In the terms of a business’ finances, capital expenditure and revenue expenditure are two important components. In this article, we will break down all the concepts of capital and revenue expenditure and seek to understand the difference between capital expenditure and revenue expenditure.
What are capital expenditures?
Capital Expenditure (CAPEX) refers to funds allocated for acquiring, maintaining, or upgrading long-term assets. These expenses are typically infrequent and aim to enhance a company's long-term efficiency.
Common examples of CAPEX include purchasing tangible assets like machinery, land, equipment, and furniture, as well as intangible assets such as patents, licenses, and trademarks. CAPEX significantly impacts a firm's financial health both short-term and long-term, contributing to improved overall operations.
The formula for calculating CAPEX is:
Capital Expenditure = Net increase in Property, Plant, and Equipment (PP&E) + Depreciation Expense.
CAPEX is reflected in the Cash Flow Statement and is also recorded in the Balance Sheet under fixed assets. It's important to note that CAPEX is capitalized, and depreciation is charged annually on these assets. This distinction between capital and revenue expenditure is crucial.
What is revenue expenditure?
Revenue Expenditure (OPEX) refers to expenses incurred by a company during its day-to-day operations. These costs are associated with production activities and generally do not result in the creation of assets. The benefits derived from OPEX are limited to the current accounting period.
While OPEX may not directly increase a company's profit-earning capacity, they are essential for managing operational activities and assets efficiently. These expenses are crucial for generating revenue within a specific accounting period.
Difference between Capital and Revenue Expenditure
Aspect |
Capital expenditure |
Revenue expenditure |
Definition |
Expenditure on acquiring, upgrading, or maintaining fixed assets. |
Expenditure on day-to-day operations and maintenance of the business. |
Nature |
Long-term: Benefits are realised over a period longer than one financial year. |
Short-term: Benefits are realised within the same financial year. |
Purpose |
To increase the earning capacity of the business by adding or improving assets. |
To manage the routine operational costs necessary for running the business. |
Examples |
Purchase of machinery, construction of buildings, upgrading equipment. |
Salaries, rent, utilities, repairs and maintenance. |
Accounting treatment |
Capitalised on the balance sheet as an asset and depreciated over time. |
Expensed fully in the income statement during the period in which they are incurred. |
Impact on financial statements |
Increases asset value on the balance sheet; affects cash flow but not immediate profit. |
Reduces profit on the income statement; does not impact the balance sheet as an asset. |
Depreciation |
Subject to depreciation (or amortisation in case of intangible assets). |
Not depreciated; fully charged to the profit and loss account. |
Recurring nature |
Generally non-recurring; occurs less frequently and irregularly. |
Recurring; occurs regularly as part of normal business operations. |
Impact on taxation |
Often results in deferred tax benefits due to depreciation allowances. |
Directly reduces taxable profit in the period it is incurred. |
Decision-making |
Typically involves strategic planning and long-term investment decisions. |
Typically involves operational and budgetary planning for short-term needs. |
The funds expended by a company for acquiring or improving long-term assets like machinery, buildings or equipment is CapEx, which is not immediately paid. This is unlike RevEx; instead, it is recorded and capitalised as assets on the balance sheet. Gradually, these assets are disbursed over time as they are used or consumed.
The expenses incurred by a company in its regular business operations to generate revenue, including rent, salaries and utilities, is RevEx. The difference between capital expenditure and revenue expenditure is that RevEx is expensed immediately and is reflected in the income statement.
What are the different types of capital expenditure and revenue expenditure?
CapEx and RevEx can be categorised into several types, in regards to capital market, as follows:
In terms of CapEx:
- Strategic: These are investments that support long-term strategy, e.g. R&D or acquisitions.
- Expansion: These are the costs incurred to increase production operations or capacity, such as facility construction or new equipment.
- Replacement: These are the costs expended to replace obsolete assets.
- Maintenance: These are costs incurred to preserve existing assets, like upgrades or repairs.
- Compliance: These are payments made for regulatory adherence, including safety regulations.
Each type of CapEx has different implications and serves a distinct function for a business’s financial health and future growth.
In terms of RevEx:
- Advertising and marketing costs
- Administrative and selling outlays
- R&D spending
- Maintenance and repair expenses
- Goods sold expenses
CapEx accounting treatment
CapEx are not instantaneously disbursed; however, they are recorded as assets on the balance sheet. The cost of the asset is then depreciated over the period during which it is used, and the expended cost is recorded in the income statement. Depreciation is a non-cash expense that spreads the cost of the asset over the duration of its consumption.
The depreciation expense diminishes the book value of the asset on the balance sheet each period until it is fully used. The difference between the selling price and the book value of the asset is recorded as a gain or loss on the income statement when an asset is sold or disposed. Proper accounting treatment of CapEx is vital for accurate financial reporting and for evaluating a business’s financial health and growth potential, including its impact on the capital asset pricing model.
Revenue expenditures accounting treatment
Revenue expenditures, also known as operating expenses, are recorded directly on the income statement in the period in which they are incurred. These expenses are crucial for maintaining the day-to-day operations of a business and ensuring that the company can continue to generate revenue.
When a company incurs revenue expenditures, such as salaries, rent, utilities, and repairs, these costs are subtracted from the revenue generated during the same period. This subtraction helps to determine the net income or profit for that specific accounting period. Unlike capital expenditures, which are spread out over several periods through depreciation, revenue expenditures are expensed immediately.
For instance, if a company pays for electricity used during the month of May, the full cost of that electricity bill is recorded as an expense in May. This immediate expensing ensures that the financial statements reflect the true cost of operating the business during that period.
Capital expenditure example
Suppose this is an excerpt of the Income Statement of XYZ Ltd. as on 30th March 2022:
Particulars |
Amount (Rs.) |
Cash flow from operating activities |
5,25,00,000 |
Cash flow from investing activities |
-1,25,50,000 |
Net change in cash |
3,99,50,000 |
Opening cash balance |
7,00,00,000 |
Closing cash balance |
10,99,50,000 |
Free cash flow |
|
Operating cash flow |
5,50,00,000 |
Capital expenditure |
-1,75,00,000 |
Free cash flow |
3,75,00,000 |
In this example, the capital expenditure of Rs. 1,75,00,000 is shown as a deduction from the operating cash flow to calculate the free cash flow. This gives a clear picture of the company's available cash after accounting for CapEx, which is essential for understanding the funds available for expansion or other operational needs.
Revenue expenditure example
Suppose this is an excerpt of the Balance Sheet of XYZ Ltd. as on 30th March 2022:
Particulars |
Amount (Rs.) |
Total revenue |
7,20,00,000 |
Cost of revenue |
3,90,00,000 |
Gross profit |
3,30,00,000 |
Operating expenses |
|
Selling, general and administration |
1,80,00,000 |
Total operating expenses |
2,45,00,000 |
In this example, revenue expenditures like selling, general, and administrative expenses are shown under operating expenses. These costs are subtracted from the total revenue to determine the gross profit, illustrating how revenue expenditures directly impact the profitability of the company within the same financial period.
Are Capital Expenditures and Revenue Expenditures the Same Thing?
Capital expenditures (CapEx) and revenue expenditures (OpEx) are both types of spending by companies. However, they differ in their purpose and time frame. CapEx is used for long-term investments in fixed assets like property, buildings, and equipment. These purchases are expected to generate revenue over a longer period. OpEx, on the other hand, covers short-term expenses needed for daily business operations.
Which expenditure method is ideal for taxation?
On the basis of the type of expenditure, the taxation treatment varies substantially. Usually, RevEx are completely deductible from taxable income in the year they are incurred, whereas CapEx are not. Instead, the cost of the asset is depreciated and capitalised over the duration of its consumption and usage. In addition, only the annual depreciation expense is deductible from the taxable income. However, regulations and tax laws regarding expenditure treatment may differ among jurisdictions and countries. This is why businesses need to comprehend the tax ramifications of their expenditures and adhere to all relevant regulations and tax laws to prevent penalties and fines.
Final thoughts
In summary, grasping the difference between capital expenditure and revenue expenditure is important for effective financial management in business. Businesses can make informed investment decisions, optimise resource allocation and attain sustained long-term growth and financial stability through strategic planning and managing these expenditures.
