Don’t let the title deter you, this one is a real page-turner!
It can be a tricky concept to understand, however the distinction between revenue and capital expenditure is something that individuals and organisations alike would do well to appreciate. Not least from a bookkeeping perspective as it is a statutory requirement to record them separately.
Lets have a look at the difference:
Revenue expenditure is what we would incur on a regular basis to fund our everyday operation. These costs tend to be consumable by nature and have a short shelf life. Examples would include food, light, heat, travel expenses, materials and labour costs etc.
Capital expenditure is what we would incur less regularly. Purchases like these are known as assets; they are more expensive and have a longer term use. They assist in creating the infrastructure to live our lives, or in a business sense – generate profit. Examples would include land, buildings, computer equipment, vehicles and machinery etc.
So why do we need to know the difference? Well, they are treated separately for accounting purposes, treated separately for tax purposes, and should be treated separately when considering how we pay for them. It’s useful for us to consider budgeting for them distinctly and to consider their impact on our retirement plans.
Treatment in Accounts
If you are running a business, revenue expenditure is displayed on the ‘Income Statement’. This is an accounting statement showing a business’ income and expenditure.
Capital expenditure is shown on the ‘Balance Sheet’, which is a comparison of what a business owns versus what it owes. Capital expenditure is gradually offset against a business’ profits using depreciation, over a number years depending on how long you would expect the asset to be in use for.
Treatment for Tax
From an individuals perspective, revenue and capital items are subject to a completely different tax altogether. You will be familiar with income tax and NI which is levied on our net earnings (which some revenue expense can be deducted from).
Gains we make in the purchase and subsequent sale we make on certain capital items such as investment property or shares, can be subject to Capital Gains Tax.
For businesses, our revenue expenditure can normally be offset in it’s entirety against profit (to lower our tax bills) in the year in which they are paid for.
For capital expenditure, tax relief is determined by what is known as ‘capital allowances’ which can affect the period over which tax relief is applied. You may have seen favourable capital allowances being used to drive economic stimulus as part of the our fiscal jiggery pokery of the last 9 months.
Sources of finance
It’s also important to think about how your respective expenditure is funded. Generally speaking it is advisable to source revenue expenditure from your operating income such as your sales, or at worst, short term finance such as an overdraft or credit card.
This works in personal finance as well. Whilst sadly unavoidable for some, particularly at the moment, expenses such as groceries would ideally be paid for from our regular income, rather than via a loan from the bank.
Similarly, because capital expenditure is longer term by nature, and it’s resulting assets are an investment in the future, then there is greater justification to seek finance as your source of funds. This can come in a range of facilities such as bank loans (debt) or in a business sense, a capital injection (equity) from new or existing investors.
You can see therefore that matching your sources of finance with the type of expenditure is an important thing to consider for us as individuals, as businesses, as not-for-profit organisations, and indeed for our government institutions.
Debt or equity funding
Choosing between debt or equity funding is an important business decision. This is because these two distinct forms of finance, have very different characteristics.
Debt funding, such as a bank loan, have obligatory repayment profiles with agreed levels of interest applied on the outstanding loan. However the contractual terms of loans are structured so that they are affordable, and the lender does not have any resulting stake in the business.
Equity funding on the other hand, can change the ownership structure of a business. This is because capital is received in exchange for a stake in the business. In Companies, this stake is in the form of shares. The good news with equity funding is that there is no obligation to service the finance. Shareholders are remunerated by dividends, but dividends are awarded at the discretion of the Company’s Directorship.
So the decision comes down to your tolerance for risk, your appetite for control, and your ability to service finance on a regular basis.
If you’re not clear on how a particular expense is classified, please get in touch. Whether you maintain your own accounting records, or employ us or another third party to maintain them for you, it is important to call out.