In accountancy, there are two types of expenditure, Capital and Revenue.
Capital expenditure is the purchase of an expensive item, normally with borrowed money, for some thing the business will hold onto for at least 12 months. These are seen as investments in the future. The repayment of the money borrowed is then spread over a period of time, normally the life of the usefulness of the purchase, and these repayments and any interest on them are then are classed as Revenue expenses.
Revenue expenses are costs that occur on a regular period. They can take the form of staff wages, utility bills and other day to day expenses, including of course, debt repayment. This must always be paid for from the income of the business. The reason for this will become clear later but first let us explore another basic concept.
The basic business model is that when income and expenditure are compared we have the equation:-
INCOME –EXPENDITURE = PROFIT or LOSS
If a business, charity, school, individual or even a government, regularly makes a loss it needs to either raise revenue/income, lower costs/expenditure or both. Success in doing this means the equation shows a profit. Failure to do this means the business; individual etc will fail and be forced by its creditors to file for bankruptcy.
A common error spotted in the wreckage of such bankrupts is that credit is used to pay off revenue expenses. A small businessman may use his/her company credit card to pay the electricity bill or take a loan to cover this quarters VAT bill. The error lies in simple maths. The businessman considers the debt paid when it is not, it is simply owed to someone else. He/she also fails to understand that not only is the debt still there but is now increasing and will continue to increase.
Consider which of these two are worse,
Owing British Gas £200 plus £15 late payment fee, or £220 to Visa going up by 2.75% a month until the debt is settled.
If credit is continually used to as a method to cover overspends over a long period of time then there is a risk of what is known as a spiral of debt, i.e.:-
Month one income £10,000 expenses £10,500
So £500 is borrowed to cover the short fall to paid off at £50 a month so,
Month two income £10,000 expenses £10,550 (including £50 a month debt repayment)
So another £550 is borrowed to cover the short fall at £55 a month on top of the £50 a month already being paid so,
Month three income £10,000 expenses £10,605(including £50 from the first months debt and £55 from the next)
Meaning another £650 is borrowed to................. well, we get the picture.
When we apply this to home, it becomes very clear. When I was a child, the money from all wages was handed to my mother. At the start of her financial week, normally Friday night when my father returned home from work with his wage packet, she would plan ahead and set a budget for each bill, meal and foreseen event. If, on the rare occasion that we run out of money before Friday night then no more purchases could be made. If there was no bread for toast in the morning you’d have to have cereal. If there was no milk for the cereal, use the tap. If something had to be paid then she would borrow the money from a friend, paying it back on the Friday night. This was only used on exceptional cases. But if she did borrow it, then come Friday night, when setting her budget for the following week, she would have less to work with, due to the over spend the week prior. For this reason we were taught never to have an overdraft or credit cards. (How I wish I’d have stuck with that) As my father got better jobs over the years, my mother was able to buy better food and clothing for us and our lifestyle improved. But it always stayed in line with the income. If we could not afford it then we did without.
The basic rule of the household was, and still is, the same. When you know how much income you have you budget accordingly. If day to day expenses are higher than expected income then you change your income, expenses or both. You give up smoking, shop at Asda rather than Waitrose, etc. If your income cannot cover the expense of an activity then clearly you must stop doing that activity.
When we come to looking at the national budget using the same accounting methods we spot something rather strange.
Bearing in mind the number of people in work did not change more than a few percentage points per annum. The treasury could get a decent estimate on the amount of tax due in to HMRC. Similarly, the numbers on benefits and the type of benefits claimed by them did not fluctuate to any great extent and so the welfare figures are also elementary. Because these two sections of the budget are pretty much fixed, the only variable is what to spend on government departments. Any over spend comes as a result the government budgeting for more than it had in the coffers. To cover this, the government would need to borrow to make up the short fall.
Unlike the global recession, this overspend had been happening since 1997. Some argue that a lot of the borrowing was down to badly needed redevelopment. This argument fails on the grounds that the bulk of the budgets since 2003 have been spent on day to day expenses with increases in benefits and public services costs and repayment of the deficit and not any large scale redevelopment. Whilst this is commendable that we have a government that wishes to help those less fortunate than our selves we must bear in mind that continued overspending that is funded by debt is, as we have seen, not sustainable. The more a country borrows the more it owes and has to pay back. Indeed, we now have deficit so large that it will top 11% of our GDP by the end of this year. To put that in perspective, the UK went bust in 1976 running a budget deficit of 6% of GDP. This means an increasingly larger portion of the income is spent on repayment of debt year on year. To take this to its logical conclusion, we would eventually reach a point at which the repayments are larger than our income. At some point a government needs to step in to reduce the deficit to avoid this happening. Sadly though, this means stripping back on what we are over spending on and the people who suffer most from this are those the original over spend was meant to help, i.e. the poor.
By using the basic laws of accountancy we can draw only two conclusions from the actions of the Labour party over the last 13 years.
Either they did not understand that continued borrowing would be a problem and so cannot be trusted in the future or that it was a deliberate attempt to curry favour with the public knowing that who ever came in to reduce the deficit would be seen as “the bad guys”. I’m not sure which is worse.
In future I believe that the country needs to follow what I call the handbag principle. That is that the economy must always be run the same way as a household. Yes it’s nice to have better things and have a better way of life. But if you cannot afford it now and can see no way to increase your incomes to allow for it then do without!