Classification of Capital and Revenue Items
We have discussed that a business prepares a Profit and Loss Account to ascertain whether it has earned profit or incurred loss and the Balance Sheet to know the financial position as at the end of a period. Both are prepared on the basis of a Trial Balance which is compendium of the final position of all ledger accounts. There is a set rule that all the accounts appearing in the Trial Balance are transferred either to the Profit and Loss Account or to the Balance Sheet. Few enterprises also prepare Trading Account in addition to Profit and Loss Account. Which item of the Trial Balance is transferred to the Profit and Loss Account and which to the Balance Sheet depends on whether it is a Capital expenditure or a revenue expenditure. Revenue expenditure is transferred to the Trading and Profit and Loss Account and Capital expenditure to the Balance Sheet under fixed assets. We have to follow this basis while preparing the Profit and Loss Account and the Balance Sheet. If we wrongly transfer an item of capital nature treating it as of revenue nature or vice versa, then neither profit and loss account will reveal the correct profit or loss nor the balance sheet will reflect the true and fair financial position of the business. It is therefore, necessary to understand and classify correctly whether an item appearing in the Trial Balance is of a capital or a revenue expenditure. Thereafter, the item should be transferred to the final accounts accordingly. There are certain rules governing the classification of expenditure and receipts between capital and revenue. Let us clearly understand these rules or basis.
Capital Expenditure is the amount spent by an enterprise on purchase of fixed assets that are used in the business to earn income and are not intended for resale. Fixed assets purchased may be tangible or intangible.
Capital Expenditure yields benefit over a period extending beyond the accounting period. The following types of expenditure are usually treated as capital expenditure.
- Expenditure which results in acquiring or bringing into existence an asset or advantage of enduring benefit - an asset means anything which can be used for a long time, like a building. All money spent in acquiring an asset is a part of capital expenditure.
- Expenditure in connection with the purchase, receipt or installation of a fixed asset - all expenses in addition to the purchase price incurred for making the asset ready for use are added to the cost of the asset and thus are capital expenditure. Expenses of this type are wages paid to workers for erecting machinery, the cost of the platform on which the machinery will be fixed, overhaul of second - hand machinery purchased, interest on the loan raised to purchase a fixed asset, etc. it is to be noted that expenses incurred after the assets have been put to use are not capital expenditure.
- Expenditure for the extension of or improvement in fixed assets - If because of any expenditure the profit - earning capacity will be capacity increases, through lowering costs or increasing output, the expenditure will be a capital expenditure.
- Expenditure incurred to acquire the right to carry on business - The expenses necessary for either establishing the business like preliminary expenses for floating a company or obtaining license are capital expenditure. Similarly, the cost of a patent, that is the right to produce certain goods in a certain manner, is capital expenditure - only the initial expenditure is capital; renewal fee is revenue expenditure.
- Expenditure incurred to acquire a tangible asset - Even if the asset does not prove to be profitable, the expenditure on it is a capital expenditure.
- Legal charges incurred - Legal expenses incurred in connection with acquiring or defending suits for protecting fixed assets, rights etc., are also capital expenditure.
Revenue Expenditure is the amount spent on running a business. In short, an expenditure which is not capital can be considered as revenue expenditure. The benefit of revenue expenditure is exhausted in the accounting period in which it is incurred. Examples of such expenses are -
- Expenses incurred in the day - to - day running of the business such as rent, salaries, wages, power, fuel etc.
- Expenses incurred for upkeep of fixed assets.
- Expenses incurred on purchase of stock of materials and goods to the extent that these are used up during the year; the remaining amount will be an asset.
- Depreciation or the expired cost of fixed assets.
The under mentioned expenses appear to be revenue expenses but they are actually capital-
- Expenses incurred on the repairs and whitewashing for the first time on the purchase of an old building, since these expenses are necessary to make the building usable;
- Wages paid to workers to produce a tool to be used by the factory itself or to fix a machine;
- Expenses incurred in connection with the purchase of land or buildings, such as fees paid to the lawyer or registration expenses;
- Interest on loan raised to acquire an asset up to the point of time it is ready for use.
Difference Between Capital Expenditure and Revenue Expenditure
|Basis||Capital Expenditure||Revenue Expenditure|
|It is incurred for acquisition of fixed assets for use in business||
It is incurred for conduct of business
|It increases the earning capacity of the business||
It is incurred for earning profits
|Its benefit extends to more than one year||
Its benefit extends to only one year
|It is debited to an asset account||
It is debited to an expense account
Nature of account
|It is a real account||
It is a nominal account
|It is shown in the Balance Sheet||
It is part of the Trading or Profit and Loss Account
|a. Cost of Plant and Machinery
b. Cost of Land and Building
c. Cost of Furniture and Fixtures
a. Depreciation on Plant and Machinery
c. Repairs, Insurance
Improper Considerations in the Determination of Capital Expenditure and Revenue Expenditure
Whether any expenditure is capital or revenue should be determined only after considering the nature of the expenditure. One should not be guided by some of the issues discussed above.
To know whether any expenditure is a capital expenditure or revenue expenditure, some issues are immaterial. One should not rely on them. These are:
- An amount of Payment: Usually the amount involved in capital expenditure is greater than in revenue expenditure. But it does not mean that if the amount is small, it is certainly a revenue expenditure and if the amount is big it is certainly a capital expenditure.
- Payment- Periodic or Lump- Sum: Usually the payment of capital expenditure is made at a time in lump sum. For example, the purchase of land; while revenue expenditures are paid periodically, such as salary. Here again, it should not be concluded that if payment is made repeatedly, it is a revenue expenditure only. It may also be possible that payment for an asset purchased ( which is a capital expenditure) be made in fixed instalments.
- Source of Payment: Mostly the payment of capital expenditure is made out of the capital while the revenue expenditure is paid out of revenue receipts. But it should not be considered as a general rule that expenses paid out of the capital are capital expenditure and expenses paid out of revenue receipts are always revenue expenditure.
- Its Nature in the Hands of Recipient: To decide whether any expenditure is a capital expenditure of revenue expenditure, it is useless to see that the payment for the recipient is an item of revenue or an item of expenditure. It may be quite possible that any item, which is an item of revenue for the payee, is an item of capital for the payer. For example, for a sewing machine manufacturer, the amount received from sale of sewing machine is a revenue receipt but for a tailor, who purchases this machine, it is a capital expenditure.
State whether the following items of expenditure are of capital or revenue natures:
- A second hand car was purchased for a sum of Rs.60000. A sum of Rs.15000 was spent on its overhauling.
- Rs.5800 paid for installation of a new machine
- Repairs for Rs. 4000 necessitated by negligence
- Cost of annual taxes paid and the annual insurance premium paid on the car mentioned above.
- Cost of air-conditioning of the office of the General Manager
- The total expenditure of Rs.60000 should be taken as capital expenditure. The sum of Rs. 50,000 was spent on a capital asset while another Rs. 10, 000 was spent on making the capital asset fit for use.
- Cost of installing the new machine should be capitalized because the amount spent is up to the point when the asset is ready for use.
- Repair charges are revenue expenditure since it is for maintaining an asset and not for improving the asset.
- Annual taxes and annual premium paid on the car are revenue expenditure because they do not add to the value of the car and their benefit will be exhausted within the year.
- This is capital expenditure because the benefit of this expenditure will be available for number of years.
Deferred Revenue Expenditure
It is that class of revenue expenditure which is incurred during an accounting period but, the benefit arising out of it extends beyond that accounting period. Such an expenditure is unusually larger than the normal expenditure under the head. An example of this is a large expense, say on advertising beyond the accounting period in which the expenditure was incurred. It will thus, be proper to spread the expenditure over a period and not charge the entire amount to the Profit and Loss Account for the year in which the expense is incurred.
It may be noted that the amount which has not been charged to the Profit and Loss account is shown in the balance sheet as an asset.
Sometimes even a large loss, arising from an accident or other unforeseen circumstances, may be spread over three or four years instead of being charged wholly against the revenues of the year in which the loss is actually suffered. The loss of a building because of an earthquake may be treated in this manner. This type of loss is also treated as a deferred revenue expenditure.
A Deferred Revenue Expenditure is a fictitious asset. Although it appears on the assets side of the Balance Sheet, it is not really an asset to the business.