Expenditures for the purchase or expansion of plant assets are called capital expenditure and are recorded in asset accounts. Expenditures for ordinary repairs, maintenance, fuel, and other items necessary to the ownership and use of plant and equipment are called revenue expenditures and are recorded by debiting expense accounts. The charge to an expense account is based on the assumption that the benefits from the expenditure will be used up in the current period, and the cost should therefore be deducted from the revenue of the period in determining the net income.
A business may purchase many small items which will benefit several accounting periods but which have a relatively low cost. Examples of such items include auto batteries, wastebaskets, and pencil sharpeners. Such items are theoretically capital expenditures, but if they are recorded as assets in the accounting records it will be necessary to compute and record the related depreciation expense in future periods. We have previously mentioned the idea that the extra work involved in developing more precise accounting information should be weighed against the benefits that it results. Thus, for reasons of convenience and economy, expenditures which are not material in dollar amount are treated in the accounting records as expenses of the current period. In brief, any material expenditure that will benefit several accounting periods is considered a capital expenditure. Any expenditure that will benefit only the current period or that is not material in amount is treated as a revenue expenditure.
Many companies develop formal policy statements defining capital and revenue expenditures as a guide toward consistent accounting practice from year to year. These policy statements often set a minimum dollar limit for a capital expenditure (such as $500).
Effect of Errors in Distinguishing between Capital and Revenue Expenditures
Because a capital expenditure is recorded by debiting an asset account, the transaction has no immediate effect upon net income. However, the depreciation of the amount entered in the asset account will be reflected as an expense in future periods. A revenue expenditure, on the other hand, is recorded by debiting an expense account and therefore represents an immediate deduction from earnings in the current period.
Assume that the cost of a new delivery truck is erroneously debited to the Repairs Expense account The result will be to overstate repairs expense, thereby understating the current year’s net income. If the error is not corrected the net income of subsequent years will be overstated because no depreciation expense will be recognized during the years in which the truck is used.
• On the other hand, assume that ordinary truck repairs are erroneously debited to the asset account, Delivery Truck The result will be to understated repairs expense, thereby overstating the current year’s net income. If the error is not corrected, the net income of future years will be understated because of excessive depreciation charges based upon the inflated balance of delivery truck.
These examples indicate that a careful distinction between capital andrevenue expenditures is essential to attainment of one of the most fundamental objectives of accounting—the determination of net income for each year of operation of a business.
The process of planning and evaluating proposals for capital expenditures is called capital budgeting. Capital budgeting includes such decisions as whether to build new factories or automate old ones, buy competing businesses, and develop new products.
Decisions regarding the acquisition of plant assets may be among management’s most significant responsibilities. These acquisitions often involve large dollar amounts, perhaps hundreds of millions—even billions— of dollars. If the company has the plant assets designed and constructed, the cash outlays to acquire these assets may continue over a period of years. In addition, acquisitions of plant assets may affect the nature and profitability of the company’s operations for many years to come.
A major factor in most capital budgeting decisions is management’s estimates of the future cash flows relating to the project—that is, the cash outlays needed to acquire the new assets, and the annual net cash receipts which these assets are expected to generate.
One approach widely used in the evaluation of capital budgeting proposals is discounting the expected future cash flows to their present value. Another approach is to compute the return on investment (ROl) expected from each proposed expenditure.
1 Decisions concerning the acquisition of plant assets are of considerable importance, as they may affect business operations for many years.
2 Accounting information—especially estimates of future cash flows and earnings—plays a vital role in these decisions.