What happens if there is an incorrect treatment of expenditure and how will this affect the
accounts of a business?
I’m Thomas Harwood and Welcome to The Accounting Student, where we create free and short videos
so that you can learn about accounting.
Today’s video is looking at the consequences of incorrect treatment of revenue and capital
expenditure.
To start with, expenditure can be referred to as a payment or agreement which in return
a benefit, asset or service will be received.
Expenditure can range from anything from water and electricity bills to the purchase of a
new car.
As there is such a variety of expenditure, it is useful for a business to categorise
them into particular groups as these will be treated differently in the accounts.
In accounting, expenditure can be distinguished into two main types. And they are known as
capital expenditure and revenue expenditure.
Capital expenditure is recognisable when a business spends money on fixed assets, additions
to a fixed asset or to get a fixed asset in a position to be ready to be used.
Additionally, capital expenditure has no relation with the owner’s capital account. As capital
relates to the owners and the owners only and capital expenditure relates solely to
the business.
On the other hand, Revenue expenditure is recognisable when the expense is incurred
in running the business on a day to day basis.
It is extremely important that there is a correct distinction between capital and revenue
expenditure as this is essential to determine an accurate and fair value for the profits
and assets of a business.
In the accounts, any expenses relating to capital expenditure will result in increased
figures for the fixed assets in the balance sheet and revenue expenditure is chargeable
to the profit and loss account.
If there was a scenario whereby the classification of expenditure was incorrect, then this will
adversely affect the profits reported as well as the value of the assets and capital in
the financial statements.
Let’s have a look at an example, to show the consequences of incorrect treatment of
revenue and capital expenditure and how this will have an effect on the accounts.
Harry owns a factory producing children’s toys. He has
some machinery in his factory which each manufacture different types of toys.
One of the machines is due for improvements. Harry called the engineer in to improve the
speed in which the machine produces the toys.
In the end, Harry had to pay £4,000 which included £2,500 for the improvements of the
machine to increase the production time and also £1,500 for unexpected repairs for the
machine.
Harry decided that the whole £4,000 is capital expenditure as the £4,000 is being spent
on the fixed asset. Therefore, the value for machinery has increased by £4,000 in the
balance sheet and as a consequence the financial statements look to be in a stronger position
compared to the position before improvement works.
Unfortunately, Harry has incorrectly treated the whole £4,000 as capital expenditure causing
the profits, machinery values and balance sheet position to be overvalued!
Instead, Harry should allocate the £2,500 relating to improvements as capital expenditure
because this is causing the machinery to contribute more productivity to the business and therefore
enhancing the value to the business.
And the other £1,500 for unexpected repairs should be allocated to revenue expenditure
as this is relates to the day to day operations of the machine in the business.
So in the accounts, the correct accounting treatment will be £2,500 allocated in the
balance sheet in the existing total machinery account value. And the £1,500 will be allocated
to the profit and loss in the repairs account value.
The difference between Harry’s treatment and the correct accounting treatment is that
the balance sheet and machinery value for Harry was over stated by £1,500.
Instead this should have been allocated to the profit and loss account in the expenses
section in the repairs account causing the profit value to be £1,500 lower compared
to Harry’s profits amount which was overstated by the same amount.
So that was the explanation of the consequences of incorrect treatment of revenue and capital
expenditure. If you enjoyed it, press the like button.
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