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Study Note 1.4, Page 47 59

Study Note 1.4, Page 47 59

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47
Financial Accounting
1.4. DISTINCTION BETWEEN CAPITAL AND REVENUE
Introduction
The concepts of capital and revenue are of fundamental importance to the correct determi-nation of accounting profit for a period and recognition of business assets at the end of thatperiod. The distinction affects the measurement of profit in a number of accounting periods.Capital has been defined by economists as those assets which are used in the production of goods and services for further production of assets. In accounting, on the other hand, thecapital of a business is increased by that portion of the periodic income which has not beenconsumed by the owner.The relationship between capital and revenue is that between a tree and its fruits. It is the treewhich produces the fruits, and it is the fruit that can be consumed. If the tree is tendered withcare, it will produce more fruits, conversely, if the tree is destroyed, there will be no morefruits. Likewise, revenue comes out of capital and capital is the source of revenue. Capital isinvested by a person in the business so that it may produce revenue. Moreover, as a fruit maygive birth to another new tree, different revenues may also produce further new capital.Capital can be brought in by a person into the business in different forms-cash or kind. Whencapital is brought in the form of cash, it is spent away on various items of assets that make thebusiness a running concern. Capital of the firm is thus, represented by its inventory of assets.Capital of a business can be increased in a two fold way:1. When the owner brings in more capital tp the business; and/or2. When the owner does not consume the entire periodic income.When the owner brings in further capital to his business, the amount is credited to the CapitalAccount.Likewise, the net income for a period is credited to the Capital Account, and if his drawingsare less than that income, the capital is increased by the difference.The difference between the two terms ‘revenue’ and receiptshould be carefully distinguished.A receipt is the inflow of money into business, whereas revenue is the aggregate exchangevalue received for goods and services provided to the customers.
Capital and Revenue Expenditures
Capital expenditure is the outflow of funds to acquire
an asset 
that will benefit the business
more than one accounting period.
A capital expenditure takes place when an asset or service isacquired or
 
improvement of a fixed asset is effected. These assets are expected to providebenefits to the business in more than one accounting period and are not intended for resale inthe ordinary course of business. In short, it is an expenditure on assets which is not written off completely against income in the accounting period in which it is incurred.
 
Fianancial Accounting
48
ACCOUNTING CONVENTION, AND PRACTICES
Revenue expenditure is the outflow of funds to meet the running expenses of a business and itwill be of benefit for the current period only. A revenue expenditure is incurred to carry on thenormal course of business or maintain the capital assets in a good condition.It may be pointed out here that an expenditure need not necessarily be a payment made tosomebody in cash - it may be made by cash, by the exchange of another asset, or by incurringa liability.
 Expenditure incurrence and expenditure recognition are distinct phenomena.
Expenditureincurrence refers to the receipt of goods and services, whereas expenditure recognition is amatter to be decided whether the expenditure is of capital or revenue nature, for example, thebuying of an asset is a capital expenditure but charging depreciation against profit is a revenueexpenditure, over the entire life of that asset. Most of the capital expenditures made by a busi-ness become revenue expenditures. On the application of periodicity, accrual and matchingconcepts, accountants identify all revenue expenditures for a given period for ascertainingprofit. An expenditure which cannot be identified to a particular accounting period is consid-ered of capital nature.
The accounting treatment of capital and revenue expenditure are as under
:Revenue expenditures are charged as an expense against profit in the year they are incurred orrecognised. Capital expenditures are capitalised-added to an asset account.
The following are the points of distinction between capital expenditure and revenue expen-diture:Rules
 for
Determining Capital Expenditure
An expenditure can be recognised as capital if it is incurred for the following purposes:An expenditure incurred for the purpose of acquiring long term assets (useful life is at leastmore than one accounting period)
 for 
use in business to earn profits and not meant
 for 
resale,will be treated as a capital expenditure. For example, if a second hand motor car dealer buys aSl.Capital ExpenditureS1.Revenue ExpenditureNo.No.1.Capital expenditures are incurred1.Revenue expenditures are incurredfur more than one accountingfor a particular accounting period.period.2.Capital expenditure are of2.Revenue expenditures are onon-recurring nature.recurring nature.3.All capital expenditures eventually3.Revenue expenditures are not generallybecome revenue expenditures.capital expenditures.4.Capital expenditures are not4.All revenue expenditures are matchedmatched with capital receipts.with revenue receipts.5.Capital expenditures are incurred5.Revenue expenditures are incurredbefore or after the commencementalways after the commencement oof the business.the business.
 
49
Financial Accounting
piece of furniture with a view to use it in business; it will be a capital expenditure. But if hebuys second hand motor cars, it will be a revenue expenditure because he deals in second handmotor cars.When an expenditure is incurred to improve the present condition of a machine or putting anold asset into working condition, it is recognised as a capital expenditure. The expenditure iscapitalised and added to the cost ofthe asset. Likewise, any expenditure incurred to put anasset into working condition is also a capital expenditure.For example, if one buys a machine
 for 
Rs 50,000 and pays Rs 20,000 as transportation chargesand Rs 40,000 as installation charges, the total cost of the machine comes upto Rs 5,60,000.Similarly, if a building is purchased
 for 
Rs 1,00,000 and Rs 5,000 is spent on registration andstamp duty, the capital expenditure on the building stands at Rs 1,05,000.If an expenditure is incurred, to increase earning capacity of a business will be considered as of capital nature. For example, expenditure incurred for shifting ‘the ‘factory
 for 
easy supply of raw materials. Here, the cost of such shifting will be a capital expenditure.Preliminary expenses incurred before the commencement of business is considered capitalexpenditure. For example, legal charges paid for drafting the memorandum and articles of association of a company or brokerage paid to brokers, or commission paid to underwriters
 for 
raising capital.Thus, one useful way of recognising an expenditure as capital is to see that the business willown something which qualifies as an asset at the end o!the accounting period.
Some examples of capital expenditure:
(1) Purchase of land, building, machinery or furniture; (2) Cost of leasehold land and building;(3) Cost of purchased goodwill; (4) Preliminary expenditures; (5) Cost of additions or exten-sions to existing assets; (6) Cost of overhauling second-hand machines; (7) Expenditure onputting an asset into working condition; and (8) Cost incurred for increasing the earning ca-pacity of a business.
Rules for Determining Revenue Expenditure
Any expenditure which cannot be recognised as capital expenditure can be termed as rev-enue expenditure. A revenue expenditure temporarily influences only the profit earningcapacity of the business. An expenditure is recognised as revenue when it is incurred for thefollowing purposes:Expenditure for day-to-day conduct of the business, the benefits of which last less than oneyear. Examples are wages of workmen, interest on borrowed capital, rent, selling expenses,and so on.Expenditure on consumable items, on goods and services for resale either in their original orimproved form. Examples are purchases of raw materials, office stationery, and the like. At theend of the year, there may be some revenue items (stock, stationery, etc.) still in hand. Theseare generally passed over to the next year though they were acquired in the previous year.

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