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CAPITAL AND REVENUE

Importance of Distinguishing between capital and


revenue items
• It is important to distinguish between capital and revenue
items because the revenue items are considered in the
preparation of profit and loss account and capital items
become part of the balance sheet of the business
enterprise.
• Determination of the net profit or net income requires the
matching concept to be applied.
– 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 Includes amount realized by
by sale of fixed assets or by sale of goods or rendering
issue of share or debentures. services
It is a receipt in substitution It is a receipt in substitution
of a source of income of an income.
Amount received for Amount received as
surrender of certain rights compensation under an
under an agreement is a agreement for the loss of
capital receipt, because a future receipts is a revenue
capital asset is being given receipt
up in the form of these
rights
Classification of income

• Capital income
• Revenue income
Capital Profits / Capital Income
Capital profits are profits earned on account of sale of
fixed assets or in connection with share capital
• 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)
Revenue Profits / Revenue income
Revenue profits are those earned in the ordinary
course of business

• 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.


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
Capital Expenditure is any expenditure which
is incurred for the purpose of long term
advantage.

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
Definition:

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:

• 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)
• 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

These are expenses whose benefit expires within


the year of expenditure and which are incurred to
maintain the earning capacity of existing assets.

• It is an expenditure on consumable items, on


services and on goods acquired for resale.
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 Is a routine expenditure incurred
improving permanent assets not in the normal course of business
meant for resale. May add to value and includes cost of sales and
of an existing asset maintenance of fixed assets.
Increases earning capacity Maintains the earning capacity
It is normally a non-recurring It is usually a recurring item
outlay.
It produces benefit over several It is consumed within an
years. accounting year i.e. benefits
Thus a small part is charged to only one year.
income statement as depreciation Thus entire amount is charged to
and the rest appears in the income statement.Does not
balance sheet appear in the balance sheet.
Is an item of balance sheet Shown in Trading and profit &
loss A/c
Revenue Expenditure becoming Capital Expenditure
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:
1. Wages: wages on erection of plant & machinery or construction
2. Raw material and stores used in construction of fixed asset
3. Transport charges: incurred for new plant & machinery
4. 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 assets
6. Repairs: Repairs on purchases of second-hand asset to put into
workable condition
7. 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.
Deferred Revenue Expenditure

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.

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
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.