Financial Reporting

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Capital or Revenue Expenditure

In this article, Steve Collings of Leavitt Walmsley Associates Ltd looks at a common question that frequently causes confusion amongst accountants; that of the capital versus revenue debate.

As an accountant and a freelance lecturer, I am commonly asked about when it is appropriate to recognise expenditure on an existing fixed asset in the balance sheet and when it should be written off to profit and loss. Undeniably this debate generates opinions at both ends of the spectrum.

In financial reporting terms, such expenditure is referred to as ‘subsequent expenditure’ and this issue is clarified in FRS 15 ‘Tangible Fixed Assets’ and in FRSSE (effective April 2008) at paragraph 6.22 as well as IAS 16 ‘Property, Plant and Equipment’. This article will be concerned with the provisions in FRS 15, though the FRSSE equivalent is a condensed version of FRS 15.

In order for an asset to be recognised in a reporting entity’s balance sheet it must meet the definition of such under the Statement of Principles issued by the UK Accounting Standards Board. The definition of an asset in the Statement of Principles is as follows:

“Assets are rights or other access to future economic benefits controlled by an entity as a result of past transactions or events”.

The days when an asset was defined simply as ‘something an entity owns’ have long since disappeared. In most circumstances this usually means that the item to be capitalised must be able to contribute to the turnover of the company. For example in a manufacturing company, silos and other items of plant and machinery would contribute to the manufacture of products which the company will then sell on to its customers therefore contributing to the turnover of the company and as such are recognised as fixed assets.

Under the provisions in FRS 15, an item of subsequent expenditure should only be capitalised in three circumstances:

• Where the subsequent expenditure enhances the fixed asset over and above its previously assessed state.

• Where a component of the fixed asset has been treated separately for the purposes of depreciation and depreciated over its useful economic life and has been replaced or restored.

• Where the subsequent expenditure relates to a major inspection or overhaul of a tangible fixed asset that restores economic benefits that have already been consumed by the entity.

Figure 1

Company A purchased an item of plant in 2007 which was capable of producing 40 units of output per hour. The company does not adopt the revaluation model for measuring its fixed assets and at the balance sheet date the plant had a useful economic life of 5 years. A competitor, Company B, has recently acquired a similar item of plant which produces 75 units of output per hour and the directors of Company A are keen to ensure they retain their competitive advantage in their market sector. Company A’s budget does not extend to purchasing a new item of machinery outright, but research has revealed that for £15,000 the existing machine can have a component fitted to it which will increase output to 90 units per hour. The estimated useful economic life of the asset remains at 5 years with zero residual value and the company’s depreciation policy is to write off the cost of this asset over its useful life.

Figure 2

A company purchased a freehold property 20 years ago and has spent £12,000 having the exterior repainted. The company’s depreciation policy in respect of its freehold buildings is to write off the cost over 50 years (2% straight line).

In Figure 1 the reporting entity carries the item of plant at depreciated historic cost and the subsequent expenditure will increase the machine’s output from 40 units per hour to 90 units of output per hour. Clearly this expenditure will enhance the asset beyond its previously assessed state so in this respect, capitalisation is appropriate. The company should recognise the expenditure as an addition to fixed assets and depreciated over the component’s estimated useful life (or the machine’s estimated useful life of five years).

In Figure 2, the reporting entity has not enhanced its building beyond its previously assessed state in any way – it has merely incurred maintenance expenditure and as such the cost of repainting the building’s exterior should be written off to the profit and loss account as ‘repairs and maintenance’ expenditure. 

Some tangible fixed assets (e.g. aircraft) require substantial expenditure (over and above routine repairs and maintenance) at periodic intervals for major refits. Where this occurs then a reporting entity should account separately for the major components that require overhaul because such components will have significantly different useful lives than the rest of the asset. Where components have been accounted for separately, then they should be depreciated over their useful economic lives to ensure that the depreciation profile accurately reflects the entity’s overall consumption of the entire asset. FRS 15 contains an example of an aircraft that requires to be overhauled once every three years otherwise the aircraft cannot be flown. The cost of such an overhaul is capitalised because it restores economic benefits which have been previously consumed.

Subsequent expenditure incurred in replacing or restoring components that have been separately accounted for should be recognised as an addition to fixed assets and the carrying amount of the replaced component is removed from the balance sheet.

In determining whether (or not) to identify separate components or future expenditures in respect of overhauls or inspections over a shorter useful life than the rest of the asset, FRS 15 suggests three conditions that should be addressed:

• Whether the useful economic lives of the components are, or the period until the next inspection or overhaul is, substantially different from the useful economic life of the remainder of the asset.

• The degree of irregularity in the level of expenditures required to restate the component or asset in different accounting periods.

• Their materiality in the context of financial statements.

Provisions for routine overhauls

Where an item of machinery requires routine overhauls, for example every 5 years, then directors of companies might ask to provide for the cost of these overhauls. An entity cannot provide for future routine overhaul costs because this contravenes the provisions in FRS 12 ‘Provisions, Contingent Liabilities and Contingent Assets’. This is because at the reporting date, the directors merely have an ‘intention’ rather than an ‘obligation’ to overhaul machinery – the directors could sell the respective machinery before the time period has lapsed for the overhaul.

When deciphering whether to capitalise subsequent expenditure or whether to write it off to the profit and loss you need to look at whether the expenditure improves the asset in any way over and above its previously assessed state (as in the machine example in Figure 1). If major components have been accounted for and depreciated separately and subsequently replaced or restored, then this expenditure should be capitalised. Finally subsequent expenditure should be capitalised where the expenditure relates to a major inspection or overhaul of an existing asset (as in the aircraft example above). In any other respects, subsequent expenditure is written off to the profit and loss account.

Steve Collings FMAAT ACCA DipIFRS is audit and technical manager at Leavitt Walmsley Associates Ltd and a partner in AccountancyStudents.co.uk. He is also the author of ‘The Core Aspects of IFRS and IAS’ and lectures student accountants on financial reporting and auditing issues.