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Capital and Revenue

Written by: Anil Kumar Gupta

Article Overview: One of the objects of accounting is to determine whether the business has earned profit or it has suffered loss. For this purpose, profit and loss account is prepared. Total expenditure incurred by the business is divided in two categories: One portion is charged against revenue while the other is shown in the balance sheet as asset. The former is known as revenue expenditure and the latter as capital expenditure. While preparing the final accounts, all revenue items are included in the revenue account i.e., manufacturing, trading and profit and loss account and all capital items in the balance sheet. Any error committed in distinguishing between 'Capital' and 'Revenue' will affect the ascertainment of profit.

Capital and Revenue

In this article we will also discuss:

Revenue


Expenditure

The use of goods and services in order to earn revenue is the expense.

Hendriksen opines, "expenses are the using or consuming of goods and services in the process of obtaining revenues".

American Accounting Association, Committee on concepts and standards, defines as under:

"Expense is the expired cost, directly or indirectly related to given fiscal period, of the flow of goods or services into the market and of related operations."

(a) Expenditure incurred during the fiscal period and related to same accounting period becomes an expense i.e. expired cost of that period.

(b) Expenditure incurred during the previous accounting period but related to current accounting period becomes an expense i.e. expired cost of the current accounting period e.g. prepaid expenses.

(c) Expenditure related to the current accounting period but not paid becomes outstanding expenses.


Expenditure is usually of two types:

(a) Capital expenditure; and

(b) Revenue expenditure.

Capital Expenditure

Capital expenditure consists of expenditure, the benefit of which is not fully enjoyed in one accounting period but spread over several accounting periods. It includes assets acquired for the purpose of earning income or increasing the earning capacity of the business or effecting economy in the operation of an asset. These are not meant for sale. Expenditure incurred for improving assets and extending an existing asset is also capital expenditure.

The sum of invoice price, freight and insurance charges, installation and erection cost and custom duty etc. will be capitalized in the books of a firm. These capital items appear on the assets side of Balance Sheet.


Examples:

(a) Interest on capital paid during the period of construction of Company (u/s 208 of Indian Companies Act)

(b) Expenditure in connection with or incidental to the purchase or installation of an asset.

(c) Acquisition of new assets.

(d) Expenditure incurred for putting the old asset purchased, into working condition.

(e) Additions and extensions to existing assets.

(f) Interest and financing charges paid, brokerage and commission paid.

(g) Betterment of fixed assets or improvement of an asset to produce more, to improve its earning capacity or to reduce its operating expenses or to increase the life of asset.

The cost of assets will be written off by way of depreciation over a period of its life. The amount of depreciation is a revenue expenditure and is debited to profit and loss account. The reason for charging depreciation to revenue i.e. profit and loss account is that the asset is used for earning revenue. Hence the depreciation is charged to profit and loss account. Thus, the benefit of capital expenditure does not exhaust in one year but extends over a number of years of its use or life of the asset.


Revenue Expenditure

Revenue expenditure consists of expenditure incurred in one period of the accounting, the full benefit of which is enjoyed in that period only. This does not increase the earning capacity of the business but it is incurred in order to maintain the existing earning capacity of the business. It includes all expenses which arise in normal course of business. The benefit of such expenditure is for a short period, say, one year only and it is not to be carried forward to the next year. The expenditure is of a recurring nature i.e. incurred every year.

Examples:

(a) Purchase of raw materials for conversion into finished goods.

(b) Selling and distribution expenses incurred for sale of finished goods e.g. sales office expenses, delivery expenses, advertisement charges, et(%

(c) Establishment expenses like salaries, wages, rent, rates, taxes, insurance, depreciation on office equipment.

(d) Depreciation of plant, machinery and equipment.

(e) Expenses incurred in order to maintain the existing fixed assets in an efficient and workable state such' as repairs to building, repairs to plant, white-washing and painting of building.


All these items appear on the debit side of trading and profit and loss account, in case of trading concerns or income and expenditure account, in case of non-trading concerns.


Deferred Revenue Expenditure (DRE)

Deferred Revenue Expenditure is a revenue expenditure which has been incurred during one accounting year which is applicable either wholly or in part to further accounting years. According to Prof. A.W. Johnson, "Deferred Revenue Expenditure includes those non-recurring expenses, which are expected to be of financial nature, distributed to several accounting periods of indeterminate total length. These are of revenue nature but are deferred or postponed. It is of quasi- capital nature."

In simpler words, we can say that Deferred Revenue Expenses are those expenses, the benefit of which may be extended to a number of years, say, 3 to 5 years. These are to be charged to profit and loss account, over a period of 3 to 5 years depending upon the benefit accrued.

Sometimes losses may be suffered of an exceptional nature e.g. loss of an asset (uninsured) due to accident or fire; confiscation of property in a foreign country etc. It is worth noting that the amount which has not been debited to the profit and loss account of the current year is shown in the balance sheet on the assets side and it is known as fictitious asset.


Development expenditure

In certain units like mines, plantations and housing colonies initially heavy expenditure has to be incurred and it is only after sometime, say three to five years, that the earnings will follow. Such heavy and initial expenditure is known as 'development expenditure' and treated as capital expenditure.


Purpose of Distinction

Profit and Loss Account is debited with revenue expenditure and credited with revenue income (i.e. sales income and from other sources). If the revenue income is higher than revenue expenditure, it will be a profit and if it is less than revenue expenditure, it will be a loss. Capital expenditure is shown on the assets side of Balance Sheet. Capital and liabilities are shown on the liabilities side of Balance Sheet. The purpose of distinction is to give "True and fair" view of the accounts and financial position of the firm.

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Article Tags: acquisition, american accounting association, assets, association committee, balance sheet examples, benefit, capital expenditure, custom duty, earning income, economy, erection, fiscal period, indian companies act, insurance, insurance charges, invoice price, periods, revenue expenditure



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