When a business makes a purchase, depending on certain factors, it’s either considered as capital expenditure or revenue expenditure. To understand the concept, there are basically two areas where money is spent in an organization;
- To purchase items that are to be used for several years, or
- To pay for items that will be used in day to day running of the business.
In this article, we will explain how expenditures are considered as capital expenditure or revenue expenditure and what is the difference between both.
Items that are bought for several years are generally not bought and sold in the normal business cycle. These are kept for the long term to produce products or to generate money for business. These items are called fixed assets or non-current assets. Money spent on these fixed assets or non-current assets are known as capital expenditure or capex.
As per the general accounting principle, any asset that has a life of longer than one year is considered as capital asset.
Here are example of fixed assets or capital expenditure
- Office equipment
- Manufacturing equipment
Capital expenditures are charged as expenses gradually over the useful life of the fixed assets purchases via depreciation.
Every large company has their own capex plan. If an internal fund is not sufficient, then companies use debt financing or equity financing to fund this type of large purchases.
The main purpose of capital expenditure is to expand a company’s ability to generate earnings.
Money spent on a day-to-day business where the benefit will be used within the same accounting year is known as revenue expenditure. It’s also known as operating expenses or opex. Benefits from revenue expenditure will be used in business within the current accounting year.
Please note, revenue expenses do not increase the efficiency of the firm for the long term. These expenses are recorded in the books of accounts based on the matching principle.
Here are example of revenue expenditures;
- Salaries and wages
- Telephone bills
- Powers and fuel
- Electricity bills
- Office rent
- Purchase of raw materials
- Travel and conveyance
- Office stationery
- Repair and maintenance costs
All these revenue expenditures are taken to income statements from their respective accounts to find out net profit of the business. However, treatment of inventory is slightly different.
A particular cost can be considered as a capital expenditure for one type of industry and revenue expenditure for another. For instance, land and building can be treated as a capital expenditure for manufacturing plants but revenue expenditure for a real-estate and housing company if it’s purchased for resale.
Similarly a machine manufacturing company will consider its machines as a product kept for resale but users of the machine will take it to their balance sheet as fixed assets.
Based on how costs are used for making money, you define a particular cost as capital or revenue expenditure. Here are certain expenses which are considered as capex even though you have not purchased an asset;
- Amount spent on the improvement of existing assets so as to increase their useful life.
- Expenses incurred for extension or addition of existing fixed assets.
- Commission or brokerage paid to arrange capital for the company.
These expenses are considered as a capex because it enhances the useful life of the fixed assets for which benefit will be received for more than one year.