You must have observed that some expenditures are capitalized whereas some expenditures are directly charged to income statement. Accountants have classified expenditures in the following two categories based on certain differentiating characteristics of expenditures:
- Capital expenditure
- Revenue expenditure
Let’s discuss each category and understand why some expenditures are capitalized and others directly charged to income statement.
The expenditure incurred by an entity is classified as capital expenditure if it is expected that economic benefits associated with that expenditure will be generated for a long term or at least for more than a year. For instance, expenditure incurred to acquire a long-term asset or replace a major part of long-term asset such as plant and machinery, building etc. are capital expenditure. A machinery whose life is ten years will keep on producing goods for ten years, which will be sold by the entity and revenues will be generated. So, it is more appropriate to capitalize the acquisition cost of machinery and depreciate it over its useful life of ten years as required by matching principle.
Once classified as capital expenditure based on the above definition, it is recorded in one of the balance sheet accounts. Capital expenditure, except for the cost of land, is usually depreciated or amortized over the economic useful life of the asset.
The expenditure incurred by an entity is classified as revenue expenditure if it is expected that economic benefits associated with that expenditure will be generated in the same period. In other words, direct and indirect costs incurred to generate income in a particular period are termed as revenue expenditure. For instance, salaries of staff working in factory, cost of material consumed, expenditure incurred on advertising etc. are all examples of revenue expenditure as the related revenue is generated in the same accounting period.
Once classified as revenue expenditure based on the above definition, it is recorded in one of the income statement accounts.