8. Capital vs. Revenue Expenditures

Let's talk about capital versus revenue expenditures. Now, what we're dealing with here is when you have an asset, you're gonna spend more money on it, and it's either gonna fall into one of two categories, the first being a capital expense and the other being a revenue or an operating expense. If it's a capital expense, we get to add it to the cost of the asset, and we get to depreciate it. If it's a revenue expense, we expense it immediately. So capital expenditures are ones that are basically bigger and better than revenue expenditures. A capital expenditure is expected to last for more than one period, so it's expected to last a couple of periods.

And you can tell that because we're going to depreciate the capital expenditure. And depreciation is a means by which we allocate expenses over some useful life, right? So if it's a revenue expenditure, and we expense it immediately, then basically what we're saying is that value is only gonna last for one period. So we just expense it immediately, because since it's not gonna last for several periods, we don't do any depreciation. The whole goal of depreciation is to match the expenses to the period that they were incurred. So capital expenditures need to be depreciated. Now, what's the difference in the real world, like in the actual running of your business?

What's the difference between a capital and a revenue expenditure? Typically, we think of it like this: a revenue expenditure is maintenance, and a capital expenditure is some kind of improvement. And this improvement could improve the useful life. It could make it last longer, or it could improve productivity.

So if the improvement increases the useful life or it increases productivity, that's a pretty good indication that what we're doing is a capital expenditure. Now, if it's maintenance and all it does is it just keeps it operating, then that's a pretty good indication that it's a revenue expenditure or an operating expense. And there's gonna be a couple times where you may think, "Oh, that could be an improvement," or, "Oh, that could be maintenance." And the deciding factor is gonna be these two guys right here. Does it make it last longer? Does the useful life increase, or does it make it more productive? So a common one that you'll see is something like engine replaced.

Well, engine replaced could technically be maintenance. Engine replaced could also be improvement. So if the replacement of the engine extends the useful life by a year or two, then you know that it's a capital improvement. But if the replacement of the engine doesn't affect salvage value, doesn't affect useful life, doesn't affect productivity, doesn't affect anything, it just keeps it going as it was, then you know it's maintenance. The way we record a capital expenditure is by adding it to the cost of the asset. So when you have a capital expenditure, let's say you replace the engine and it increases useful life, well, then you add it to whatever asset it is.

It could be, let's call it truck. You increase the truck account, and you decrease however you paid for it. And so this is capitalizing it. This is putting it directly into the truck account. So in that account, you had your acquisition cost at some amount, and then you have your capital improvement, your improvement that extended the life of the truck, you put in here also.

Now, over on the revenue side, it's pretty straightforward. You just have some kind of expense and however you paid for it, and that's it. That's all you do, because on the revenue side, it's really just an expense journal entry. So if you replace the spark plug, you say, "Well, I spent 20 bucks on replacing the spark plug." That's an expense. That's an operating or a maintenance expense, and that's all you really have to do for that one. Now, I wanna talk about what happens when you have a capital expenditure like this. What do you do about depreciation? So if we say that the truck is a $10,000 asset, it has a useful life of five years, and we'll just say zero salvage value, and we'll use straight-line depreciation.

Now, after one year, we have a $2,000 capital expenditure, $2,000 CapEx. Now, what is depreciation gonna be in Year 2? Because our formula says cost minus salvage value over useful life. So for the first year, we're gonna have $10,000 over five years, so it's gonna be $2,000 for the first year. So Year 1 is gonna be: depreciation expense, 2,000; accumulated depreciation, 2,000. Now, when we get down to Year 2, so at the beginning of Year 2, we have a $2,000 capital expenditure, and we'll say plus one year of useful life. So this $2,000 adds one year of useful life.

Now, I'm gonna change this $2,000 to $1,000, 'cause I don't want it to match this $2,000, 'cause that gets confusing. So we have a capital expenditure of $1,000, so that's one year of useful life. So what is depreciation at Year 2?

Because our depreciation expense is going to change because we changed the cost, and now we've changed the useful life. So we know that it can't just be $2,000 again. So what we're gonna do, instead of saying depreciable base over useful life, what we're gonna do is we're gonna say remaining depreciable base over remaining useful life.

And the reason we do this is because we were going along nice and slow, just like that, and then we had a capital expenditure. And now our slope is gonna change one way or the other, right? Because this was our depreciation slope back when everything was normal. Then we had this change that changed both cost and useful life. So now, once you have a capital expenditure change, your slope is gonna change somehow. So what we do is we basically just do whatever method we're using, we do that equation again, but we add this word, remaining. What's the remaining depreciable base?

What's the remaining useful life? Well, the original useful life was five years. We added one year after one year. So it turns out the remaining useful life is still five years. One year passed and we added one year on. So we're still going at five right here. Now, what's the remaining depreciable base? Well, we had a $10,000 acquisition cost. We said the truck cost $10,000. And then in the first year, we took a $2,000 depreciation expense, so our accumulated depreciation is $2,000, right? So now we're down to an $8,000 book value. But we also had a $1,000 capital expenditure.

So now we're up to a $9,000 book value. And because we have zero salvage value, our remaining depreciable base is $9,000. So what we do is we take our remaining depreciable base, and we put it over our remaining useful life, and we end up with our new depreciation rate. So it turns out ours is gonna be a little less slopey after, because this was $2,000 a year, and now we're at $1,800 a year. So it's gonna be a little bit of a flatter line. Now, the way I like to think about this is basically just treating it as if it's a new asset, a brand-new asset, and you just do the equation again.

You take the cost, you take out any accumulated depreciation you may have. You take all that out, and that's your book value. Then you add in all your capital expenditures, and you say, "Okay, this is how much my new book value is." So your book value before your capital expenditures and your book value after your capital expenditures. And now you're right back to where you need to be. You just say, "Okay, well, my depreciable base is what my new book value is minus my salvage value," 'cause you can never depreciate more than your salvage value. And you say, "I'm gonna put it over my useful life."

And your salvage value could change, too, so you would just plug in your new salvage value. So when you have a change in depreciation like this, when you have something that changes your depreciation, try to get to your new value of the asset. Your new value of the asset is the original value minus the accumulated depreciation plus what you just spent on it. This is your new value. This is the amount that you're gonna calculate your depreciable base off of, and then you're just gonna do it like it's a brand-new asset. Book value minus salvage value over useful life gives you your new depreciation expense.