Jumat, 24 Oktober 2014

Differences Between Capital and Revenue Expenditure

 Any business entity has various expenses to bear―office furniture, machinery, stationery, salary of employees, Internet and telephone expenses, transportation of a machine, etc. However, for accounting these expenses, they have to be classified either as capital or revenue expenditure. This classification depends on various factors, such as the nature of business of the entity, the tenure of benefit from the expense, and other accounting policies, followed by the respective organization as per the accepted policies of their nation. 

This classification forms the basis of accounting and any mistake will have a direct impact on the financial statements of the entity. Wrong classification can also be deliberately done to dress up and manipulate accounts, to deceive potential investors. If you're planning to be an accountant, or you're a reader of financial statements, it is essential that you know the difference between the expenses. Let's see the key differences between capital and revenue expenditure with the help of few examples.

Capital ExpenditureRevenue Expenditure


◼ It is that expense which is spent for buying an asset, providing a long-term benefit, i.e., for a period which is more than the business operating cycle. Such assets are known as fixed assets in accounting language.◼ In layman's terms, revenue expenses are a business entity's everyday expenses to earn their operating revenue. Usually, in accounting, matching concept is followed, i.e., revenue expenses and operating income are recorded for the relevant accounting period.

Treatment in Financial Statements

◼ It is transferred to the balance sheet of the business entity, and entered under the 'Fixed Assets' column.◼ It is recognized immediately after it is incurred. However, there are two systems of accounting―cash and accrual system. In the accrual system, non-cash items are also recorded. Revenue Expenses are written off, thus forming part of the 'Profit and Loss' statement.

Examples of How to Classify? (With Journal Entries)

Classification is a crucial part, and there are various criteria on which you should classify the expenses. Consider the following parameters:

(a) Business of the Entity

Example#1: Company X has a business of buying and selling cars. Company Y has a bought a car to be used as transportation for the employees. 

◼ Company Y has purchased the car as a 'fixed asset' which is going to be used for long-term benefit, i.e., to facilitate commuting of its employees. Therefore, it will treat it as capital expenditure. 

Journal entry in this case will be:

Fixed Asset (debit)
Cash/Creditor (credit)

◼ Business of Company X is to buy and sell cars, thus these cars are 'current assets' for them. Thus, it will be treated as revenue expense, as these cars will form part of their inventory expense. 

Journal entry in this case will be:

Purchases (debit)
Cash/Creditor (credit)
(b) Purpose of Purchase

Example#2: Sam has a business of buying and selling computers. He buys 8 computers and uses 2 of them for his office. In this case, purpose of buying of computers in each case has to be analyzed. 
◼ Sam has bought the 2 computers for office use, and not for trading. Thus, they will be treated as assets in the books of his accounts.

Journal entry in this case will be:

Computers (debit)
Cash/Creditor (credit)
◼ On the other hand, Sam has bought the other six computers, for regular trading. Thus, for him, these computers are stock to be sold off.

Journal Entry in this case will be:

Purchases (debit)
Cash/Creditor (credit)

Costs Associated with Purchase of a New Asset
◼ Various costs are associated with the purchase of assets, and a very careful understanding of this matter is required, since you have to follow relevant accounting policies followed by that particular country. For example, some accounting principles prescribes that installation expenses, professional fees for technical experts, delivery handling expenses, etc., should be added to the cost of the asset.◼ After you purchase an asset, there are various costs which will be attracted in due course. For example, repairs and maintenance costs are required to be written off (i.e., treated as revenue expenditure). There is going to be reduction in the value of an asset, due to usage and passage of time, thus depreciation of an asset is provided for, to reduce its value. It implies that depreciation is treated as a revenue expenditure.

Benefit of capital expenditure lasts for more than one accounting period; however, revenue expenses form the backbone of any organization. It might happen that the organization does not have any capital expenses in any particular year, but it is impossible to not have any revenue expenditure. Of course, capital expenses symbolize growth and expansion of that organization, and impaired assets are required to be replaced over a period of time; whereas revenue expense are required to earn the operating income. If you mistakenly capitalize expenses instead of writing it off, your assets will increase and profits will be inflated for that amount. That is the reason, special care is taken by accountants and auditors while verifying their classification.
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