CAPITAL AND REVENUE EXPENDITURE

  Capital and Revenue Expenditure Advance Learning

The concepts of capital and revenue are of paramount importance in accounting. The true performance of a business enterprise can be measured by matching the business incomes with business expenses of the same period. The distinction between the capital and revenue items is necessary to determine accounting profit for a particular period and to recognize the business assets and liabilities at the end of that period. Economists also use the term ‘revenue’ for sale proceeds of goods and services or earnings from interest, dividend, rent, etc., but the accountants do not use the term revenue strictly in the same sense as used by economists. Accountants use the term revenue for the items of recurring nature, the benefit of which expires within an accounting period.

 

Capital and Revenue Expenditure

The total payments or receipts of a business may be of capital or revenue nature. The capital items are non-recurring in nature and are recorded in the balance sheet, while the revenue items are of recurring in nature and are recorded in the income statement. However, a distinction between capital and revenue items is a difficult task. The dividing line between the two is very thin in many cases.

Distinguish between capital and revenue

The proper identification of Capital and revenue items must be based upon sound accounting practices so as to get fair information about the business for a stipulated period. The followings are the objects of differentiating between these items:

(a) To ascertain true and fair net profit: The main motive of a business entity is to find out net profit or loss at the end of an accounting period. Proper measurement of business income can be made if revenue items only are included in the income statement (Profit and Loss Account) while capital items form part of the balance sheet.

(b) To meet requirements of income tax provision: The distinction between capital and revenue is important for the purpose of payment of income tax also. Unless the differentiation between these two is clear, it will be difficult to calculate income liable to tax.

(c) To allocate depreciation at the end of accounting period: Depreciation is a charge against profit. At the end of the year, a part of the fixed asset consumed during the year is debited in Profit and Loss Account. Similarly, some expenses like installation charges may be debited to the cost of fixed assets.

(d) To find out true and fair position of business: Every organization prepares a balance sheet at the end of year so as to know its true economic and financial position. This can only be possible in case a desirable distinction between capital and revenue items is properly maintained and all capital items are recorded in the balance sheet.

(e) To maintain record on scientific lines : In accounting theory and practice, all capital transactions should form a part of the position statement (Balance Sheet) and all revenue items be included in the income statement of every business.

In order to achieve the above mentioned objectives, the capital and revenue items are classified in the following categories:

  • Capital and Revenue Expenditures.
  • Capital and Revenue Payments.
  • Capital and Revenue Receipts.
  • Capital and Revenue Profits.
  • Capital and Revenue Losses.

Meaning of Capital Expenditure

Capital expenditure is that expenditure which results in the acquisition of a long term asset (i.e. fixed asset) or results in the betterment or replacement of such an asset. It is generally restricted to that expenditure which increases quantity, quality or results in the replacement of fixed assets.

DEFINITION

“Capital expenditure is an expenditure intended to benefit future periods, in contrast to a revenue expenditure, which benefits a current period, an addition to a capital asset. The term is generally restricted to expenditure that add fixed asset units or that have the effect of increasing the capacity, efficiency, life span or economy of operation of an existing fixed asset”.              Kohler

“Capital items are those, the benefit of which is received over a number of accounting periods”       Carter

“Capital expenditure may be described as outlay resulting in the increases or acquisition of asset or increase in the earning capacity of a business”                                                William Pickles

Characteristics of Capital Expenditure

After studying the above definitions, the following characteristics of capital expenditure may be laid down:

  1. Expenditure of capital nature is incurred to acquire long term or long lived assets whose useful life is at least more than one accounting period.
  2. Capital expenditure is incurred in acquiring those assets which are not for resale.
  3. Capital expenditure is incurred to improve the present condition of an asset as it reduces the cost of production.
  4. Capital expenditure is of such nature that it has physical existence and can be seen.
  5. Capital expenditure is the cost incurred on increasing the earning capacity of business.

Examples of Capital Expenditure

  1. Purchase of permanent tangible or intangible assets such as Plant and machinery, Building, Furniture, and Goodwill etc.
  2. These expenses are incurred in connection with or incidental to the purchase of fixed assets such as cost of transportation, installation, registration etc.
  3. The cost of additions or extensions of fixed assets.
  4. Cost of improving the quality of fixed assets to increase the production capacity or earning capacity or to reduce operating cost of production or to increase the useful life of the asset.
  5. Expenditures incurred for putting the old asset into running condition.
  6. The cost of shifting the business from one location to another favorable location.
  7. Preliminary expenses incurred before the commencement of business, such as underwriting commission, legal charges paid for drafting the memorandum and Articles of association.

Revenue Expenditure

‘Revenue Expenditure’ and ‘Expense’ are considered synonymously in accounting. It is an expenditure incurred in the normal course of the business and the benefit of which is not carried over to several accounting periods. The revenue expenditures are incurred to maintain the earning capacity of the business enterprises or for the maintenance of the fixed assets.

DEFINITION

“Revenue expenditure is the expenditure on purchasing items which are used, directly or indirectly, to produce revenue in the current accounting period.” “Revenue expenditure is such outlay as is necessary for the maintenance of earning capacity”                      Collin

 

including the up-keep of fixed assets in a fully efficient state and the normal total cost involved in setting, including the cost of goods and services of the business to which it relates.”                        William Pickles

Characteristics of Revenue Expenditure

From the definitions given by various authorities on accounting, the following salient features of the revenue expenditure can be inferred:

(a) It is expenditure incurred on the day to day conduct of the business. (b) Its periodicity is, generally, one accounting year.

(c) It is the expenditure on consumable items of goods and services for re-sale, either in original or improved form.

(d) It is incurred on maintaining the fixed assets in working order i.e. repairs, renewals and depreciation.

(e) It is of recurring or repetitive in nature.

(f) It is incurred to maintain the earning capacity of the business.

Examples of Revenue Expenditure

  1. Cost of raw material consumed in the course of manufacturing of goods.
  2. Wages and salaries paid to the employees.
  3. Rent, rates, taxes, insurance, postage, printing and stationery etc.
  4. Interest on loan borrowed for running the business.
  5. Legal expenses and audit fees.
  6. Depreciation on fixed assets.
  7. Discount and allowances.
  8. Selling and distribution expenses like advertisement, commission, cartage, freight, delivery van running etc.

Deferred Revenue Expenditure

A heavy expenditure of revenue nature incurred, having the effect of generating income over a number of years is classified as deferred revenue expenditure. It is certainly a revenue expenditure and not a capital expenditure but such an expenditure may be temporarily capitalised and spread equally over the number of years for which the benefit is anticipated.

Definition Deferred Revenue Expenditure

“Deferred Revenue Expenditure are those non-recurring expenses which are expected to be of financial nature distributed to several accounting periods of indeterminate total length.”     Johnson, A.W.

It may be concluded that deferred revenue expenditure include:

1. Revenue expenditure providing long term benefit.

2.Heavy abnormal losses arising from fire, flood or other losses of exceptional nature.

Examples of Deferred Revenue Expenditure

  1. Heavy advertisement expenditure incurred to launch a new product or a new venture.
  2. Exceptional repairs of machinery.
  3. Expenses on the issue of shares or debentures.
  4. Discount on issue of shares or debentures.
  5. Expenses incurred before the formation of a company i.e.. Preliminary expenses.
  6. Research and development expenses.
  7. Any heavy loss of exceptional nature.
  8. Cost of dismantling, removing and re-erection of plant and machinery.

Capital Receipts and Revenue Receipts

                       It is also necessary to distinguish between capital and revenue receipts as has been done in the case of capital and revenue expenditure. Capital receipts are to be shown on the liabilities side of the balance sheet and revenue receipts are recorded on the credit side of Profit and Loss Account of a business entity. The main purpose of the distinction is to present a ‘true’ and ‘fair’ view of the income and position statement.

Capital Receipts:-

 consist of non-recurring receipts into the business from the owner or partner towards the capital of the firm and also the receipts from sale of fixed assets or in the form of loans from banks and other financial institutions. These are shown on the liabilities side of the Balance Sheet.

Example:

  • Amount received from the sale of fixed assets.
  • Amount received from the sale of investments.
  • Amount received from the owner/partners towards the capital of the enterprise.
  • Amount raised by way of loans from any source.

Revenue Receipts:-  

              consist of recurring receipts into the business as an outcome of the firm’s activities in the accounting period. Revenue receipts compromise of sale proceeds of goods and services, discount received, commission received, interest received, rent received, etc. Revenue receipts do not create any liability of the firm. These are shown on the credit side of the Trading and Profit & Loss Account. Receipt of money in the revenue nature increase the profits or decreases the losses of a business and must be set off against the revenue expenses in order to find out the profit or loss for the period. Example:

  • Sale proceeds of goods and services.
  • Rent or commission received.
  • Interest or dividend received on investments

Distinction Between Capital Receipt and Revenue Receipt

Basis of Distinction Capital Receipts Revenue Receipts
1. Creation of liability The amount received may create a liability for the business. Revenue Receipts does not create any liability. it represents a gain which is not repayable.
2. Sale of asset It may result from the sale of fixed assets. It may result from the sale of current assets.
3. Regularity It is non-recurring in nature. It is recurring in nature and arises out of day-to-day operations of the business.
4. Long term effect It has a long term effect spreading over a number of accounting periods. It has no long term effect. It is exhausted within the current accounting period.
5. Creation of Profit It creates revenue profit as well as capital profit. It does not create any capital profit.
6. Treatment in final accounts It is an item of Balance sheet. It is an item of trading and profits & loss account.

Capital and Revenue Profits

Capital Profits are earned on account of sale or revaluation of fixed assets, or profits in connection with share capital such as premium received on the issue of shares, profits made on the sale of forfeited shares, or profits made prior to the incorporation of a company. When a building purchased for 3,00,000 is sold for 3,80,000, the excess of 80,000 is a capital profit. Capital profits are usually shown on the liabilities side of the Balance Sheet. In practice, profit on sale of assets is credited to Profit & Loss Account.

Revenue Profits are earned in the normal course of business. When goods costing 30,000 are sold for 40,000, the excess of 10,000 is a revenue profit. Revenue profit is a part of the income statement. Though, purchase and sale of goods is debited and credited to trading account, profit on sale of goods does not form a part of trading account. The followings are some of fundamental differences between Capital Profit and Revenue Profit.

Capital Profit Revenue profit
*It does not arise from ordinary course of conduct of business.
*It is of non-recurring in nature.
*It is not available for distribution of profit to owner.
*It facilitates in the creation of capital reserve.
*It arises from ordinary course of conduct of business.
*It is of recurring in nature.
*It is available for distribution of profit to owner.
*It is a source of creation of revenue reserve.

Capital and Revenue Losses

Capital losses are not related with the normal course of business. The loss related with the sale of fixed assets, premium paid on redemption of preference shares or debentures, loss on issue of shares or debentures are called capital losses, which may be treated as deferred revenue exenditure.

Revenue losses are those losses which are incurred in the normal course of business or are incidental to it. If the revenue income is less than the revenue expenditure, it is a revenue loss. Loss of stock by fire, bad debts, embezzlement of cash by employees are the examples of revenue losses.

Capital Loss Revenue Loss
* It does not arise in ordinary course of business operation.
* It is not ascertained from profit and loss account.
* It may arise before or after commencement of business.
* It is transferred to balance sheet.
* It arises in the ordinary course of business operation.

* It is ascertained through profit and loss account.

* It arise after commencement of business.

* It is usually transferred to profit and loss account or balance sheet.

Leave a comment