Accounting equation and account types - Capital vs revenue e...

Learning Outcomes

After reading this article, you will be able to explain the accounting equation, classify account types, and distinguish between capital and revenue expenditure. You will learn how these concepts impact financial statements, identify common errors in classification, and apply correct double-entry bookkeeping for capital and revenue items—a frequent area of ACCA FA2 assessment.

ACCA Maintaining Financial Records (FA2) Syllabus

For ACCA Maintaining Financial Records (FA2), you are required to understand how business transactions affect the accounting equation and how to correctly classify and record capital and revenue expenditure. Specifically, ensure you can:

• Explain and apply the accounting equation in the context of double-entry bookkeeping.
• Define and differentiate between asset, liability, capital, income, and expense accounts.
• Distinguish between capital expenditure (asset expenditure) and revenue expenditure (expenses charged to profit or loss).
• Identify the effect of misclassification on the statement of profit or loss and the statement of financial position.
• Prepare correct journal entries for both capital and revenue transactions.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which equation expresses the basic relationship between a business's assets, liabilities, and owners' capital?
2. Which of the following is typically capital expenditure? a) Wages paid to staff
   b) Purchase of a delivery van c) Payment for advertising d) Monthly utility bills
3. What is the consequence of recording the cost of a new machine as an expense rather than an asset?
4. State whether the following are current or non-current assets: (a) Inventory, (b) Office computer.
5. Why is correct classification of capital and revenue expenditure important in financial reporting?

Introduction

Every accounting system is built on the balance between what an entity owns and what it owes—this is summarized by the accounting equation. Fully understanding the accounting equation and correctly identifying account types is essential for maintaining accurate financial records.

Many exam questions test your ability to classify expenditure as either capital or revenue because this impacts both the statement of profit or loss and the statement of financial position. Incorrect classification can lead to a significant misstatement of profit or net assets.

This article explains the accounting equation, outlines the key account types, and gives clear guidance on the difference between capital expenditure (asset expenditure) and revenue expenditure (expenses). It also highlights the effects of incorrect classification, with typical exam scenarios for practice.

The Accounting Equation

The accounting equation forms the backbone of all bookkeeping systems:

Key Term: accounting equation
Assets = Capital + Liabilities
This expresses that all resources owned by the business must be funded by either the owners (capital) or external parties (liabilities).

When a transaction occurs, it will always impact at least two elements in order to keep the equation balanced.

Example: How Transactions Affect the Equation

If the owner invests $10,000 in cash, the business's assets (cash) increase by $10,000 and so does capital. If the business then buys equipment for $2,000, assets (equipment) go up and cash goes down by the same amount, so the total assets remain unchanged.

Worked Example 1.1

On 1 July, Lee invested $8,000 to start a business. The business then bought inventory for $2,500 and a computer for $1,200.

Question:
Show how each transaction affects the accounting equation.

Answer:

• After investment: Assets (Cash $8,000) = Capital $8,000 + Liabilities $0
• After inventory purchase: Assets (Cash $5,500 + Inventory $2,500) = Capital $8,000
• After computer purchase: Assets (Cash $4,300 + Inventory $2,500 + Equipment $1,200) = Capital $8,000

Account Types and Definitions

All business transactions are classified into five account types:

Key Term: asset
A present economic resource controlled by the entity as a result of past events.

Key Term: liability
A present obligation of the entity to transfer an economic resource as a result of past events.

Key Term: capital
The residual interest in the assets of the entity after deducting all liabilities; the owners' investment.

Key Term: income
Increases in assets or decreases in liabilities that result in increases to capital; typically sales revenue.

Key Term: expense
Decreases in assets or increases in liabilities that reduce capital; typically costs incurred in running the business.

Assets, liabilities, and capital appear in the statement of financial position. Income and expenses are reported in the statement of profit or loss.

Capital vs Revenue Expenditure

A key area of ACCA assessment is the correct classification between capital expenditure (asset expenditure) and revenue expenditure (expense).

Capital Expenditure

Capital expenditure is the cost incurred in acquiring or improving non-current assets—items expected to provide benefits over more than one period. These are recorded on the statement of financial position.

Key Term: capital expenditure
Amount spent to acquire or improve non-current assets, providing benefits lasting beyond the current accounting period.

Revenue Expenditure

Revenue expenditure is the day-to-day cost of running a business, which benefits only the current accounting period. This is charged to the statement of profit or loss as an expense.

Key Term: revenue expenditure
Spending required for the routine operation of the business or maintaining assets in their current state.

How to Distinguish

• Capital Expenditure:

  • Buying land, buildings, machinery, vehicles
  • Upgrading an asset to extend its useful life or capacity
  • Installation and legal costs directly attributable to bringing asset into use

• Revenue Expenditure:

  • Repairs and routine maintenance
  • Rent, utilities, wages, consumables
  • Minor enhancements that do not significantly increase asset value

Worked Example 1.2

A business purchases a delivery van for $18,000 and spends $600 on the first service. Should both amounts be recorded as capital expenditure?

Answer:

• The $18,000 purchase is capital expenditure (asset acquisition).
• The $600 service is revenue expenditure (routine maintenance).

Effect of Incorrect Classification

Incorrect classification changes profit and net assets:

• Charging capital expenditure (e.g. buying equipment) as revenue expense will:

  • Understate non-current assets
  • Understate profit (expense too high)
  • Understate owner's capital

• Treating revenue expenses as capital expenditure will:

  • Overstate assets and profit
  • Possibly inflate depreciation charges in later periods

Worked Example 1.3

An entity mistakenly charges $3,500 for new machinery to 'Repairs and Maintenance'.

Question:
What is the impact on the financial statements?

Answer:

• Non-current assets understated by $3,500
• Expenses overstated by $3,500, reducing profit
• Owners' capital understated by $3,500

Exam Warning

Be prepared to justify why a cost is classified as capital or revenue. Exam questions often present ambiguous scenarios involving installation costs, upgrades, or combined invoices—read carefully.

Summary Table: Capital vs Revenue Expenditure

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the accounting equation and how it remains balanced after any transaction
• Identify and define asset, liability, capital, income, and expense accounts
• Distinguish between capital expenditure and revenue expenditure using clear criteria
• Recognize the financial statement impact of correct and incorrect classification
• Prepare accurate journal entries for both capital and revenue items

Key Terms and Concepts

• accounting equation
• asset
• liability
• capital
• income
• expense
• capital expenditure
• revenue expenditure