Capital and revenue items, and valuing inventory

Last time

Before we start: last time, in Depreciation, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Is it an asset or an expense?

A business buys a delivery van, and then buys fuel for it. The van will be used for years; the fuel is used up this month. Treating them differently is essential for a true profit. This lesson covers capital and revenue items, and how to value closing inventory.

Capital expenditure

Capital expenditure is spending on buying or improving non-current assets, which will be used for more than one year. It includes the cost of the asset plus costs to get it ready: delivery, installation and legal fees. It goes to the statement of financial position, not the income statement.

Revenue expenditure

Revenue expenditure is spending on running the business day to day: wages, rent, fuel, repairs and insurance. It is charged as an expense in the income statement of the year it relates to. Repairs keep an asset working; improvements make it better. Repairs are revenue, improvements are capital.

Capital and revenue receipts

Capital receipts come from selling non-current assets, or from the owner putting in more capital, or from loans. Revenue receipts come from normal trading: sales, rent received, commission received. Only revenue receipts are income in the income statement.

Why the difference matters

If capital expenditure is wrongly treated as revenue, expenses are too high, so profit is understated and assets are understated. If revenue expenditure is wrongly treated as capital, profit is overstated and assets are overstated. So the distinction is needed for a true and fair view of profit and of the business's value.

Sort them

Here are common items sorted.

Valuing inventory

Closing inventory is valued at the lower of cost and net realisable value. Net realisable value is the price it can be sold for, minus any costs to make it saleable, such as repairs. This follows the prudence concept: never value assets above what they are worth.

Worked: damaged inventory

A shop has 20 handbags that cost 15 dollars each: 300 dollars at cost. They are damaged and can now be sold for only 13 dollars each: 260 dollars net realisable value. The lower figure, 260 dollars, is used. Inventory falls by 40, so gross profit falls by 40.

Inventory and profit

Closing inventory is subtracted in cost of sales. A lower closing inventory means a higher cost of sales and a lower gross profit. An overvalued closing inventory overstates profit this year, and understates it next year, when it becomes opening inventory. So inventory must be counted and valued carefully at the year end.

Including damaged items

A question asked about including damaged inventory at a reduced value. Reducing the value lowers closing inventory. So cost of sales rises and gross profit falls. It is correct, though, because of prudence: the inventory is shown at what it can really be sold for.

Mistakes that lose marks

Mistake one: treating a repair as capital expenditure. Mistake two: valuing inventory at selling price when that is higher than cost. Mistake three: getting the profit effect of an inventory change backwards. The fix: lasting benefit means capital; lower of cost and NRV; lower inventory means lower profit.

The full-marks tip

The full-marks tip: ask whether the spending gives benefit for more than a year: if so, it is capital. Value inventory at the lower of cost and net realisable value, and show the working.

On one card

So, on one card: capital, revenue and inventory. Keep it for revision.