Capitalisation vs Expense: A Practical UK Startup Guide to Accounting and Reporting

Capitalisation vs Expense: Understanding the Impact on Your Startup's Finances

For a UK startup founder, the line between managing cash and reporting progress to investors is incredibly fine. You track your runway meticulously, but if your Profit & Loss (P&L) statement tells a different story, it can create confusion during a fundraise. The decision of whether to capitalise a cost or expense it immediately is not just an accounting formality; it directly impacts your key metrics like EBITDA, net profit, and the financial narrative you present. Getting this wrong can lead to skewed performance data, which jeopardises investor confidence and complicates future funding rounds. Making the right call from the start ensures your financial records are consistent, defensible, and a true reflection of your company's health.

For detailed rules on this topic, see the Capex, Depreciation, and Intangibles hub.

Capex vs Opex: The P&L Impact

At its core, the expense vs capitalise decision is about timing. It dictates when a cost hits your P&L and reduces your stated profit. While both options involve cash leaving your bank account today, the accounting treatment is fundamentally different, creating a significant divergence between your cash flow and your reported profitability.

An Operating Expense (Opex) is a cost incurred in the day-to-day running of the business. Think of salaries, rent, or your monthly Xero subscription. These costs are recognised on your P&L in the period they occur, immediately reducing your profitability for that month. They represent the ongoing cost of doing business.

A Capital Expenditure (Capex), on the other hand, is an investment in an asset that will provide value to the business for more than one year. This includes tangible items like a new server or intangible assets like a patent. Instead of hitting the P&L at once, a capitalised cost is recorded on the Balance Sheet as an asset. Its cost is then gradually released to the P&L over its useful life through depreciation or amortisation. This smooths the impact on your profitability. The practical consequence tends to be that capitalising significant costs can make your short-term EBITDA and net profit appear healthier, a key consideration when reporting to a board or potential investors.

When to Capitalise Costs Under UK GAAP: The Litmus Test

For UK-based startups, the rulebook is Financial Reporting Standard 102 (FRS 102). This is the standard your accountant will use and what HMRC expects. The official litmus test for capitalisation is straightforward in principle. According to the standard, under UK GAAP standard FRS 102, a cost can be capitalised if it is probable that it will generate future economic benefit for the business for more than one year.

This principle applies to both tangible assets, like laptops and office furniture, and intangible assets, such as software, patents, and trademarks. While buying a laptop is simple to classify, intangible assets require more scrutiny, especially internally-developed software for SaaS, Deeptech, or E-commerce platforms.

The Crucial Line Between Research and Development

FRS 102 makes a critical distinction between the 'research' phase and the 'development' phase of a project. This distinction is vital for UK GAAP capitalisation rules and for R&D tax relief claims.

• Research Phase: Costs associated with the research phase must always be expensed as they are incurred. This includes activities like investigating the viability of a new technology, exploring alternative solutions, or conducting market analysis. The outcome is considered too uncertain to be recognised as an asset. For more details on this, see the government's official R&D guidance.
• Development Phase: Costs in the development phase, however, can be capitalised, but only if a strict set of conditions is met. This is the point where an idea transitions from a theoretical possibility to a concrete project plan with a clear commercial outcome.

FRS 102 states that to capitalise internally-developed software, six criteria must be met: technical feasibility, intention to complete, ability to use/sell, demonstration of future economic benefits, availability of resources, and reliable measurement of expenditure. (FRS 102, Section 18).

Let's break down these six conditions:

1. Technical Feasibility: You must be able to demonstrate that completing the asset is technically possible.
2. Intention to Complete: There must be a clear intention from management to complete the asset for use or sale.
3. Ability to Use or Sell: The business must have a plan to either use the asset internally or sell it to customers.
4. Future Economic Benefit: You must be able to show how the asset will generate probable future economic benefits, for example, through increased revenue or reduced costs.
5. Availability of Resources: The company must have adequate technical, financial, and other resources to complete the development.
6. Reliable Measurement: You must be able to measure the expenditure attributable to the asset reliably. This often requires robust time-tracking for developer salaries.

For an excellent practical overview, refer to guidance on capitalising website development from ICAEW.

Example: A UK SaaS Startup

Consider a SaaS startup. The salaries of engineers refactoring old code or fixing bugs on the current platform are Opex; this is maintenance. If that same team spends two months researching a potential AI-driven analytics feature, those salary costs are also Opex, as they fall under the 'research' phase. However, once the board approves the feature, confirms technical feasibility, and allocates a budget, the project moves into the 'development' phase. From that point forward, the direct salary costs for the engineers building that specific, new, sellable module can be capitalised as an intangible asset. You can find more on this distinction in our guide to research versus development accounting.

Setting Your Startup Expense Policy: The Capitalisation Threshold

The idea of assessing every single purchase against FRS 102 criteria is impractical. You should not be capitalising and depreciating a £100 office printer over three years; the administrative effort in your accounting software far outweighs the benefit. This is where the accounting principle of 'materiality' comes in, implemented through a formal capitalisation threshold.

This threshold, or de minimis rule, is a simple statement in your accounting policy that sets a minimum cost for an item to be considered for capitalisation. Any item costing less than this amount is automatically treated as an operating expense, regardless of its useful life. This policy is your single source of truth that prevents inconsistent bookkeeping and the painful year-end scramble to clean up the accounts. Lacking this clear policy is a common trigger for issues during financial diligence or potential HMRC scrutiny.

What is a Defensible Threshold?

The reality for most pre-seed to Series B startups is more pragmatic than for large corporations. Your threshold should be high enough to eliminate administrative noise but not so high that you expense material investments. In practice, we see that a common and defensible capitalisation threshold for UK startups (pre-seed to Series A) is between £500 and £2,000.

Your specific stage and revenue provide further guidance. For smaller companies, the following fixed asset thresholds are prudent:

• Threshold guidance by stage: A £500 or £1,000 threshold is prudent for companies with <£1M revenue or at seed stage. A £1,000 or £2,000 threshold is appropriate for companies with >£1M revenue or at Series A+.

Documenting this is simple. Your written accounting policy should contain a sentence like this:

All individual tangible and intangible assets with a cost of £1,000 or greater and an estimated useful life of more than one year will be capitalised. All items with a cost below this threshold will be expensed as incurred.

Useful Life & Amortisation: Spreading the Cost Realistically

Once you’ve decided to capitalise an asset, the next step is to determine its 'useful life'. This is the estimated period over which the asset is expected to generate economic benefits for your company. It’s important to distinguish this from its physical life. A developer’s laptop might physically function for five years, but given the pace of technology, its effective useful life to the business is likely shorter.

Choosing an unrealistically long useful life will understate your monthly expenses, while choosing one that is too short will overstate them. Both scenarios distort your P&L and complicate accurate cash-flow planning. The goal is consistency and defensibility.

The mechanism for spreading this cost across the useful life is called depreciation for tangible assets (like a laptop) and amortisation for intangibles (like software). The most common and straightforward approach is the 'straight-line method', where the asset's cost is divided equally across each period of its useful life. For a comparison of different approaches, see this note on straight-line vs reducing balance depreciation.

To maintain consistency, early-stage businesses should establish standard useful lives for common classes of assets. The following estimates are widely accepted and provide a solid starting point for your policy. Common useful life estimates for startup assets: Laptops & IT Equipment (3 years), Office Furniture & Fit-out (5-7 years), Internally-Developed Software (3-5 years), Patents/Trademarks (legal life, often capped at 10-20 years).

Using these standards helps ensure your financial statements are comparable and grounded in best practice. For specific guidance on legal-life assets, see our guide on patent capitalisation and amortisation.

Practical Takeaways for UK Founders

Navigating when to capitalise costs under UK GAAP does not require a large finance team, but it does require a clear and consistent policy. Misclassifying spend is one of the quickest ways to erode investor trust, as it directly impacts the metrics you use to measure business health. By establishing a simple framework now, you create a scalable foundation for financial reporting that will serve you through future funding rounds.

Here are three immediate steps to take:

1. Define and Document Your Threshold. Based on your startup's current stage and revenue, choose a capitalisation threshold between £500 and £2,000. Add a single sentence to your internal finance policy stating this rule. This is your most important defence against inconsistency.
2. Review Major Recent Spend. Look at your last six months of spending in your bookkeeping system. Did you purchase significant IT equipment or invest heavily in developing a new software feature? Check if these items were expensed or capitalised and ensure the treatment aligns with your new policy.
3. Establish Standard Useful Lives. Use the common estimates provided as a guide to set default useful life periods for your common asset categories. This ensures depreciation and amortisation are calculated consistently for every new asset you add.

As your company grows towards Series B, your processes will need to mature. The threshold may increase, and your method for tracking capitalisable development time will need to become more robust, but the core principles you set today will remain the same. For more advanced guidance, explore the Capex, Depreciation, and Intangibles topic.

Frequently Asked Questions

Q: What is the difference between depreciation and amortisation?
A: Both are methods for spreading the cost of an asset over its useful life. Depreciation is used for tangible assets that you can physically touch, like laptops or office furniture. Amortisation is used for intangible assets, which lack physical substance, such as software, patents, or trademarks.

Q: Can I capitalise staff training costs in the UK?
A: Generally, no. Under FRS 102, staff training costs must be expensed as they are incurred. While training provides future benefits, it does not create an asset that the company controls, as employees can leave. Therefore, it does not meet the criteria for capitalisation.

Q: What happens if I misclassify a cost?
A: Misclassifying costs can lead to inaccurate financial statements. Expensing a large capital asset will artificially lower your short-term profit and EBITDA, while capitalising a routine expense will inflate it. This can mislead investors, complicate due diligence, and may require you to restate your financials later, which can damage credibility.

Q: Does capitalising R&D costs affect my tax credit claim?
A: Yes, it can. For UK R&D tax relief, you can typically claim qualifying expenditure whether it is capitalised or expensed. However, the accounting treatment determines which scheme you use and how the relief is calculated. It is crucial to align your accounting policy with your tax strategy, so consult an advisor on this.