BAM6008 Financial Reporting for Management Lecture 5: Capital and Revenue

Expenditure

Lecture 5 – Capital and Revenue Expenditure

Introduction
Whenever a company incurs expenditure, it is classified as either ‘capital’ expenditure, or else treated as an
expense (also known as ‘revenue’ expenditure).
The distinction is important, as it directly impacts on how much profit a business reports, and the value of
its assets. This can influence the perceived financial status of the company, so the correct treatment of
expenditure is vital if financial results are to be meaningful.
This session will start by looking at capital expenditure, and will also illustrate how depreciation works. It will
then consider revenue expenditure, and finally illustrate why the distinction between the two is important.

Lecture 5. learning objectives

After completing this session you should be able to:
6.1 Give examples of capital expenditure, and explain the implications of categorising an item as capital.
6.2 Give examples of expense items, and explain the implications of categorising an item as an expense.
6.3 Describe the difference between capital and expense items, and why the difference is important.

Capital expenditure and the impact of depreciation

Capital expenditure essentially relates to longer-term investment. If expenditure is likely to be of benefit in
more than one accounting period, it should be classed as capital. There are, though, other likely attributes
of capital expenditure:
• It is likely to involve a large amount.
• Its benefits will be spread over more than one year.
• It is likely to be linked to an organisation’s longer-term goals.

Investment is necessity if a company wants to grow, and if the existing assets base is not replaced or
enhanced, growth is unlikely to be achievable.

An important financial term to be aware of at this stage is ‘fixed asset’. The word ‘asset’ in a financial
context describes something that a company owns. A ‘fixed asset’ is something that a company owns, and
is using, on a long-term basis. ‘Long-term’ is usually understood to mean more than one year.

It is also worth pointing out at that companies preparing their accounts under IFRS will use the term ‘non-
current asset’ instead of ‘fixed asset’. ‘Whatever the term used, however, fixed assets can be found in a
company’s balance sheet.

In summary, money spent on acquiring new fixed assets, or enhancing existing ones, is classed as capital
expenditure.

All other expenditure is money spent on items from which no ongoing longer-term value is derived. This is
classed as revenue expenditure, or simply termed as ‘expensed’ items.
The distinction is crucially important when it comes to working out how much profit has been achieved.

If an item is treated as revenue, or ‘expensed’ as it is sometimes referred, then it is charged against profits
at the time the expenditure is incurred.

If, however, the item in question is being treated as capital expenditure, then the expenditure will not be
deducted from profits in the year it is incurred — or at least not all of it. The cost will be spread over the
expected life of the asset using depreciation. This spreading of the expenditure is known as depreciation,
and is a measure of the loss in value of an asset due to use, the passage of time or obsolescence.

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Different types of depreciation

There are several different types of depreciation. The two most commonly used are:
• straight-line depreciation
• reducing balance depreciation.

For straight-line depreciation, a company must decide what the expected useful life of the asset will be, and
what it is likely to be worth at the end of that useful life.
For example, a company might acquire some equipment for £235,000. The expected useful life of the
equipment is five years, after which time the company expects to be able to sell the asset for £55,000.

The annual depreciation charge over the next five years will be calculated as follows: -

Cost of asset £235,000

Less: Residual value £55,000
Depreciable amount £180,000

Expected useful life 5 years

Annual depreciation charge = £180,000/5 = £36,000

An amount of £36,000 will therefore be recorded as an expense each year

for the next five years, and will therefore reduce the reported profit by the
same amount. Additionally, the asset value shown on the balance sheet will
reduce by the same amount:
• balance sheet value at purchase £235,000
• balance sheet value after 1 year £199,000
• balance sheet value after 2 years £163,000 and so on.

The main alternative to the above method is known as ‘reducing balance’ depreciation. Here, we also start
with the capital cost of £235,000, but we do not need to concern ourselves with any estimate of a residual
value. Instead, we reduce the asset value by a certain percentage each year. Let us say, for this example,
that a reducing balance charge of 25% is appropriate:

Cost of asset 235,000

Year 1 depreciation (235,000 x 25%) 58,750
Net book value (NBV) after 1 year 176,250

Year 2 NBV 176,250

Year 2 depreciation (176,250 x 25%) 44,063
Net book value after 2 years 132,188

Year 3 NBV 132,188

Year 3 depreciation 33,047
Net book value after 3 years 99,141

Year 4 NBV 99,141

Year 4 depreciation 24,785
Net book value after 4 years 74,355

Year 5 NBV 74,355

Year 5 depreciation 18,589
Net book value after 5 years 55,767

You will see that a different amount of depreciation is charged each year, and that it is more heavily loaded
towards the earlier years. This may be particularly logical if a company gets more use out of an asset in its
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earlier years of use a common scenario. The first year’s depreciation is £58,750, but by year 5 the charge
has fallen to under £20,000.

There are no actual rules for depreciation, and what a company’s depreciation policy should be. There is a
need, however, for a company’s accounts to be independently audited. The auditor must sign off the
accounts on the basis that they represent a ‘true and fair view’ of the company — and clearly an unrealistic
depreciation policy would undermine such a view.

Expense items and their impact on profitability.

We have so far concentrated on capital items, and the way they are treated. Expense items are a lot more
straightforward, in that their costs are deducted from the profit and loss account at the time they are
incurred

Revenue Expenditure (Expense) Capital Expenditure

Definition Spending on assets that are used up Spending (acquiring or improving) on

or consumed within the financial year assets being used on a long term
basis

Examples Buying materials Buying equipment

Hiring a car Buying a car

Effect on Included in the P&L in the period Vlaue of the asset shown in the
Financial balance sheet at cost less
Statements depreciation. Depreciation of asset
included in the P&L

Potential Unless controlled can have a direct Profits only impacted via depreciation
impact on bearing on profitability
Profit

Examples of areas where the capital v revenue distinction can be a little blurred include:

Finance costs
Finance costs can be capitalised where the interest can be specifically linked to a project that is expected
to generate revenue in the future. The interest costs involved, for example, while constructing an asset
such as a major building can be included in the capital cost of the asset, and then depreciated once the
building is completed (even if it is not yet operational).

R&D
The rules on the treatment of research and development expenditure are quite rigid. While many would
naturally view R&D expenditure as an investment, it can only be classified as such in certain clearly defined
circumstances.
Broadly speaking, all research costs must be expensed. Development costs can be capitalised (treated as
a fixed asset) but only if certain criteria have been met. These are:

• There is a clearly defined project.

• The project expenditure is separately identifiable.
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• There is reasonable certainty about the project’s feasibility and viability.

• Revenues earned from the project will exceed its costs.
• Resources are in place to enable the project to be completed.
All the above criteria must be met for the expenditure to be treated as capital.

Leasing
With leases, it depends on the nature of the lease. Accountants will classify a lease as one of the following:

• finance lease
• operating lease.

A finance lease is one where the lessee has use of the asset for most of its life, and therefore bears the
risks and enjoys the benefits of the asset as if they owned it. An operating lease tends to be shorter term,
and would describe a situation where an asset would be leased by different lessees over a period of years.
Accounting for leases is quite complex, but a finance lease is treated as if it were a capital asset, whereas
an operating lease is effectively treated as an expense.

Marketing/advertising
One might argue that certain marketing and advertising initiatives should be deemed investment. For
example, money spent on advertising to create brand awareness might logically fit the investment
description. However, under current UK and international accounting regimes, such expenditure should not
be treated in this way — or at least not in the first instance. If subsequently either a brand, or a company
that has invested in such brands, gets sold, then an intangible fixed asset may be created and its value
then depreciated.

Why the difference between capital and revenue is important?

We have so far looked at the difference between capital and expense items, considered how they are
treated, and explored some areas where appropriate classification can be difficult.

It would be useful here to demonstrate, using some figures, exactly why the distinction is important.
To take the example used in above a stage further, let us consider the impact on profitability if the £235,000
expenditure was treated as ‘capital’ but also if it was treated as revenue. Let us assume that the company,
before accounting for this £235,000 investment, made annual profits shown in the table below

Year 1 Year 2 Year 3 Year 4 Year 5

Profit before £235,000 purchase 100,000 120,000 140,000 160,000 180,000

the £235K item as capital, and used the straight-

How would the profit position look if the Co treated
line method as illustrated above, with annual depreciation of £36,000?

Year 1 Year 2 Year 3 Year 4 Year 5

Profit before £235,000 purchase 100,000 120,000 140,000 160,000 180,000
Depreciation (36,000) (36,000) (36,000) (36,000) (36,000)
Net profit 64,000 84,000 104,000 124,000 144,000

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This shows the profits reduced by the additional annual depreciation charge, but still showing a gradual
improvement over the five-year period. If, however, the item had been treated as revenue, the profit stream
would look very different

Year 1 Year 2 Year 3 Year 4 Year 5

Profit before £235,000 purchase 100,000 120,000 140,000 160,000 180,000
Additional revenue expenditure 235,000) 0 0 0 0
Net profit (135,000) 120,000 140,000 160,000 180,000

One aspect of the capital v expense topic that we have not considered yet is taxation. In the UK tax is levied
on profits that companies make. It might therefore seem possible for a company, by choosing the way it
treats its expenditure to manipulate its profits and therefore its tax bill. It is important to note, therefore, that
depreciation is not itself a tax-deductible expense. The amount of depreciation charged, therefore, will not
affect the company’s tax bill. Instead, the tax authorities will apply their own rules for the acquisition of
assets and grant a company what are called tax allowances. This means that the company can offset the
cost of fixed assets against their tax bill, but can only do so using the rules provided by the Inland Revenue.

Summary
This session has outlined the important distinction between capital and revenue expenditure. It has looked
at the criteria that are used to determine whether an item should be capitalised or expensed, and has
summarised the different depreciation treatments that can be applied to capital items, and the resulting
impact on profitability.

Lecture 5 - Exercise

1. A company buys new equipment costing £500,000

Use the table below to calculate the annual depreciation and the balance sheet value at
the end of the year for the next four years using straight-line depreciation. The equipment
has an expected life of 4 years and a residual value of £120,000.

Recalculate the figures using the reducing balance method using a rate of 30%

Opening Depreciation Closing

Balance £ to be deducted from Profit £ Balance £

Year 1
Year 2
Year 3
Year 4

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BAM6008 Financial Reporting for Management Lecture 5: Capital and Revenue
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2. Identify whether the following items should be treated as capital expenditure or

expensed as revenue expenditure.

Leasing of IT equipment over a four-year period – capital / expense

Building a new power station – capital / expense

Interest on money to finance the power station above – capital / expense

Repair to capital equipment – capital / expense

The cost of training staff on a newly acquired item of plant – capital / expense

Refurbishment of the head office reception area – capital / expense