Capital and Revenue

CAPITAL AND REVENUE

Importance of Distinguishing between capital and revenue items

• TO DETERMINE WHICH ITEMS APPEAR IN WHICH FINANCIAL STATEMENT.Revenue items - profit and loss accountCapital items - balance sheet

• DETERMINATION OF THE NET PROFIT Requires Matching of revenue expenditure and revenue income– As per matching concept, the expenses (revenue expenditure)

need to be matched with revenue (Revenue Income), irrespective of whether the payment has been made or not or income has been received or not.

To ascertain profits, revenue expenses are deducted from revenue receipts.

Capital and Revenue Receipts• Capital Receipts comprise of

– payments or contributions into the business by the proprietor, partners or shareholders towards the capital of the firm and

– any sums received from debenture holders, – any loans and – the proceeds of sale of any fixed assets and long term

investments.• Revenue Receipts or income

– are the outcome of firm’s activity in the accounting period;

– money received on sale of goods in trade or on rendering of services.

• Eg. Sales, commission and fees received, interest/dividend on investments

Distinction Between Capital and Revenue Receipts

Capital Receipts Revenue Receipts

Includes amounts realized by sale of fixed assets or by issue of share or debentures.

Includes amount realized by sale of goods or rendering services

It is a receipt in substitution of a source of income

It is a receipt in substitution of an income.

Amount received for surrender of certain rights under an agreement is a capital receipt, because a capital asset is being given up in the form of these rights

Amount received as compensation under an agreement for the loss of future receipts is a revenue receipt

Classification of income

• Capital income

• Revenue income

Capital Profits / Capital Income

• Capital income is an income which does not relate to operations of the business or which does not grow out of or pertain to the running of the business proper.

• Examples: Share premium, sale of a fixed asset for a value more than that for which it was purchased.eg. Capital gain of Rs 150,000 arises when building bought for Rs. 200,000 is sold for Rs. 350,000.

• Note: Only the profit realised over and above the cost of the fixed asset should be taken as capital profit (transferred to capital reserve) while the profit realised over and above book value of the asset till it does not exceed the original cost fo the asset should be taken as revenue profit (credited to Profit and Loss Account)

Capital profits are profits earned on account of sale of fixed assets or in connection with share capital

Revenue Profits / Revenue income

• Revenue income is an income which arises out of and in

the course of regular operations of the business concern

• Eg Profit made on sale of goods, income received from letting out

of the business property, dividends received on business

investments, etc.

• Revenue profits appear in the Profit and Loss Account

• Revenue profit and revenue income are synonymous.

Revenue profits are those earned in the ordinary

course of business

Expenditure

Expenditure refers to a payment or spending or a

promise to make future payment for benefits

received i.e. for assets or services.

Classification of Expenditure

• Capital Expenditure

• Revenue Expenditure

• Deferred Revenue Expenditure

Capital Expenditure

Such expenditure is either incurred for acquisition of a

fixed asset (tangible or intangible) or on permanent

improvement or addition or substitution or extension to

an asset to increase the earning capacity of the business

enterprise

Capital Expenditure is any expenditure which

is incurred for the purpose of long term

advantage.

Capital ExpenditureDefinition:

Expenditure incurred in purchasing or constructing property which is intended to assist in the production of profit or in permanently improving, enlarging or extending existing property in order to increase its profit earning capacity. The direct benefit of such an expenditure will extend over several trading periods and it replaces cash by permanent asset.

(Rowland, S.M. in Principles of Accounting)

Guidelines to determine that expenditure is capital expenditure:

1. Increases Profits

• If expenditure is for the purpose of increasing profit

either positively by increasing earning capacity or

negatively by decreasing working expenditure (day to

day expenses)

2. Produces an asset

• If whether increasing the earning capacity or not, it

produces an asset comparatively permanent in nature.

Examples of Capital Expenditure

• Purchase of permanent tangible asset

– such as plant and machinery, office equipment, furniture

• All sums spent up to the point an asset is ready for use

– including expenditure on its purchase, receipt or erection

• eg. cartage charges paid to bring the machinery to factory,

• installation charges,

• fees paid to lawyer for drawing land purchase deed,

• overhauling expenses of second-hand machinery,

Examples of Capital Expenditure• Financing cost for a fixed asset

• (i.e. interest paid on loans to purchase a fixed asset) for the period up to the time the asset is put to use. Such interest is added to the cost of fixed asset.

• The amount spent on existing asset for the purpose of its improvement or extension

• which will raise the output or reduce the cost of production

• Money paid for goodwill

• Money spent to reduce working expenses

• eg. Conversion of hand-driven machinery to power-driven machinery.

Revenue Expenditure

• It is an expenditure on consumable items, on

services and on goods acquired for resale.

These are expenses whose benefit expires within

the year of expenditure and which are incurred to

maintain the earning capacity of existing assets.

Revenue Expenditure

Revenue items generally include:

• The cost of materials used in manufacturing goods intended for resale.

• Wages paid in connection with the production of goods meant for sale.

• Selling and distribution expenses.

• All expenses incidental to the working of the business such as depreciation, rent, salaries, interest, etc.

• All expenses incurred for maintaining the efficiency of fixed assets by means of repairs, replacement, renewals and insurance.

Principles for determining the nature of expenditure

1. Expenditure in the – acquisition of an income earning asset - capital expenditure– in the process of earning of the profits - revenue expenditure.

2. Expenditure is deemed to be capital when it is made for the initiation of a business, for extension of a business or for a substantial replacement of equipment.

3. Expenditure is capital when it is made not only once and for all but with a view to bringing into existence an asset or an advantage for the enduring benefit.

4. Whether the expenditure incurred was part of the fixed capital of the business or part of its circulating capital

Distinction between Capital and Revenue Expenditure

Capital Expenditure Revenue Expenditure

Incurred in acquiring or improving permanent assets not meant for resale. May add to value of an existing asset

Is a routine expenditure incurred in the normal course of business and includes cost of sales and maintenance of fixed assets.

Increases earning capacity Maintains the earning capacity

It is normally a non-recurring outlay.

It is usually a recurring item

It produces benefit over several years. Thus a small part is charged to income statement as depreciation and the rest appears in the balance sheet

It is consumed within an accounting year i.e. benefits only one year. Thus entire amount is charged to income statement.Does not appear in the balance sheet.

Is an item of balance sheet Shown in Trading and profit & loss A/c

1. Wages: wages on erection of plant & machinery or construction2. Raw material and stores used in construction of fixed asset3. Transport charges: incurred for new plant & machinery4. Interest on capital: Interest on capital especially where the nature of business requires

construction work for a long period, before the commencement of the production.5. Legal expenses: Legal expenses incurred to acquire the assets6. Repairs: Repairs on purchases of second-hand asset to put into workable condition7. Advertising: The cost of special advertising campaign for the purpose of introducing

new products.8. Development expenditure: The development expenditure incurred on rubber

plantations, horticulture, coal mines,etc.

Certain expenditures usually revenue in nature are treated as capital expenditures since they lead to the establishment of business and its efficient running in the following circumstances:

Revenue Expenditure becoming Capital Expenditure

Deferred Revenue Expenditure

For Example: Heavy advertising expenditure incurred in introducing a new line or developing a new market, Cost of issuing shares and debentures, Cost of experiments, discount on debentures, Preliminary expenses

Deferred revenue expenditures are expenditures which are basically in the nature of revenue expenditure but whose benefit covers a number of years i.e. their benefit may extend over a number of years.

Distinction between Capital Expenditure and Deferred Revenue Expenditure

1. Nature of expenditure-deferred revenue expenditure is a revenue in nature but is spread over a number of years because it is incurred for a period more than one accounting year.

2. Years of benefit: The deferred revenue expenditure benefits lesser number of years in comparison to capital expenditure.

– Deferred revenue expenditure-for 3-5 years– Capital expenditure-for 10-15 years

3. Recovery: Deferred revenue expenditure once incurred cannot be recovered back generally. While capital expenditure is capable of being reconverted into cash though at a loss.