Capital expenditure is expenditure which results in the acquisition of non-current assets.
Revenue expenditure is expenditure incurred for the purpose of the trade or to maintain non current assets. You need to be familiar with an important distinction, the distinction between capital and revenue expenditure.
Capital expenditure is expenditure which results in the acquisition of non-current assets, or an improvement in their earning capacity.
(a) Capital expenditure is not charged as an expense in the income statement, although a depreciation charge will usually be made to write off the capital expenditure gradually over time. Depreciation charges are expenses in the income statement.
(b) Capital expenditure on non-current assets results in the appearance of a non-current asset in the statement of financial position of the business.
Revenue expenditure is expenditure which is incurred for either of the following reasons.
(a) For the purpose of the trade of the business. This includes expenditure classified as selling and distribution expenses, administration expenses and finance charges.
(b) To maintain the existing earning capacity of non-current assets.
Revenue expenditure is charged to the income statement of a period, provided that it relates to the trading activity and sales of that particular period. For example, if a business buys ten steel bars for $200 ($20 each) and sells eight of them during an accounting period, it will have two steel bars left in inventory at the end of the period. The full $200 is revenue expenditure but only $160 is a cost of goods sold during the period. The remaining $40 (cost of two units) will be included in the statement of financial position in inventory, ie as a current asset valued at $40.
A business purchases a building for $30,000. It then adds an extension to the building at a cost of $10,000. The building needs to have a few broken windows mended, its floors polished and some missing roof tiles replaced. These cleaning and maintenance jobs cost $900.
In this example, the original purchase ($30,000) and the cost of the extension ($10,000) are capital expenditures, because they are incurred to acquire and then improve a non-current asset. The other costs of $900 are revenue expenditure, because these merely maintain the building and thus the 'earning capacity' of the building.
1.1 Capital income and revenue income
Capital income is the proceeds from the sale of non-trading assets (ie proceeds from the sale of non- current assets, including long-term investments). The profits (or losses) from the sale of non-current assets are included in the income statement of a business, for the accounting period in which the sale takes place. For instance, the business may sell vehicles or machinery which it no longer needs – the proceeds will be capital income.
Revenue income is income derived from the following sources. (a) The sale of trading assets, such as goods held in inventory (b) The provision of services
(c) Interest and dividends received from investments held by the business
1.2 Capital transactions
The categorisation of capital and revenue items given above does not mention raising additional capital from the owner(s) of the business, or raising and repaying loans.
(a) These transactions add to the cash assets of the business, thereby creating a corresponding liability (capital or loan).
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(b) When a loan is repaid, it reduces the liabilities (loan) and the assets (cash). None of these transactions would be reported through the income statement.
1.3 Why is the distinction between capital and revenue items
important?
Revenue expenditure results from the purchase of goods and services for one of the following reasons. (a) To be used fully in the accounting period in which they are purchased, and so be a cost or expense
in the income statement. OR
(b) To result in a current asset as at the end of the accounting period because the goods or services have not yet been consumed or made use of. The current asset would be shown in the statement of financial position and is not yet a cost or expense in the income statement.
For instance, inventory which is purchased for resale will either be sold during the period as per (a) or still be in inventory as per (b).
Capital expenditure results in the purchase or improvement of non-current assets, which are assets that will provide benefits to the business in more than one accounting period, and which are not acquired with a view to being resold in the normal course of trade. The cost of purchased non-current assets is not charged in full to the income statement of the period in which the purchase occurs. Instead, the non- current asset is gradually depreciated over a number of accounting periods.
Examples of non-current assets are computers for the office, delivery vans, factory machines. Since revenue items and capital items are accounted for in different ways, the correct and consistent calculation of profit for any accounting period depends on the correct and consistent classification of items as revenue or capital.
This may seem rather confusing at the moment, but things will become clearer in the next few chapters. You must get used to the terminology used as these words appear in the accounting standards
themselves, as we will see.
Question
Capital or revenueState whether each of the following items should be classified as 'capital' or 'revenue' expenditure or income for the purpose of preparing the income statement and the statement of financial position of the business.
(a) The purchase of a property (eg an office building) (b) The annual depreciation of such a property
(c) Solicitors' fees in connection with the purchase of such a property
(d) The costs of adding extra storage capacity to a mainframe computer used by the business (e) Computer repairs and maintenance costs
(f) Profit on the sale of an office building (g) Revenue from sales by credit card (h) The cost of new plant
(i) Customs duty charged on the plant when imported into the country
(j) The 'carriage' costs of transporting the new plant from the supplier's factory to the premises of the business purchasing the plant
(k) The cost of installing the new plant in the premises of the business (l) The wages of the machine operators
Answer
(a) Capital expenditure
(b) Depreciation of a non-current asset is a revenue expenditure.
(c) The legal fees associated with the purchase of a property may be added to the purchase price and classified as capital expenditure. The cost of the property in the statement of financial position of the business will then include the legal fees.
(d) Capital expenditure (enhancing an existing non-current asset) (e) Revenue expenditure
(f) Capital income (net of the costs of sale) (g) Revenue income
(h) Capital expenditure
(i) If customs duties are borne by the purchaser of the non-current asset, they may be added to the cost of the machinery and classified as capital expenditure.
(j) Similarly, if carriage costs are paid for by the purchaser of the non-current asset, they may be included in the cost of the non-current asset and classified as capital expenditure.
(k) Installation costs of a non-current asset are also added to the non-current asset's cost and classified as capital expenditure
(l) Revenue expenditure
Exam questions are highly likely on the distinction between capital and revenue expenditure.
2 Depreciation accounting
Thecost of a non-current asset, less its estimated residual value, is allocated fairly between accounting periods by means of depreciation. Depreciation is both:
x charged against profit; and
x deducted from the value of the non-current asset in the statement of financial position.
Where assets held by an enterprise have a limited useful life, it is necessary to apportion the value of an asset used in a period against the revenue it has helped to create. If an asset's life extends over more than one accounting period, it earns profits over more than one period. It is a non-current asset.Current assets, such as stock and cash, are continually being used and replaced. Non-current assets such as plant and vehicles are intended for long-term use in the business.
With the exception of land held on freehold or very long leasehold, every non-current asset eventually wears out over time. Machines, cars and other vehicles, fixtures and fittings, and even buildings do not last for ever. When a business acquires a non-current asset, it will have some idea about how long its useful life will be.
(a) To keep on using the non-current asset until it becomes completely worn out, useless, and worthless.
(b) To sell off the non-current asset at the end of its useful life, as a second-hand item or as scrap.
Since a non-current asset has a cost, a limited useful life, and its value eventually declines, it follows that a charge should be made in the income statement to reflect the use that is made of the asset by the
business. This charge is called depreciation.
Depreciation accounting is governed by IAS 16 Property, plant and equipment, which will be looked at in detail in Section 5 of this Chapter. However, this section will deal with some of the IAS 16 definitions of depreciation.
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Exam focus
point
x Depreciationis the allocation of the depreciable amount of an asset over its estimated useful life. Depreciation for the accounting period is charged to net profit or loss for the period either directly or indirectly.
x Depreciable assets are assets which:
– are expected to be used during more than one accounting period; – have a limited useful life; and
– are held by an enterprise for use in the production or supply of goods and service, for rental to others, or for administrative purposes.
x Useful life is either:
– the period over which a depreciable asset is expected to be used by the enterprise; or – the number of production or similar units expected to be obtained from the asset by the
enterprise.
x Depreciable amount of a depreciable asset is the historical cost or other amount substituted for historical cost in the financial statements, less the estimated residual value. (IAS 16)
An 'amount substituted for historical cost' will normally be a current market value after a revaluation has taken place.
2.1 Depreciation
IAS 16 requires the depreciable amount to be allocated on a systematic basis to each accounting period during the useful life of the asset.
One way of defining depreciation is to describe it as a means of spreading the cost of a non-current asset over its useful life, and so matching the cost against the full period during which it earns profits for the business. Depreciation charges are an example of the application of the accrual assumption to calculate profits.
There are situations where, over a period, an asset has increased in value, ie its current value is greater than the carrying value in the financial statements. You might think that in such situations it would not be necessary to depreciate the asset. The standard states, however, that this is irrelevant, and that
depreciation should still be charged to each accounting period, based on the depreciable amount, irrespective of a rise in value.
2.2 Useful life
The following factors should be considered when estimating the useful life of a depreciable asset. x Expected physical wear and tear
x Obsolescence
x Legal or other limitson the use of the assets
Once decided, the useful life should be reviewed periodically and depreciation rates adjusted for the current and future periods if expectations vary significantly from the original estimates. The effect of the change should be disclosed in the accounting period in which the change takes place.
The assessment of useful life requires judgementbased on previous experience with similar assets or classes of asset. When a completely new type of asset is acquired (ie through technological advancement or through use in producing a brand new product or service) it is still necessary to estimate useful life, even though the exercise will be much more difficult.
The standard also points out that the physical life of the asset might be longer than its useful life to the enterprise in question. One of the main factors to be taken into consideration is the physical wear and tearthe asset is likely to endure. This will depend on various circumstances, including the number of shifts for which the asset will be used, the enterprise's repair and maintenance programme and so in. Other factors to be considered include obsolescence (due to technological advances/improvements in
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production/reduction in demand for the product/service produced by the asset) and legal restrictions, eg length of a related lease.
2.3 Residual value
In most cases the residual value of an asset is likely to be immaterial. If it is likely to be of any significant value, that value must be estimated at the date of purchase or any subsequent revaluation. The amount of residual value should be estimated based on the current situation with other similar assets, used in the same way, which are now at the end of their useful lives. Any expected costs of disposal should be offset against the gross residual value.
(a) A non-current asset costing $20,000 which has an expected life of five years and an expected residual value of nil should be depreciated by $20,000, in total over the five year period. (b) A non-current asset costing $20,000 which has an expected life of five years and an expected
residual value of $3,000 should be depreciated by $17,000 in total over the five year period.
2.4 Depreciation methods
Consistency is important. The depreciation method selected should be applied consistently from period to period unless altered circumstances justify a change. When the method ischanged, the effect should be quantified and disclosed and the reason for the change should be stated.
Various methods of allocating depreciation to accounting periods are available, but whichever is chosen must be applied consistently(as required by IAS 1: see Chapter 3), to ensure comparability from period to period. Change of policy is not allowed simply because of the profitability situation of the enterprise. The various accepted methods of allocating depreciation and the relevant calculations and accounting treatments are discussed in the next section.
2.5 Disclosure
An accounting policy note should disclose the valuation bases used for determining the amounts at which depreciable assets are stated, along with the other accounting policies: see IAS 1.
IAS 16 also requires the following to be disclosed for each major class of depreciable asset. x Depreciation methods used
x Useful lives or the depreciation rates used x Total depreciation allocated for the period
x Gross amount of depreciable assets and the related accumulated depreciation
2.6 What is depreciation?
The need to depreciate non-current assets arises from the accrual assumption. If money is expended in purchasing an asset then the amount must at some time be charged against profits. If the asset is one which contributes to an enterprise's revenue over a number of accounting periods it would be
inappropriate to charge any single period (eg the period in which the asset was acquired) with the whole of the expenditure. Instead, some method must be found of spreading the cost of the asset over its useful economic life.
This view of depreciation as a process of allocation of the cost of an asset over several accounting periods is the view adopted by IAS 16. It is worth mentioning here two common misconceptions about the purpose and effects of depreciation.
(a) It is sometimes thought that the net book value (NBV) of an asset is equal to its net realisable value and that the object of charging depreciation is to reflect the fall in value of an asset over its life. This misconception is the basis of a common, but incorrect, argument which says that freehold properties (say) need not be depreciated in times when property values are rising. It is true that historical cost statements of financial position often give a misleading impression when a property's NBV is much below its market value, but in such a case it is open to a business to
incorporate a revaluation into its books, or even to prepare its accounts based on current costs. This is a separate problem from that of allocating the property's cost over successive accounting periods.
(b) Another misconception is that depreciation is provided so that an asset can be replaced at the end of its useful life. This is not the case.
(i) If there is no intention of replacing the asset, it could then be argued that there is no need to provide for any depreciation at all.
(ii) If prices are rising, the replacement cost of the asset will exceed the amount of depreciation provided.