Expenditure on fixed assets may be classified into Capital Expenditure and Revenue Expenditure. The distinction between the nature of capital and revenue expenditure is important as only capital expenditure is included in the cost of fixed asset.
Capital Expenditure
Capital expenditure includes costs incurred on the acquisition of a fixed asset and any subsequent expenditure that increases the earning capacity of an existing fixed asset.
The cost of acquisition not only includes the cost of purchases but also any additional costs incurred in bringing the fixed asset into its present location and condition (e.g. delivery costs).
Capital expenditure, as opposed to revenue expenditure, is generally of a one-off kind and its benefit is derived over several accounting periods. Capital Expenditure may include the following:
- Purchase costs (less any discount received)
- Delivery costs
- Legal charges
- Installation costs
- Up gradation costs
- Replacement costs
As capital expenditure results in increase in the fixed asset of the entity, the accounting entry is as follows:
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Debit |
Fixed Assets |
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Credit |
Cash/Payables |
Quiz
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Question
Which of the following are examples of capital expenditure?
Cost incurred in testing whether a newly installed asset is functioning properly.
Correct.
Testing of assets is necessary in bringing them into usable condition and therefore any associated costs incurred must be capitalized. However, proceeds from sale of any items produced during the test phase must be deducted from the amount to be capitalized as per IAS 16.
Cost incurred in relocating a machine to a new factory.
Incorrect.
Recognition of cost ceases when the asset is made capable of operating unless it improves its earning potential. Subsequent expense on shifting an asset from one place to another does not enhance the earning capacity of the asset which is why such costs are classified as revenue expenditure.
Cost incurred in replacing an old engine of the aircraft with a new one.
Correct.
New engine significantly increases the useful life of the aircraft and as such, its cost must be capitalized. However, the carrying amount of the replaced engine must be de-recognized in the same manner as disposal of any fixed asset.
Revenue expenditure incurred on fixed assets include costs that are aimed at ‘maintaining’ rather than enhancing the earning capacity of the assets. These are costs that are incurred on a regular basis and the benefit from these costs is obtained over a relatively short period of time. For example, a company buys a machine for the production of biscuits. Whereas the initial purchase and installation costs would be classified as capital expenditure, any subsequent repair and maintenance charges incurred in the future will be classified as revenue expenditure. This is so because repair and maintenance costs do not increase the earning capacity of the machine but only maintains it (i.e. machine will produce the same quantity of biscuits as it did when it was first put to use).
Revenue costs therefore comprise of the following:
- Repair costs
- Maintenance charges
- Repainting costs
- Renewal expenses
As revenue costs do not form part of the fixed asset cost, they are expensed in the income statement in the period in which they are incurred. The accounting entry to record revenue expenditure is therefore as follows:
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Debit |
Revenue Expense (Income Statement) |
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Credit |
Cash/Payables |
