1.0
INTRODUCTION
You know that a firm
prepares Profit and Loss Account for ascertaining the net result of business
operations and the balance sheet for determining the financial position of the
business. These are prepared with the help of trial balance- which shows the final position
of all ledger accounts. All
items appearing in the Trial Balance are
transferred either to the profit and loss account or to the Balance Sheet.
As
per rules, the items of revenue nature are taken to the profit and loss account
and the items of capital nature are shown in the Balance Sheet. In other words
whether an item appearing in the Trial Balance is to be taken to the Profit and
Loss Account or the Balance Sheet depends upon the capital and revenue nature
of the item.
If any item is wrongly classified i.e., if an item of revenue
nature is treated as a capital item or vice verse, the Profit and Loss Account
will not reveal the correct amount of profit and the Balance Sheet will not
reflect the true and fair view of the affairs of the business. It is therefore
necessary to determine correctly whether an item is of capital nature or
revenue nature and record it in the books accordingly.
There are certain rules
governing the allocation of expenditures and receipts between capital and
revenue which should be clearly understood. In this note you will learn about
all these.
2.0
OBJECTIVES
At the end of this note,
you should be able to:
• explain the
importance of distinction between capital and revenue
• identify correctly
whether an expenditure or receipt is of a capital or revenue nature.
3.0
MAIN CONTENT
3.1
Capital and Revenue Expenditures
You incure
expenditure on various items every day. You buy food items, stationery,
cosmetics, utensils, furniture, etc. Some of the items are consumables and some
are durables. The benefit of expenditure on consumable like stationery,
cosmetics, etc is derived over short period. But in case of durables like
furniture, utensils etc the benefit spread over a number of years.
Same is true
of business also. In business you incure expenditure on two types of items: (i)
routine items like stationery, and (ii) fixed assets like machinery, building,
furniture, etc. whose benefit is available over a number of years. In
accounting terminology the first category of expenditure is called revenue
expenditure and the second one is called capital expenditure. Let us now study
the exact nature of capital and revenue expenditures.
3.2
Capital Expenditure
As stated above, when
the benefit of an expenditure is not exhausted in the year in which it is
incurred but is available over a number of years it is considered as capital
expenditure. The following expenditure are usually treated as capital
expenditure.
• Any expenditure
which results in the acquisition of fixed assets such as land, buildings, plant
and machinery, furniture and fixtures, office equipment, copyright, etc, you
should note that such capital expenditure include not only purchase price of
fixed assets but also the expenses incurred in connection with their acquisition.
Thus, the brokerage or commission paid in connection with the acquisition of an
asset the freight and cartage paid for transportation of machinery, the
expenses incurred on its installation, the legal fees and registration charges
incurred in connection with purchase of land and building are also treated as
capital expenditure.
• Any expenditure
incurred on a fixed asset which results in (a) its expansion (b) substantial
increase in its life, or (c) improvement in its revenue earning capacity. Improvement
in the revenue earning capacity can be in the form of (i) increased production
capacity, (ii) reduced cost of production, or (iii) increase in sales of the
firm. Thus, cost of making additions to building and the amount spent on
renovation of the old machinery are also regarded as capital expenditures. If
you have a second hand machinery and incur heavy expenditure on reconditioning
it, such expenditure is also to be treated as capital expenditure. Similarly,
expenditure on structural improvement or alterations to existing fixed assets
whereby their revenue earning capacity is increased, is also treated as capital
expenditure.
• Expenditure
incurred, during the early years, on development of mines and land for
plantations till they become operational.
• Costs of
experiments which ultimately result in the acquisition of a patent. The cost of
experiments which are not successful is not to be treated as capital
expenditure. It is treated as a deferred revenue expenditure which is written
off within two to three years.
• Legal charges
incurred in connection with acquiring or defending suits for protecting fixed
assets, rights, etc.
3.3
Revenue Expenditure
When the benefit of
an expenditure is not likely to be available for more than one year, it is
treated as revenue expenditure. So all expenses which are incurred during the
regular course of business are regarded as revenue expenditures. The example of
such expenses are:
• Expenses incurred
in day-to-day conduct of the business such as wages, salaries, rent, postage,
stationery, insurance, electricity, etc.
• Expenditure
incurred for buying goods for resale or raw materials for manufacturing.
• Expenditure
incurred for maintaining fixed assets such as repairs and renewals of building,
machinery, etc.
• Depreciation on
fixed assets. This can also be termed as revenue loss.
• Interest on loan
borrowed for running the business. You should know that any interest on loan
paid during the initial period before production commences, is not treated as
revenue expenditure. It is treated as capital expenditure.
• Legal charges
incurred during the regular course of business such as legal expenses incurred
on collection from debtors, legal charges incurred on defending a suit for
damages, etc.
3.4
Deferred Revenue Expenditure
Sometimes, certain
expenditure which is normally treated as revenue may be unusually heavy and its
benefit is likely to be available for more than one year. In such a situation,
it is considered appropriate to spread the cost of the expenditure over a
number of accounting years. Hence, it is capitalized and only a portion of the
total amount spent is charged to Profit and Loss Account of the current year.
The balance is shown as an asset which will be written off during the
subsequent accounting years. Such expenditure is called a Deferred Revenue
Expenditure because its charge to Profit and Loss Account has been deferred to
future years.
Some example of such expenditure are:
• Expenditure
incurred on advertising campaign to introduce a new product in the market.
• Expenditure
incurred on formation of a new company (preliminary expenses).
• Brokerage charges,
underwriting commission paid and other expenses incurred in connection with the
issue of shares and debentures.
• Cost of shifting
the plant and machinery to a new site which may involve dismantling, removing
and re-erection of the plant and machinery.
Let us take the case
of expenditure on advertising campaign. It is not a routine advertisement and
the amount involved is unusually heavy. Its benefit will not completely exhaust
in one accounting year but will continue over two to three years. Hence, it is
not proper to charge such expenditure to the Profit and Loss Account of one
year. It is better to distribute it carefully over three years. So, in the
first year we may charge one-third of the amount spent to the Profit and Loss
Account and show the balance in the balance sheet as an asset.
In the second
year again we may charge a similar amount to the Profit and Loss Account and
show the balance as an asset. In the third year we may charge this balance to
the Profit and Loss Account. Every expenditure which is regarded as deferred
revenue is treated in this way in the final accounts.
3.5
Capital and Revenue Receipts
Receipts refer to
amounts received by a business i.e. cash inflows. Receipts may be classified as
Capital Receipts and Revenue Receipts. It is necessary to note this distinction
clearly because only the revenue receipts are taken to the Profit and Loss
Account and not the capital receipts.
•
Capital Receipts
Capital Receipts are
the amounts received in the form of (a) additional capital introduced in the
business. (b) Loans received, and (c) sales proceeds of fixed assets. You are
aware that a loan taken by the business is repayable sooner or later. Similarly,
additional capital received represents an increase in the proprietor's claim
over the business assets. Thus these two items represent increase in
liabilities of the business and obviously are not incomes or revenues.
These
are capital receipts and should be treated as such. The sale proceeds of a
fixed asset are also treated as a capital receipt because the amount received
is not revenue earned in the normal course of business. The capital receipts
increase the liabilities or reduce the assets. They do not affect the profit or
loss.
•
Revenue Receipts
Revenue receipts are
the amount received in the normal and regular course of business. They take the
form of (a) sale proceeds of goods and (b) incomes such as interest earned,
commission earned, rent received, etc, these receipts are on account of goods sold
or some services rendered by the business and as such they are not repayable.
All revenue receipts are treated as incomes and shown on the credit side of the
Profit and Loss Account.
5.0
SUMMARY
Capital Expenditure
consist of expenditure the benefit of which is not fully consumed in one period
but spread over several periods, and Revenue expenditure consists of
expenditure incurred in one period of account, the full benefit of which is
consumed in that period. We also have Deferred
Revenue Expenditure this is
expenditure which would normally be treated as revenue expenditure which is not
written off in one period. Exceptional expenditure on an advertising campaign
might be treated in this way.
0 comments:
Post a Comment