Learning objectives
By the end of this chapter you should be able to:
- Distinguish capital expenditure from revenue expenditure and explain why the distinction matters for reported profit or loss and asset values.
- Apply a recognition-based approach to classifying expenditure in exam-style scenarios, including component replacements and major refurbishments.
- Calculate the initial cost of a non-current asset, including trade discounts, directly linked set-up costs, and VAT (recoverable vs non-recoverable).
- Prepare journal entries for acquiring and disposing of non-current assets, showing correct treatment for cash and credit transactions and for VAT.
- Build and maintain a simple asset register that supports internal control, depreciation calculations, and a clear audit trail.
Overview & key concepts
Non-current assets are long-term resources used to generate income over more than one accounting period. The key reporting decision is whether spending should:
- be recorded as part of an asset (capitalised) and then charged to profit or loss over time through depreciation, or
- be charged to profit or loss immediately (expensed) in the period in which it is incurred.
Recognition anchor (stay consistent in exams):
Capitalise a cost when it is expected to contribute to the business’s results in future periods and you can measure the amount with reasonable certainty. If the spend does not meet that test, recognise it as an expense when it is incurred (applying accruals/prepayments where relevant).
This decision affects:
- Profit or loss for the year (expenses reduce profit immediately; capitalised costs reduce profit over time via depreciation), and
- Statement of financial position totals (capitalised costs increase assets; expensed costs do not).
A second practical requirement is record-keeping. A well-maintained asset register helps prevent errors such as missing assets, duplicated purchases, incorrect depreciation, or failure to remove disposed assets from the accounts.
Capital expenditure
Capital expenditure is spending that results in a non-current asset being acquired or improved in a way that increases the benefits expected from that asset.
Typical indicators include spending that:
- covers the costs needed to get the asset installed/positioned and ready to be used by the business (not merely administrative steps like ordering), or
- increases performance/output, improves quality, extends useful life, or reduces operating costs beyond what was previously expected.
Capitalised amounts are recorded as part of the asset’s cost and depreciated over its useful life.
Revenue expenditure
Revenue expenditure is spending that supports day-to-day operations or keeps assets working at their current level of performance. These costs are recognised in profit or loss in the period incurred (subject to accruals and prepayments).
Typical examples include:
- routine repairs and servicing,
- consumable parts replacements that do not improve performance beyond the previously assessed standard, and
- support contracts and similar running costs (apportioned over the coverage period where relevant).
Asset registers
An asset register is a detailed list of a business’s non-current assets. It supports:
- control over physical assets (existence, location, responsibility),
- depreciation calculations,
- disposal tracking (date, proceeds, gain/loss), and
- audit evidence (purchase details, asset identification).
To make the register “examiner-proof” in practice, include control features such as:
- periodic reconciliation of the register totals to the general ledger (PPE control account),
- physical verification (tagging/barcoding where appropriate), and
- authorisation controls for additions, transfers, and disposals.
A simple register typically includes:
- asset reference/ID
- description and category
- location / cost centre
- purchase date, supplier, invoice reference
- cost (and VAT treatment)
- depreciation method, useful life, residual value
- accumulated depreciation to date and carrying amount
- disposal date, proceeds, and gain/loss (if disposed)
Capitalisation and initial asset cost
Initial measurement: what goes into the asset figure?
When you first record a non-current asset, start with the real purchase cost to the business, then add only those extra costs that are unavoidable to get the asset ready for use in the business.
A practical exam method is to group costs into three buckets:
- Purchase cost (net)
- Invoice price after trade discounts and similar reductions.
- Getting it on site and ready (directly linked set-up costs)
- Costs directly linked to installing/setting up this specific asset, such as delivery, installation/assembly, and site preparation.
- Making sure it works (pre-use checks)
- Costs of checking the asset operates properly before it is brought into use. If testing produces items that are sold, treat the sale proceeds as reducing the net testing cost (so only the net testing cost is added). This avoids overstating cost where testing generates incidental income.
Do not add costs that relate to operating the business generally or to using the asset after it is ready—common examples are staff training, general administration, and routine servicing.
Settlement discounts (cash discounts)
- Trade discounts reduce the recorded cost of the asset.
- Settlement/cash discounts depend on the scenario and policy. In many exam questions, you ignore them unless the question indicates they are expected to be taken or provides a required treatment. Where relevant, the key is to treat the transaction consistently with the expectation of take-up.
VAT (recoverable vs non-recoverable)
VAT treatment depends on whether the business can reclaim it:
- Recoverable VAT is not part of the asset cost and is recorded separately as a VAT receivable.
- Non-recoverable VAT is included in the asset cost.
VAT rules vary by jurisdiction and by the type of asset and use. In exam questions, follow the wording given (for example, “VAT is recoverable” or “VAT is not recoverable”).
Subsequent expenditure and component replacements
Subsequent expenditure
Once an asset is ready for use, later spending is usually treated as a day-to-day expense unless it clearly upgrades the asset (for example, a modification that increases output or extends useful life beyond what was previously assessed).
Mini-examples (borderline help):
- Annual service of a machine to keep it running: expense.
- Modification that increases output capacity beyond the original standard: capitalise.
Component replacements (common exam trap)
If a major part of an asset is replaced (for example, a roof, an engine, or a major inspection), the new part is usually capitalised if it brings additional or extended benefits. At the same time, avoid “double counting”: where the replaced part can be identified or reasonably estimated, its remaining carrying amount is removed from the accounts when the replacement occurs.
If the old component’s carrying amount cannot be identified and cannot be estimated sensibly, exam questions usually will not require a derecognition calculation—follow the data given.
Depreciation timing reminder:
Start depreciating when the asset is ready for use in the business, even if it is not yet being used.
Disposal of non-current assets
When an asset is disposed of (sold, scrapped, traded in), it must be removed from the accounts. The reporting outcome is based on:
- Carrying amount at disposal date: the balance still sitting in the accounts for that asset (after depreciation and any impairment adjustments), and
- Proceeds received on disposal.
The difference between proceeds and carrying amount is recognised in profit or loss as a gain or loss.
A clear way to structure the bookkeeping is to use a disposal account (T-account approach). This keeps the logic visible and reduces errors.
Journal entries
Acquisition of a non-current asset
The journal entry depends on whether the supplier is paid immediately or later, but the asset recognition is the same.
Credit purchase
- Dr Non-current asset (net of recoverable VAT)
- Dr VAT receivable (recoverable VAT)
- Cr Payables (gross)
Cash purchase
- Dr Non-current asset (net of recoverable VAT)
- Dr VAT receivable (recoverable VAT)
- Cr Bank
Disposal of a non-current asset (disposal account method)
Transfer original cost to disposal account
- Dr Disposal account
- Cr Non-current asset (cost)
Transfer accumulated depreciation
- Dr Accumulated depreciation
- Cr Disposal account
Record proceeds
- Dr Bank / Receivable
- Cr Disposal account
Recognise gain or loss (balance the disposal account)
- If disposal account has a credit balance → gain (Cr profit or loss)
- If disposal account has a debit balance → loss (Dr profit or loss)
A “direct method” (without a disposal account) can also be used, but if proceeds are not equal to the carrying amount you must include a gain or loss line.
Worked example
Narrative scenario
A manufacturing company, ABC Ltd, prepares financial statements for the year ended 31 December 2025. During the year it had the following transactions involving non-current assets:
- Purchased a new machine on 15 March for £50,000, with a 5% trade discount. Delivery costs were £2,000 and installation costs were £3,000. VAT at 20% is recoverable.
- Replaced the roof of its warehouse with a stronger design for £10,000, extending the building’s useful life.
- Paid £1,500 for routine maintenance on machinery.
- Sold an old machine on 30 September for £8,000. The machine originally cost £30,000 and had accumulated depreciation of £22,000 at the disposal date.
- Purchased office furniture on 1 July for £5,000, plus £500 delivery. VAT at 20% is not recoverable.
- Paid £1,200 for an annual software support contract.
- Installed a new production line for £40,000, increasing output capacity.
- Incurred staff training costs of £2,000 after installing the new production line.
- Purchased a vehicle on 10 November for £20,000 plus £1,000 delivery. VAT at 20% is recoverable.
- Paid £800 for routine servicing of the vehicle.
Required
- Calculate the capitalised cost of the new machine, including VAT considerations.
- Prepare journal entries for the acquisition of the new machine and the disposal of the old machine.
- Determine the gain or loss on the disposal of the old machine.
- Classify each expenditure as capital or revenue.
- Update the asset register for the new machine and the disposed machine.
Solution
1) Capitalised cost of the new machine (VAT recoverable)
List price: £50,000
Less trade discount (5%): £50,000 × 5% = £2,500
Net purchase price: £50,000 − £2,500 = £47,500
Directly linked set-up costs
Delivery £2,000 + Installation £3,000 = £5,000
Capitalised cost (net of VAT)
£47,500 + £5,000 = £52,500
Recoverable VAT (20%)
£52,500 × 20% = £10,500 (record separately; not part of asset cost)
2) Journal entries
(a) Acquisition of the new machine (credit purchase)
Dr Non-current asset (machine) …………… £52,500
Dr VAT receivable ………………………………………… £10,500
Cr Payables ……………………………………………………… £63,000
Effect on the accounting equation:
Assets increase by £63,000 (machine £52,500 + VAT receivable £10,500). Liabilities increase by £63,000 (payables). Equity is unchanged at this point.
(b) Disposal of the old machine (cash sale) — disposal account method
- Transfer cost:
- Dr Disposal account ……………………………………… £30,000
- Cr Non-current asset (cost) ………………………… £30,000
- Transfer accumulated depreciation:
- Dr Accumulated depreciation ……………………… £22,000
- Cr Disposal account ……………………………………… £22,000
- Record proceeds:
- Dr Bank …………………………………………………………… £8,000
- Cr Disposal account ……………………………………… £8,000
- Balance the disposal account:
- Credits = £22,000 + £8,000 = £30,000
- Debits = £30,000
- Balance = nil → no gain or loss
Direct method note: If proceeds ≠ carrying amount, the difference must be recognised as a gain or loss in profit or loss.
3) Gain or loss on disposal
Carrying amount at disposal date is the balance still sitting in the accounts for that machine (after depreciation and any impairment adjustments).
Here: £30,000 − £22,000 = £8,000
Proceeds = £8,000
Gain/(loss) = £8,000 − £8,000 = £0
4) Classification of each item (capital vs revenue)
- New machine (including delivery and installation): Capital
- Warehouse roof replacement extending useful life: Capital (and consider component derecognition where measurable)
- Routine maintenance on machinery: Revenue
- Old machine sale: Not expenditure (disposal transaction)
- Office furniture plus delivery plus non-recoverable VAT: Capital
- Annual software support contract: Revenue— expense the portion relating to the current year; carry the remainder as a prepayment
- New production line increasing capacity: Capital
- Staff training: Revenue
- Vehicle plus delivery (VAT recoverable): Capital
- Routine vehicle servicing: Revenue
5) Asset register update
New machine (added)
- Asset ID: 001
- Description: Production machine
- Location: Factory
- Purchase date: 15 March 2025
- Supplier: XYZ Ltd
- Cost (net of recoverable VAT): £52,500
- VAT treatment: VAT recoverable (VAT recorded separately)
- Depreciation method: Straight-line
- Useful life: 10 years
- Residual value: (as per estimate/policy)
- Notes: Includes directly linked set-up costs (delivery and installation)
Old machine (disposed)
- Asset ID: 002
- Description: Machine (old)
- Original cost: £30,000
- Accumulated depreciation at disposal: £22,000
- Carrying amount at disposal: £8,000
- Disposal date: 30 September 2025
- Proceeds: £8,000
- Gain/(loss): £0
- Notes: Cost and accumulated depreciation removed from the ledger on disposal
Common pitfalls and misunderstandings
- Forgetting the recognition anchor. Capitalise costs expected to benefit future periods and measurable with reasonable certainty; otherwise expense (with accruals/prepayments as needed).
- Treating component replacements as “add only”. If you capitalise a major replacement, consider whether the replaced part’s remaining carrying amount should be removed to avoid double counting.
- Over-capitalising post-installation costs. Training and routine servicing are normally operating expenses.
- Using VAT inconsistently. Recoverable VAT is not part of the asset cost; non-recoverable VAT is included. Follow the question’s VAT data.
- Missing trade discounts. Apply trade discounts before adding other directly linked set-up costs.
- Incorrect disposal bookkeeping. Remove both cost and accumulated depreciation; recognise gain/loss when proceeds differ from carrying amount.
- Ignoring timing for annual contracts. Support contracts often require time apportionment, creating prepayments at the reporting date.
- Weak asset control. Without register–ledger reconciliation and disposal authorisation, assets are easily misstated.
Summary and further reading
Correctly separating capital and revenue expenditure is essential because it determines whether spending is recognised as an asset (and charged to profit or loss over time) or recognised as an expense immediately. Initial asset cost starts with the net purchase cost and then includes only directly linked set-up costs and necessary pre-use checks, plus any non-recoverable taxes such as blocked VAT. Subsequent expenditure is usually expensed unless it upgrades the asset; major component replacements may require both capitalising the new component and removing the remaining carrying amount of the replaced part where that amount can be identified or reasonably estimated. Disposals require removing both the asset’s cost and accumulated depreciation, recognising any gain or loss in profit or loss. An accurate asset register supports internal control, depreciation accuracy, and a reliable audit trail, particularly when reconciled to ledger balances and supported by physical verification and disposal authorisation.
FAQ
Why does the capital vs revenue decision matter so much?
Because it changes both profit or loss and asset values. Capitalising a cost increases assets and spreads the expense through depreciation. Expensing a cost reduces profit or loss immediately and does not increase assets.
Which costs are usually included in an asset’s initial cost?
The purchase price after trade discounts, plus costs directly linked to getting the asset ready for use in the business (for example delivery and installation). Costs such as training and routine servicing are normally expensed.
How does VAT affect asset cost?
If VAT is recoverable, it is recorded separately and excluded from the asset cost. If VAT is not recoverable, it forms part of the amount paid and is included in the asset cost. VAT rules can vary, so follow the question’s information.
How is gain or loss on disposal calculated?
Work out the asset’s carrying amount at the disposal date (the undepreciated balance left in the accounts after depreciation and any impairment adjustments). Compare proceeds with that carrying amount: proceeds higher gives a gain; proceeds lower gives a loss.
What is the purpose of an asset register?
It provides a clear record of asset additions, depreciation policies, locations, and disposals. Strong registers are periodically reconciled to the ledger, supported by physical checks, and backed by authorisation controls for disposals.
Summary (Recap)
This chapter explained how to classify spending on non-current assets as capital or revenue using a recognition-based approach. It showed how to measure an asset on initial recognition (net purchase cost plus directly linked set-up costs and pre-use checks, with VAT included only where it is not recoverable). It also covered subsequent expenditure, including the component replacement trap where derecognition of the replaced part may be needed. Finally, it demonstrated disposal accounting and the calculation of gains and losses in profit or loss, and showed how an asset register supports both reporting and control through reconciliation, verification, and authorisation.
Glossary
Non-current asset
A long-term resource used by the business to generate income over more than one accounting period.
Capital expenditure
Spending that acquires a non-current asset or improves one in a way that increases the benefits expected from it.
Revenue expenditure
Spending that supports normal operations or keeps assets working at their current level, usually recognised in profit or loss as incurred (subject to accruals/prepayments).
Capitalisation
Recording expenditure as part of an asset’s cost rather than as an immediate expense.
Initial measurement (asset cost)
The amount recorded when an asset is first recognised, usually the net purchase cost plus directly linked set-up costs and necessary pre-use checks, plus any non-recoverable taxes.
Directly linked set-up costs
Costs that are unavoidable to get a specific asset installed/positioned and ready for business use, such as delivery, installation, and directly related site preparation.
Pre-use checks
Testing and checking activities carried out before the asset is brought into use, included in cost only to the extent they represent net costs (after any incidental proceeds).
Residual value
The estimated amount expected to be recovered from an asset at the end of its useful life.
Carrying amount
The undepreciated balance left in the accounts for an asset at a point in time (after depreciation and any impairment adjustments).
Accumulated depreciation
Total depreciation charged on an asset from the date it is ready for use up to the reporting date or disposal date.
Derecognition
Removing an asset, or a replaced component, from the accounts when it is disposed of or replaced, or when it no longer contributes expected benefits.
Disposal proceeds
The value received on disposal of an asset.
Gain or loss on disposal
The difference between disposal proceeds and the asset’s carrying amount at the disposal date, recognised in profit or loss.
Asset register
An internal record listing non-current assets and key details used for control, depreciation, reporting support, and audit trail.