Following the matching principle of accounting, all revenue items must be matched to their costs so that a correct picture of profit or loss in a year can be ascertained. For this, the classification of capital and revenue expenditure is important. In the below paragraphs, you will get to know the difference between capital expenditure and revenue expenditure.
All about capital expenditure
Capital expenditure is the expense that you make on the acquisition of an asset or that contributes to an increase in the earning capacity of your business. The benefit resulting from such kind of expenditure lasts for a long period of time.
A common example of capital expenditure is the purchase of land, buildings, machinery, patents, or furniture. These assets stay in the business for a long time, are used again and again, and thus continue to reap benefits for a long period. Some other examples may be the purchase of technology-driven machinery in place of hand-driven machinery to reduce daily operating expenses, money paid for goodwill/right to use the established name of an outgoing firm to attract its old customers and capture its market share so as to get higher profits, or any other similar kind of expenditure incurred for allowing a firm to produce a larger quantity of goods.
All these expenditures increase a firm’s capacity to generate higher revenue or sales in the future. Thus, a company’s profit increases manifold. It should be remembered that if an expenditure does not result in an increase in capacity or in a reduction of daily expenses thereby increasing profits, it can’t be regarded as a capital expenditure.
In addition, the money that you spend up to the point an asset becomes ready for use is also capital expenditure. Examples of such expenses could be fees paid to a lawyer for drafting a purchase deed of land, money paid on the overhaul of second-hand machinery, the amount spent on installation of new machinery, freight charges to bring the asset from the supplier’s warehouse to factory, or even interest charges on loan taken to buy a fixed asset until the time the asset becomes operational.
All about revenue expenditure
Unlike capital expenditure, the benefit derived from revenue expenditure expires within a year of its incurrence. They do not reap long-term benefits. Moreover, revenue expenditures are rather incurred to maintain the earning capacity of a business or an existing asset than to increase it.
Some common examples of revenue expenditure are amounts paid for wages, salaries, repairs, carriage of goods, interest, rent, and so on. In fact, depreciation charged on fixed assets is also a revenue expenditure. Further, the consumption of raw materials and the cost of goods sold is also a revenue expenditure.
It can be said that when an asset is acquired, its acquisition cost is capital in nature, however, the costs incurred in keeping such asset in working condition and defending its ownership are of a revenue nature. Suppose when you hire a lawyer to check that all papers are in order and to draft a purchase deed before acquiring land, it amounts to capital expenditure. But later if a suit is filed against you questioning the legality of ownership, the legal costs incurred then will be of a revenue nature.
The logic behind their classification and treatment
It is one of the primary goals of accounting to determine and report the genuine outcomes of a firm in terms of profit or loss during a specific accounting period. A company’s profit or loss can be calculated by comparing its revenue against its costs during the same time period. As a result, a good understanding of capital and revenue (both expenditures and receipts) is required for the proper calculation of profit or loss, since revenue items are only included in the income statement and capital items are included in the balance sheet statistics.
How is deferred revenue expenditure different from capital expenditure?
Certain expenses may be in the nature of revenue, but the benefit may not be consumed in the year in which such expenditure was incurred; instead, the benefit may be spread over a number of years, such as huge marketing expenditure incurred in introducing a new line or creating a new market. The costs for these expenses are deferred because they benefit more than one accounting period. This is required by the matching principle. Normally, the basis of debiting to the P/L account is proportional to the benefit consumed. The deferred revenue expenditure not yet written off is shown on the assets side of the balance sheet.
Now, the key characteristic of capital expenditure is that it produces a benefit that will accrue to the business for a long time, perhaps 10 or 15 years. Deferred revenue expenditure also results in a benefit that accrues in the future, but often over a period of 3 to 5 years.
Further, another factor differentiating capital expenditure from deferred revenue expenditure is that capital expenditure or the resultant asset is usually convertible into cash even though at a loss. But this is not practicable in the case of deferred revenue expenditure. Sometimes a huge loss such as loss due to an earthquake is treated as deferred revenue expenditure in the sense that it is written off over 3 to 5 years. It can’t be treated as a capital expenditure.
Drawing a line of distinction between capital and revenue expenditure
From the above discussion, capital expenditure and revenue expenditure can be differentiated on the following grounds:
|Basis||Capital expenditure||Revenue expenditure|
|Meaning||Capital expenditure is incurred on the acquisition or improvement of permanent assets that are not intended for resale.||However, revenue expenditure is a regular expense incurred in the usual course of business and comprises the cost of sales as well as the maintenance of fixed assets, among other things.|
|Impact on earnings||Capital expenditure attempts to enhance the earning potential of the business.||Whereas revenue expenditure seeks to maintain the earning capacity of the business.|
|Nature||Capital expenditure is typically a one-time expense.||Whereas revenue expenditure is generally recurring.|
|Period of benefit and treatment||Capital expenditure yields long-term advantages. As a result, only a portion is charged to the income statement as depreciation, while the remainder appears on the balance sheet.||However, the benefit of revenue expenditure is consumed within an accounting year and is therefore charged to the (current year’s) income statement in its entirety. As a result, it does not appear on the balance sheet. However, there is an exception to this rule: deferred revenue expenditure.|
|Part of financial statements||Part of the Balance Sheet and shown on the assets side||Part of Income Statement; reduces the profit or surplus and shown on the debit side|
By examining the fundamental nature of transactions, a distinction between capital and revenue transactions may be made. A transaction’s recurring nature and its relationship to an accounting period determine the classification.
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