Small Business Finance

Although the definitions of capital and revenue expenditure provide a clear basis for distinguishing between them, it is always useful to use examples to understand fully how the definitions translate in reality. Capital expenditure is basically expenditure on the acquisition or improvement of a non-current asset. Revenue expenditure is that on the acquisition of tradable assets or mere maintenance of the earning capacity of a non-current asset.

== Acquisitions and costs associated with acquisition ==

Both forms of expenditure can result in the acquisition of assets, but for different purposes. Examples of capital acquisitions include the purchase of an office building and the purchase of a vehicle for business use. However, in acquiring a capital asset, certain costs are incurred, such as carriage inwards, installation costs, import duties and valuator fees. Those costs are included as part of the acquisition cost and form part of capital expenditure as well.

Revenue expenditure acquisitions involve those of trade able assets or assets that can be fully utilized within one accounting period. As a result, the purchase of trade able goods or raw materials is an expense to be written off in the period. Recurring expenditure, such as stationary, also form part of revenue expenditure since these costs are minor and the assets require frequent replenishing or replacement. In addition, an entity might acquire a vehicle or building, but pays rent for it. Such expenditure is of the revenue genre since it is consumed fully utilized in the period.

== Improvement or maintenance ==

The distinction between revenue and capital expenditure is also the distinction between improving and maintaining a non-current asset. Let us use a movie theatre for this example. Assume that the movie theatre is merely repairing old seats and re-upholstering, without increasing the seating capacity of the movie theatre.

Although the benefit of that change would extend to several accounting periods, it is not capital expenditure. This is because repairing the seats does not necessarily improve the earning capacity of the movie theatre. However, if the theatre added more seats, it is improving its asset-not merely maintaining it. In addition, if the movie theatre replaces the old seats with new ones, it can consider this capital expenditure.

== Other examples of the forms of expenditure ==

Depreciation of non-current assets: Revenue Exp.

Insurance, salaries and regular maintenance: Revenue Exp.

Major repairs of a fixed asset that increases its productivity: Capital Exp.

Transport costs for trade able assets: Revenue Exp.

Transport and installation costs for non-current assets: Capital Exp.

The examples of capital and revenue expenditure are by no means exhaustive. What is important is that an entity classifies its expenditure correctly, according to the business context, and consistently, according to prior classifications.

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Within accounting, it is common knowledge that different methods of arriving at a result or outcome exist. Asset valuation, which is critical in financial accounting, is not always straightforward. Asset values change yearly, due to depreciation and appreciation, and the nature of assets (current versus non-current) make asset valuation methods significant.

Four basic methods of valuation of assets in financial statement include:

i) Historical cost

ii) Replacement cost

iii) Net realisable value

iv) Economic value

Historical cost is the most common valuation of assets in financial statements. This is because historical cost is provable and known. As its name suggests, historical cost recorded cost of an asset when the cost was incurred. In other words, the amount that an entity pays for an asset represents the historical cost. If, for example, you purchased an item for $10,000.00, then it would be valued at its cost. Although financial accountants find “costs” a more objective index than asset values, asset valuations are important for fairly presenting the position of a business.

The use of historical cost can be problematic in periods of high inflation. It can lead to the position of the business not being fairly presented if the asset has a lower valuation than its current cost. This is because historical cost does not recognize unrealised holding gains of a non-current asset (like property). The historical cost convention is generally used, except where it conflicts with other fundamental accounting concepts, such as prudence.

The replacement cost of an asset values the asset at the amount needed to replace it with an identical asset. For example, if you bought a mobile phone for $400.00 two years ago, but the current cost of replacement is $200.00, a replacement cost values the mobile phone at $200.00, whereas the historical cost convention would use the $400.00 valuation. If an entity is valuing an asset for insurance purposes, it might have to choose between replacement cost and actual cash value. The actual cash value refers to the fair market value of the asset in its current condition.

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