Capital expenditure is expenditure that is expected to generate economic benefits for a company in more than one period. Unlike revenue expenditure, which is recorded as an expense in income statement, capital expenditure is recorded as an asset in balance sheet and depreciated/amortized over its useful life using any of the acceptable depreciation/amortization methods.
Compared with revenue expenditure
Classification of expenditure as capital expenditure or revenue expenditure depends on the applicable accounting framework and materiality level adopted by the company.
In general, accounting standards require expenditure to be treated as capital expenditure if it is such that it will benefit the company over more than one period of time (typically more than one year). This is because a capital expenditure helps in generating revenues in more than one period. Hence, it is more logical to record the expenditure as an asset initially and then charge it as an expense in income statement over the relevant periods using the mechanism of depreciation/amortization. This approach helps in better matching of revenues with expenses. Expensing out expenditure eligible for capitalization in the period in which it is incurred will result in mismatch between revenues and expenses. It will understate current period net income and overstate future period net income.
Materiality is also important in determining whether expenditure is capitalized or expensed. For example, a company might have a policy of expensing all expenditures less than $500 for the sake of simplicity. In such a situation, a laptop computer RAM upgrade of less $500 will be expensed out even if it is expected to last for more than one year.
Following are examples of capital expenditure:
- Purchase of vehicles
- Construction of buildings
- Improvements to land
- Licenses, patents and copy rights
- Purchase of office equipment
- Development of computer software
Following are typical journal entries involved in recognition and depreciation of capital expenditure:
- Capital expenditure involving purchase:
Long-lived asset ABC Accounts Payable/Cash ABC
- Capital expenditure involving construction:
Capital work-in-progress ABC Accounts Payable/Cash ABC Long-lived asset ABC Capital work-in-progress ABC
- Depreciation/amortization of a capitalized asset:
Depreciation/amortization XYZ Accumulated depreciation/amortization XYZ
Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork