In accounting, the term expenditure refers to the payment of an asset or the incurrence of liability in exchange for another asset or service rendered.
Expenditures occur in cash or on credit. The process results in firms receiving another asset, such as a delivery truck, or using a service, such as repairing a delivery truck. When the expenditure produces another asset, it is called capital expenditure.
Thus, the term “capitalize,” when used in this sense, means to consider an expenditure as an asset.
When expenditure results in a service whose benefits are consumed in the current period, it is called an item of revenue expenditure.
Revenue expenditures are current expenses and include ordinary repairs, maintenance, fuel, and other items required to keep assets in normal working condition.
The following diagram illustrates the difference between capital and revenue expenditures.
Difference Between Capital and Revenue Expenditures
The difference between capital and revenue expenditures is important when determining periodic net income.
This is because capital expenditures affect several accounting periods, whereas revenue expenditures affect only the current period’s income.
If an error is made and an item of capital expenditure (e.g., an equipment purchase) is recorded as revenue expenditure, the net income will be misstated for both the current and future period.
The current period’s income will be understated because the entire expenditure was expensed when only a portion of it (i.e., the current year’s depreciation) should have been expensed.
The income of future periods will be overstated because no depreciation expense is recorded in these years. Although over the useful life of the asset the error is self-correcting, the income is misstated in the interim.
How do firms distinguish between capital and revenue expenditures?
Clearly, the purchase of a delivery truck is a capital expenditure, whereas an engine tune-up is a revenue expenditure. But what about purchasing a wastepaper basket or ordering a major engine overhaul that practically constitutes a new engine?
To establish consistent accounting policies that can be followed from year to year, firms develop guidelines or formal policies to handle these items.
Materiality considerations play a large role in the design of such policies. Most firms put a minimum dollar limit for capital expenditures, ranging from $100 in small companies to several thousands of dollars in large companies.
This problem is further complicated by the fact that the same item can sometimes be considered a capital expenditure and at other times a revenue expenditure.
For example, the labor cost to adjust a new machine during installation is considered a capital expenditure and, therefore, forms part of the acquisition cost of the machine. This is because the expenditure is necessary to make the machine ready for use.
On the other hand, the same labor cost subsequent to the operation of the machine is an item of revenue expenditure. This is because, at that time, it is a normal and recurring repair.
Therefore, the purpose, as well as the nature, of the expenditure, must be considered when deciding whether an item is a capital or a revenue expenditure.