Accounting aims to determine and present business results for a specific accounting period. To do this accurately, it is important to distinguish whether transactions are of capital or revenue nature.
Revenue Expenses:
- Related to the operations of the business within the accounting period.
- These are expenses that relate to the revenue earned during that period.
- The benefits of revenue expenses do not extend beyond the accounting period.
- Examples: wages, rent, utilities, raw materials, advertising expenses.
- These expenses are charged directly to the Profit & Loss Account.
- They must be connected with the current period’s activity (production and sales).
Capital Expenditure:
- Generates enduring benefits beyond one accounting period.
- Helps in revenue generation over multiple periods.
- Examples: purchase of machinery, building, land, or vehicles.
- These expenditures are recorded as assets on the Balance Sheet.
- The cost is gradually charged to the Profit & Loss Account over the years as depreciation or amortization, reflecting the utilization of benefits.
Key Points:
- The main difference is the time period of benefit:
- Revenue expenses: benefit is for one period only.
- Capital expenses: benefit lasts for many periods.
- Matching Principle: Expenses are recognized in the Profit & Loss Account when they help earn revenue. Capital expenditures are allocated over periods to match the revenue they help generate.
- Capitalization: An expenditure can only be capitalized if it can be directly linked to future economic benefits.
Why is this distinction important?
- To decide whether to record a transaction as an expense (in Profit & Loss Account) or as an asset (in Balance Sheet).
- Correct classification affects reported profit and financial position.
- Revenue expenditures are fully expensed in the year incurred.
- Capital expenditures are expensed over the asset’s useful life.
Challenges:
- Sometimes it is difficult to clearly distinguish between capital and revenue expenses (the borderline can be thin and requires judgment).
Identification of Capital & Revenue Expenditure
To distinguish between capital and revenue expenditure, the following key considerations are important:
(a) Nature of Business
- The classification depends on the type of business.
- For example, a trader dealing in furniture treats the purchase of furniture as revenue expenditure (since it is part of the trading stock).
- For other businesses, furniture purchase is treated as capital expenditure and recorded as an asset on the balance sheet.
- Thus, the nature of business is a critical factor in this distinction.
(b) Recurring Nature of Expenditure
- If an expense occurs frequently within an accounting year, it is typically a revenue expenditure.
- Example: Monthly rent, salary, utility bills — these are recurring and thus revenue expenses.
- Non-recurring expenditures, such as purchasing machinery or furniture, happen infrequently and are usually capital expenditures.
- However, materiality may override this; small value purchases may be treated as revenue expenses even if infrequent.
(c) Purpose of Expenses
- Expenses for routine repairs and maintenance of an asset are revenue expenses because they maintain the asset’s current condition.
- Expenses incurred for major repairs or improvements that increase the productive capacity or extend the life of the asset are capital expenditures.
- The distinction can be complex and requires judgment (i.e., deciding when repairs become improvements).
(d) Effect on Revenue Generating Capacity
- Expenses that help generate revenue only in the current period are revenue expenses and are matched against current revenues.
- Expenses that enhance or create benefits extending over multiple accounting periods are capital expenditures.
- For example, routine repairs go to the Profit & Loss Account, but an improvement increasing the asset’s capacity is capitalized.
(e) Materiality of the Amount
- The size or relative importance of the expenditure matters.
- A small purchase might be treated as revenue expenditure to avoid unnecessary complexity, even if it’s capital in nature.
- Conversely, large amounts usually warrant capitalization.
Summary Table
| Consideration | Capital Expenditure | Revenue Expenditure |
| Nature of Business | Asset purchase for use over time | Purchase of goods for resale (if core business) |
| Recurring Nature | Infrequent or one-time | Frequent, regular expenses |
| Purpose | Improves or extends asset life | Maintains asset in normal condition |
| Effect on Revenue Capacity | Benefits extend beyond current accounting period | Benefits limited to current accounting period |
| Materiality | Large, significant amounts | Small or insignificant amounts |
Capital Expenditures vs Revenue Expenditures
| Capital Expenditures | Revenue Expenditures |
| - Incurred to acquire or improve fixed assets (tangible or intangible). | - Incurred for day-to-day operations of the business. |
| - Benefits extend beyond one accounting period. | - Benefits relate to only the current accounting period. |
| - Examples: Purchase of machinery, building, patents. | - Examples: Cost of goods sold, salaries, rent, utilities. |
| - Increases the revenue earning capacity of the business. | - Related directly to revenue generation or the specific accounting period. |
| - Recorded as assets in the Balance Sheet and depreciated over time. | - Charged fully to the Profit & Loss Account in the period incurred. |
Explanation:
- Capital expenditure adds long-term value to the business by creating or enhancing assets that will be useful for many periods.
- Revenue expenditure covers routine costs necessary to keep the business operational and to generate revenue within the same accounting period.
Question 1
Decide whether the following statements are True or False, and explain why:
- Overhaul expenses for second-hand machinery are revenue expenses.
- Money spent to reduce working expenses is revenue expenditure.
- Legal fees paid to acquire property are capital expenditures.
- Lawyer’s fees spent to defend a lawsuit over the factory site are capital expenditures.
- Money spent to replace a worn-out machine part is capital expenditure.
- Expenses for repairs and whitewashing an old building for the first time are revenue expenses.
- Expenses related to obtaining a license for running a cinema are capital expenditures.
- Money spent on temporary huts necessary during the construction of a cinema, which were later demolished, is capital expenditure.
Answer 1
- False. Overhaul expenses for second-hand machinery are meant to get the machine working again and provide long-term benefits, so these costs should be treated as capital expenditure, not revenue.
- False. Money spent to reduce working expenses is generally considered capital expenditure, especially if it results in long-term benefits such as improved technology or assets.
- True. Legal fees incurred to acquire property are part of the property’s cost, so they are capital expenditures.
- False. Legal fees to defend a lawsuit about ownership of a factory site are maintenance costs and don’t add long-term benefits. Therefore, they are revenue expenses.
- False. Replacing worn-out parts is considered a maintenance cost, so it is a revenue expense, not capital.
- False. Repairing and whitewashing an old building for the first time is necessary to put it into usable condition, so these are capital expenses.
- True. The license is essential to operate the cinema, so the costs related to obtaining it are capital expenditures, often amortized over time.
- True. Temporary huts built to support the construction of the cinema (and later demolished) are part of the construction cost and should be capitalized.
