5 000.
  • Profit for the year: No effect (depreciation will be charged later).
• If mistakenly recorded as revenue expenditure:
  • Profit for the year is reduced by $5 000 (expense recognised immediately).
  • Balance sheet: No computer asset shown – asset value is understated by $5 000.

The same logic applies in reverse for receipts: treating a bank loan (capital receipt) as revenue would over‑state profit and equity.

Classification Flow‑Chart

1. Is the cash flow related to the acquisition or disposal of a non‑current asset?
   • Yes → Capital receipt (or capital expenditure if cash is flowing out).
   • No → Go to step 2.
2. Is the cash flow a financing activity (share issue, loan, capital contribution)?
   • Yes → Capital receipt.
   • No → Go to step 3.
3. Is the cash flow generated from the core operating activities of the business (sales, interest, rent, fees)?
   • Yes → Revenue receipt.
   • No → Re‑examine; it may be a non‑operating income (e.g., dividend) which is still treated as revenue.

Worked‑through Example – Bank Loan

Transaction: The business receives a $10 000 bank loan.

1. Step 1 – Not related to a non‑current asset → continue.
2. Step 2 – It is a financing activity (borrowed money) → Capital receipt.
3. Step 3 – Not needed.

Result: Record as a capital receipt; it increases a liability (Loans Payable) and does not affect profit.

Financing Activities – Why They Are Capital Receipts

Financing activities are transactions that raise or repay capital for the business. According to the Cambridge syllabus they “increase equity or liabilities, not profit”. Therefore:

• Issue of share capital → increases Share Capital (equity).
• Bank loan received → increases Loans Payable (liability).
• Both are capital receipts because they do not arise from the ordinary trading operations and are excluded from the profit‑and‑loss account.

Depreciation – Turning a Capital Expense into Revenue Expense

When a capital asset is purchased, its cost is allocated over its useful life. Two methods are required by the syllabus:

1. Straight‑Line Method (SL)

Depreciation per period = (Cost – Residual value) ÷ Useful life

2. Reducing‑Balance Method (RB)

Depreciation per period = Book value at start of period × Depreciation rate

The rate is usually given in the exam question; if not, it can be derived from the useful life (e.g., 20 % for a 5‑year asset).

Step‑by‑Step Illustration (Straight‑Line)

1. Purchase entry (capital expenditure)

   Debit   Delivery Van ........ $25 000
   Credit  Bank ................. $25 000

2. First‑year depreciation (revenue expense)

   Depreciation per year = (25 000 – 5 000) ÷ 5 = $4 000

   Debit   Depreciation Expense – Van .... $4 000
   Credit  Accumulated Depreciation – Van . $4 000

3. Impact on the profit‑and‑loss account – the $4 000 appears as an expense, reducing profit for the year.
4. Balance‑sheet after year 1 – Net book value of the van = $25 000 – $4 000 = $21 000.

Journal Entries

Capital Expenditure

Debit   [Asset account] .......... Amount
Credit  Bank (or Creditor) ....... Amount

Revenue Expenditure

Debit   Expense account .......... Amount
Credit  Bank (or Creditor) ....... Amount

Capital Receipts

• Sale of a non‑current asset (capital receipt)

  Debit   Bank ........................................ $8 000
  Debit   Accumulated Depreciation – Machinery ....... $4 000
  Credit  Machinery (cost) ........................... $10 000
  Credit  Gain on Sale of Machinery (if any) ........ $2 000
  *If there is a loss, debit “Loss on Sale” instead of crediting a gain.*

• Issue of share capital

  Debit   Bank ................................. $10 000
  Credit  Share Capital – Ordinary .............. $10 000

• Bank loan received (capital receipt)

  Debit   Bank ................................. $10 000
  Credit  Loans Payable .......................... $10 000

Revenue Receipts

• Cash sale

  Debit   Bank ................................. $5 000
  Credit  Sales Revenue ......................... $5 000

• Credit sale

  Debit   Debtors .............................. $5 000
  Credit  Sales Revenue ......................... $5 000

• Interest received

  Debit   Bank ................................. $200
  Credit  Interest Income ........................ $200

• Rent received

  Debit   Bank ................................. $3 000
  Credit  Rent Income ............................ $3 000

Common Errors & Their Impact (Expanded)

Key Points to Remember

• Capital items appear on the balance sheet; revenue items affect the profit‑and‑loss account.
• Only revenue receipts are included in the calculation of profit for the period.
• Depreciation spreads the cost of a capital asset over its useful life, converting a capital expense into a series of revenue expenses.
• When a capital asset is sold, the difference between the sale proceeds and the net book value (cost less accumulated depreciation) is recorded as a gain or loss in the profit‑and‑loss account.
• Financing activities (share issues, loans) generate capital receipts; they increase equity or liabilities, not profit.
• Use the flow‑chart to decide the classification; practice with worked examples.

Practice Questions

1. Classify and explain why each of the following is capital or revenue expenditure:
   • Purchase of a computer for $1 200.
   • Annual software subscription of $300.
2. Record the journal entry for the receipt of $5 000 from a bank loan.
3. A piece of equipment costing $15 000 with accumulated depreciation of $9 000 is sold for $7 000. Prepare the journal entry and state the profit or loss on disposal.
4. Prepare the annual depreciation entry for a delivery van that cost $25 000, has a residual value of $5 000 and a useful life of 5 years (straight‑line).
5. Using the flow‑chart, classify the following cash flow and write the appropriate journal entry: “Received $2 000 interest on a bank deposit.”

Summary

Accurate classification of capital versus revenue items is the foundation of reliable financial reporting. Capital expenditures and receipts affect the balance sheet and are recognised over time (through depreciation or as financing). Revenue expenditures and receipts flow directly through the profit‑and‑loss account, determining the period’s profit. Mis‑classification distorts profit, asset values, and equity, which is why the Cambridge IGCSE exam tests both knowledge (AO1) and application (AO2) of these concepts. Master the definitions, the flow‑chart, and the journal‑entry formats, and you will be well‑prepared for the assessment.