Business expenditures are accounted for in either one of the two ways. They are either expensed in the income statement (revenue expenditures) or capitalized as fixed assets in the balance sheet (capital expenditures).
If you are new to accounting, the difference between capital expenditures and revenue expenditures can seem a bit confusing. Once you learn the basics however it is actually pretty easy to differentiate between the two.
Capital Expenditures
Capital expenditures are the long-term costs that a business incurs to acquire and improve its fixed assets.
Capital expenditures are not the regular costs of running a business. They are usually significant expenses incurred once in a while to increase or improve the fixed assets of a business.
Examples of capital expenditure include the following costs relating to fixed assets:
- Purchasing cost.
- Registration, licensing, and other legal fees.
- Installation charges.
- Transportation cost.
- Testing & inspection cost.
- Cost of major extensions, overhauls, renovations, and other significant improvements to existing fixed assets.
Capital expenditures are not immediately expensed in the income statement because the business derives its benefit for several years. Instead, their cost is gradually charged to the income statement in the form of depreciation over its useful life.
Capital expenditures include not only the purchase cost but also the cost required to bring the asset into use for the first time, such as legal fees, installation charges, and the cost of transportation.
However, as you will learn in the next section, not all costs relating to long term assets are capital expenditures.
Revenue Expenditures
Revenue expenditures are recurring costs that are necessary for running the day to day operations of the business and maintaining the existing assets.
Revenue expenditures are recurring costs that are necessary for running the day to day operations of the business and maintaining the existing assets.
Revenue expenditures are short term costs that are charged to the income statement as soon as they are incurred.
They are the default category for recording expenses. If a cost does not meet the definition of capital expenditure or is too insignificant to track as a fixed asset, it is classified as a revenue expense.
Examples of revenue expenditure include the following:
- Operating expenses of a business such as production, selling, administrative, and finance cost.
- Repair and maintenance expenditure on fixed assets.
- Cost of operating a fixed asset.
- Any capital expenditure that is below the capitalization limit.
Comparison
Example 1
Sara renovated her office recently.
The renovation firm charged her for the following:
-New desk
-Repair of floor
-Repainting of walls
-Redecoration of office
-Replacement of broken window
The cost of a new desk is a capital expense for Sara. The remaining expenditures are revenue costs.
Repairs & Overhauls
Repairs need to be differentiated from overhauls when differentiating capital and revenue expenditures.
A minor repair restores the asset into its working condition, and its cost is classified as revenue expenditure.
Overhauls involve the substantial replacement or upgrade of an asset that improves its useful life, and its cost is capitalized in the balance sheet.
Example 2
James took his tractor to a workshop after its gear jammed while working on his farm. Upon inspection, the mechanic convinced James to get his tractor's engine replaced as well because the old one had completely worn out.
The workshop billed James for the following:
-Repair of gears
-Cleaning service
-Engine replacement
The cost of repairing gears and cleaning charges are revenue expenditures. However, the cost of engine replacement should be capitalized as it increases the useful life of the tractor.
Inventory & Capital Expenditure
It is important not to confuse expenditure on stock in trade as capital expenditure when the business involves the sale of long term assets.
Example 3
Bill purchased the following vehicles for his car sale and repair business:
-A tow truck for bringing indisposed vehicles to his workshop.
-A car for the purpose of resale.
-A spraying machine for repainting jobs.
The tow truck and spraying machine should be capitalized as capital expenses. The purchase of a car is a revenue expenditure for Bill as it is not intended for the long term use in the business but only for resale.
Operational cost of asset
The cost of operating an asset such as the fuel expense of a vehicle is not a capital expenditure but a revenue expense that must be charged immediately in the income statement.
Example 4
Jane got a printer for her office. Along with the printer, she also purchased:
-A set of papers for printing.
-A table to place the printer.
The costs of the printer and the table are capital expenditures, but the purchase of papers is a revenue expense for Jane.
Quiz
How much do you know about Capital & Revenue Expenditures?
Instructions for solving quiz:
- Click on one of the given options that you think is correct.
- If you are not sure about a question, review the lesson above.
- Mark yourself out of 11 by rewarding 1 mark for each correct answer.
Good luck!
Question 1
Capital expenditure is the cost of acquiring _______________ assets.
Current
Wrong answer.
Expenditure on current assets is classified as a revenue expense.
Fixed
Correct!
Question 2
Incorrectly recording a revenue expenditure as a capital expenditure has the effect of overstating assets.
True
You're right!
False
Wrong answer.
Revenue expenditure should be charged as an expense in income statement. If it is incorrectly capitalized, the value of assets in the balance sheet will be overstated.
Question 3
Accounting for a capital expenditure as a revenue expense has the effect of ______________ profits.
Overstating
Incorrect.
Capital expenditure is charged as an expense in income statement gradually over its useful life. If it is incorrectly treated as a revenue expense, the amount of expenses will be significantly rise in the income statement leading to a lower profit.
Understating
Precisely!
Question 4
Sophia owns an ice cream parlor, which she has been operating for more than six months now.
The business seems to be doing well, but Sophia can’t be too sure unless she runs the numbers on her financial statements.
She has listed all the expenditures of her business in her diary but can’t seem to decide which ones to recognize in the balance sheet as fixed assets and which ones to write off in the income statement as an expense.
Can you classify the following expenditures correctly?
a) Purchase cost of the shop.
Capital expense
Correct!
Revenue expense
Wrong answer.
Shop is a long term asset which should be capitalized in the balance sheet.
b) Legal charges for transferring the ownership of the shop.
Capital expense
You're right!
Revenue expense
Incorrect.
Legal fees relating to the purchase of assets need to be capitalized in the cost of the asset.
c) Electricity expense of the shop.
Capital expense
Wrong answer.
Electricity charges are an operating expense.
Revenue expense
Spot on!
d) Purchase cost of a refrigeration system.
Capital expense
Correct!
Revenue expense
Incorrect.
Refrigeration system is a fixed asset of the business.
e) Charges for installation of refrigeration system.
Capital expense
Exactly right!
Revenue expense
Wrong answer.
Installing the refrigeration system is necessary for using it for the first time and its cost is therefore a capital expenditure.
f) Cost of repairing the refrigeration system.
Capital expense
Incorrect.
Repair cost of an asset is a revenue expenses rather than a capital expenditure.
Revenue expense
Absolutely!
g) Cost of buying milk for making ice cream.
Capital expense
Incorrect.
Production expenses are a revenue expense.
Revenue expense
Correct!
h) Salaries paid to employees working at the shop.
Capital expense
Wrong answer.
Payroll expense is usually charged to income statement unless the employees had worked on the construction of a long term asset.
Revenue expense
You're right yet again!
How many questions did you answer correctly?
Score Grade
11 Master
9 – 10 Pro
7 – 8 Pass
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