What is the expenditure?
Throughout accounting, we have used the term expenditure to refer to payment of an asset or the incurrence of liability in exchange for another asset or for a service rendered.
The expenditure is made in cash or on credit and results in the firm’s receiving another asset, such as delivery truck, or in using a service, such as a repair to a delivery truck. When the expenditure produces another asset, it is called a capital expenditure. Thus, the term capitalize, when used in this sense, means to consider an expenditure as an asset.
When the expenditure results in a service whose benefits are consumed in the current period, it is called a revenue expenditure. Revenue expenditures are current expenses and include ordinary repairs, maintenance, fuel, and other items required to keep the asset in normal working condition.
The following diagram illustrates the difference between capital and revenue expenditures.
Difference between Capital and Revenue Expenditures
The distinction between capital and revenue expenditures is important in determining periodic net income, because capital expenditures affect several accounting periods, whereas revenue expenditures affect only the current period’s income. If an error is made and a capital expenditure, such as equipment purchase, is recorded as a revenue expenditure, both the current period’s and future periods’ net income will be misstated.
The current period’s income will be understated because the entire expenditure was expensed when only a portion of it, the current year’s depreciation, should have been expensed. Future periods’ income 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, in the interim the income is misstated.
How do firms decide what is a capital and what is a revenue expenditure? Clearly, the purchase of a delivery truck is a capital expenditure, whereas an engine tune-up is a revenue expenditure. But what about the purchase of a wastepaper basket or a major engine overhaul that practically constitutes a new engine? In order to have 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 part in the design of such policies. Most firms put some minimum dollar limit for capital expenditures. The minimum can range from one hundred dollars for small companies to several thousand dollars for 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 thus 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 a revenue expenditure. This is because at that time it is a normal and recurring repair. Thus, 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.