Last Updated on Mar 2, 2022 by
If you run a business, it is a given that you incur expenses. These expenses range from everyday spending to outflows that do not occur often. You may spend on buying raw materials, manufacturing goods, or for advertising and selling them.
All these expenses are different in nature. The accounting rules classify them into revenue and capital expenditure. Let us understand what the two mean and how they differ.
This article covers:
- What is capital expenditure?
- What is revenue expenditure?
- Why is classification into revenue and capital expenditure needed?
- Difference between revenue and capital expenditure
Table of Contents
What is capital expenditure?
Capital expenditure involves cash outflow for acquiring, maintaining, or upgrading fixed assets. It is non-recurring in nature, implying that it does not occur in the ordinary course of business. However, such expenditure comes with long-term benefits. It improves the efficiency of the business and helps in expansion. Let us see what all comes under this category.
Activities treated as capital expenditure
- Expenditure on purchasing tangible and intangible fixed assets. For example, you buy a new plant or machinery. These are tangible assets. Purchase of intangible assets includes buying copyright, patent, goodwill, etc.
- Spending on the improvement or extension of a fixed asset.
- Expenses incurred on installing a new fixed asset. This may include freight, stamp duty, and wages paid for installation. All direct charges involved with making the asset usable are capitalised.
- Repairing second-hand fixed assets before putting them to use.
- Any interest or related costs on borrowed funds, used for obtaining a fixed asset.
Let us see how to treat capital expenditure while preparing accounting statements.
You must show capital expenditure on the asset side of the balance sheet. Open a separate asset account that shows the details of all expenses that are capitalized while acquiring the asset. The balance sheet reflects only the asset account.
Since capital expenditure comes with long-term benefits, you must write it off over several years. This period is determined by estimating the life of the asset purchased. An amount, termed depreciation, is deducted every year from the asset’s account.
For example, assume that you purchase a machine worth Rs. 1,00,000. You spend Rs. 50,000 on its installation. The estimated life of the machine is 10 yrs.
- The total capital expenditure, in this case, would be Rs. 1,50,000.
- The amount of depreciation charged every year will be = 1,50,000/10 = 15,000.
Thus, every year for 10 yrs, Rs. 15,000 would be written off for the capital expenditure.
What is revenue expenditure?
Expenses incurred in the ordinary course of business are classified as revenue expenditure. These are recurring in nature and pertain to the ongoing financial year. Such expenses help in maintaining the business operations.
Activities treated as revenue expenditure
- Purchasing stock for resale or any items for consumption.
- Outflow on direct expenses. These are the expenses related to the production of goods, including raw material costs, wages, and freight.
- Office, administration, and selling expenses are also revenue in nature. These may involve paying salaries, electricity bills, rent, internet charges, etc.
- Depreciation on fixed assets is a non-operating revenue expense.
- Amount spent on subsequent repairs and maintenance of fixed assets.
Let us see how to record revenue expenditure in the books of accounts.
You must show the direct revenue expenses in the trading account. On the other hand, indirect revenue expenses are shown in the profit or loss account. The revenue expenses are subtracted from the revenue incomes to arrive at the net profit or loss in the financial year.
Now that you understand revenue and capital expenditure, let us see why this classification is important.
Why is classification into revenue and capital expenditure needed?
Differentiating between revenue and capital expenditure shows the correct standing of the company’s financial position. The profit or loss in the income statement shows your earnings. Moreover, the assets and liabilities in the balance sheet determine your financial position.
While preparing these two financial statements, all expenditure is classified depending on their applicability in the financial year. Showing a capital expense as revenue expenditure will reduce the net profit for the year. Similarly, mentioning a revenue expense in the balance sheet will give a wrong view of the company’s assets.
Moreover, it helps you treat the expenses fairly, depending on the number of years their benefit is spread across. Capital expenditure leads to changes that have a prolonged effect. On the other hand, revenue expenditure affects the immediate functioning of the business. This is why such a classification is necessary.
Let us now summarise the difference between the two.
Difference between revenue and capital expenditure
We can tabulate the difference between revenue and capital expenditure as follows:
|Particulars||Revenue expenditure||Capital expenditure|
|Tenure||These are short-term expenses.||This relates to long-term expenses.|
|Frequency||Recurring in nature.||Non-recurring in nature.|
|Size||These are usually expenses of smaller amounts.||This generally involves a large sum.|
|Use||To maintain everyday business activities such as purchasing inventory and spending on direct expenses.||To acquire a capital asset, which is used in the business and is not meant for sale. It is also incurred to increase the business’ earning capacity.|
|Accounting treatment||Is shown in the trading account or profit and loss statement and written off in the year it is incurred.||Is shown in the balance sheet and written off over several years.|
|Matching principle||Revenue expenditure must be matched with revenue receipts.||Capital expenditure and receipts are not matched.|
|Time of incurring||These are incurred only after the business operations commence.||You may incur capital expenditure even before the business is commenced.|
Capital expenditure is long-term and non-recurring. On the other hand, short-term recurring expenditure is revenue in nature. This classification is essential from the accounting point of view. It helps in providing a true picture of the financial position of the business. Understand them in detail to fair’s ascertain a company’s standing.