1The idea in one paragraph

Finance is the money a business raises and the way it uses that money. Every business needs it, for three jobs: to start, to keep running from week to week, and to grow or replace what wears out. The money it spends falls into two kinds. Capital expenditure buys things the business keeps and uses for more than a year: a van, an oven, a building. Revenue expenditure pays for running the business now: wages, rent, electricity, the stock it sells. The difference is not about size. It decides where the spending is recorded, how much of it reduces this year's profit, and what kind of finance should pay for it.

2The role of finance: why every business needs money

A business spends money before it earns any. That single fact is why finance matters. The baker buys flour on Monday and is paid for the bread on Tuesday; the car maker pays for a factory years before the first car is sold. Somewhere in the gap, money has to come from somewhere.

Take an invented business and follow it. Kestrel Cycles is a bicycle shop with a repair workshop, run by its owner, Nadia Ferreira, as a sole trader. Her need for money falls into five jobs, and between them they are the role of finance.

To start the business. Before the first sale Nadia needs a shop, a workbench, tools, a till, and stock on the shelves. The money used to set a business up is start-up capital, and without it there is no business to run.

To run it from day to day. Rent is due on the first of the month whether bikes sold or not. Mechanics are paid every Friday. Suppliers want paying in 30 days. Customers who have bikes serviced often pay on collection, days later. Finance fills that gap between paying out and being paid, which is the subject of 3.7.

To grow. Nadia wants to add a second workshop bay so she can repair twice as many bikes. That is new spending before the extra revenue arrives, and it is usually the biggest single call on finance a small business makes.

To replace what wears out. The repair stands, the van and the till all have a working life. When it ends, they must be bought again, and a business that has not planned for this finds itself paying for it out of a bad month.

To deal with the unexpected. A flood in the stockroom, a supplier who goes bust, a quiet spring. A business with some finance to fall back on survives these; one without it may not.

The finance function also does something beyond paying bills. It records what came in and what went out, so that the owners, the bank and the tax authority can see what happened (the final accounts, 3.4), and it plans what will come in and go out, so that shortfalls are seen before they arrive (cash flow forecasts and budgets, 3.7 and 3.9). Figure 1 puts the whole cycle on one page.

Read Figure 1 from left to right. Money is raised from a source of finance, internal or external, which is 3.2. It is spent in one of two ways. Each way is recorded in a different place. At the bottom, the business earns sales revenue, and whatever profit it keeps becomes a source of finance for next year. The rest of this page is about the middle column, because it decides the right-hand one.

3Capital expenditure

Capital expenditure is spending on non-current assets: items the business buys to keep and use repeatedly for more than one year.

A non-current asset is something the business owns and will use over several years to produce what it sells, rather than something it sells or uses up. Land, buildings, vehicles, machinery, computers, furniture and fixtures are the everyday examples. So is spending that adds to an existing asset: an extension that gives a building more floor space, or a refrigeration unit fitted to a delivery van so that it can carry food it could not carry before.

For Kestrel Cycles, capital expenditure is the electric cargo van, the two hydraulic repair stands, the new till system and laptop, and the building of a second workshop bay.

Capital expenditure has a recognisable pattern, and seeing it helps you spot it in a case study.

• It is occasional. A van is bought every few years, not every month.
• It is usually large relative to the business and planned in advance, often with an investment appraisal (3.8) to check it will pay for itself.
• It is recorded as an asset on the statement of financial position, because the business still owns something of value after the money has gone.
• It reduces profit slowly. The cost is not deducted from this year's revenue in one go. It is spread over the years the asset is used, as depreciation, a slice each year. You meet the name here; HL students learn to calculate it in 3.4.

That last point is the one that matters most, and section 6 shows why.

4Revenue expenditure

Revenue expenditure is spending on the day-to-day running of the business: costs that are used up within the year and do not create a lasting asset.

Wages and salaries, rent, electricity and water, insurance, advertising, fuel, telephone and internet, interest on loans, the stock bought to be sold, the raw materials that go into a product, and the repairs and maintenance that keep existing assets working as they did before. Every one of these is used up: this month's rent buys this month in the shop, and next month must be paid for again.

For Kestrel Cycles: the rent on the shop, the mechanics' wages, the bicycles bought from the manufacturer to sell, the spare parts used in repairs, the electricity, the van insurance, online advertising, and repainting the shopfront.

Revenue expenditure has the opposite pattern.

• It is regular and recurring: weekly, monthly, yearly.
• Each item is usually smaller, though over a year the total is normally far bigger than capital expenditure.
• It is recorded as a cost in the statement of profit or loss, as cost of sales or as expenses.
• It reduces this year's profit in full, in the year it is spent.

Do not be misled by the name. Revenue expenditure is not revenue, and it is not spending that earns revenue. It is spending that is matched against this year's revenue.

5Telling them apart

The one test that works every time is how long the business will use what it bought. Size is not the test: a €40 drill Nadia will use for five years is capital expenditure in principle (small businesses often treat very cheap items as running costs simply for convenience, but the logic is the same), while her €96,000 of bicycles bought for resale is revenue expenditure because it is gone within the year.

Figure 2 turns the test into three questions, asked in order.

Three cases trip students up, and Figure 2 is built to catch them.

Stock is revenue expenditure, however expensive. The bicycles Nadia buys to sell are used up in the sense that matters: they leave the business within the year. The same is true of flour for a baker and fabric for a clothing maker.

The same item can be either, depending on the business. Nadia's van is capital expenditure because she keeps it and uses it. A van bought by a van dealer to sell is stock, and so it is revenue expenditure. Always ask what this business will do with the item.

A repair is revenue expenditure; an improvement is capital expenditure. Replacing the van's worn brakes keeps it as it was, so it is revenue expenditure. Fitting it with a larger battery that doubles its range makes it able to do more than before, so it is capital expenditure. Repainting the shopfront keeps the shop as it was; building a second workshop bay gives it space it never had.

Figure 3 sets the two kinds side by side. It is the page to revise from.

Worked example. Here is Kestrel Cycles' spending for one year. Classify each item, and total the two kinds.

Notice the proportions. Capital expenditure is about a quarter of the year's spending, and most of it came in two lumps: the van and the new bay. Revenue expenditure is three-quarters, spread across every month. That is the normal shape for a small business.

6Why the difference matters

Classifying spending is not bookkeeping for its own sake. Three things depend on it.

It decides the profit. Revenue expenditure is deducted from this year's revenue in full. Capital expenditure is deducted a slice at a time. Suppose Nadia expects the €38,000 van to last five years and be worth nothing at the end. Spread evenly, the van reduces profit by €7,600 a year.

Now suppose the van is wrongly recorded as revenue expenditure. The whole €38,000 is deducted in year 1, and nothing in years 2 to 5. Figure 4 shows what that does.

The total charged over the five years is €38,000 either way. What changes is when, and that is enough to make one year look like a disaster and four years look better than they were. The statement of financial position is wrong too: the van, which the business still owns and uses, has vanished from its assets.

It decides the right finance. Capital expenditure buys something that earns for years, so it should be paid for with finance that lasts for years: a long-term loan, share capital, retained profit. Revenue expenditure recurs and should be met from revenue, with short-term finance such as an overdraft or trade credit to cover the gaps. A business that buys a van on its overdraft has matched a five-year asset to a debt the bank can demand back next week. This matching idea is the heart of 3.2.

It decides the planning. Capital expenditure is large and occasional, so it is planned project by project and tested with investment appraisal (3.8). Revenue expenditure is regular, so it is planned month by month in cash flow forecasts and budgets (3.7, 3.9).

Ethics and creativity in financial reporting. Because the choice moves profit between years, it can be abused. Recording running costs as capital expenditure makes this year's profit look higher than it is, which flatters managers, supports the share price and can attract lenders. The most famous case is the American telecoms company WorldCom, which in 2002 admitted that it had recorded billions of dollars of ordinary operating costs as capital expenditure; the company filed for bankruptcy the same year. The reverse trick, recording capital expenditure as a running cost to make profit, and so tax, look lower this year, is also a misstatement. Accounting rules and tax authorities set out what counts as each, and auditors check. For a student, the point is this: honest classification is part of what makes a business trustworthy to its stakeholders over the long run, which is why the guide ties ethical accounting to sustainable business behaviour.