Capital And Revenue Expenditure

In order to understand the preparation of final accounts (ie., Trading and Profit & Loss Account Balance Sheet), it is essential to have a clear understanding of the distinction between 'capital', 'revenue' and 'items'. This distinction is of great significance because all revenue items are taken to Trading and Profit and Loss Account while all capital items are taken to Balance Sheet. If any error is committed in distinguishing between capital and revenue items, the profit or loss disclosed by Trading and Profit and Loss Account would be inaccurate and the Balance Sheet would not give a true and fair view of the state of affairs of the business enterprise.

I. CLASSIFICATION OF CAPITAL AND REVENUE ITEMS

Capital and Revenue iteras may be classified as follows:

(A) Capital Expenditure and Revenue Expenditure
(B) Capital Receipts and Revenue Receipts
(C) Capital Loss and Revenue Loss
(D) Capital Profit and Revenue Profit

(A) Capital Expenditure and Revenue Expenditure

It is extremely difficult to lay down a hard and fast rule for distinguishing capital expenditure from revenue expenditure. For example, The purchase of chairs by a cloth merchant for seating his customers is in the nature of capital expenditure whereas the chairs purchased by a furniture merchant, for the purpose of sale, is very much a revenue expenditure. However, an attempt has been made to explain the distinction between capital and revenue expenditure on the basis of accounting conventions.

Capital Expenditure: Any expenditure which is incurred in acquiring or increasing the value of a fixed asset is termed as capital expenditure. As such, the amount spent on the purchase of Land and Building, Plant and Machinery, Furniture etc, is capital expenditure. Such expenditure yields benefit over a long period and hence it is written in Assets. Following are the examples of capital expenditure:

Expenditure which results in the acquisition of a fixed asset such as land, building, plant, motor vehicles, trade marks etc. Such asset would be used in the business for a number of years.
Expenditure in connection with the purchase or erection of a fixed asset such as wages paid to workers for erecting machines, cartage paid on acquiring plant and machinery, overhauling of second-hand machines etc.
Expenditure which results in the extension or improvement of fixed asset and which increase the earning capaiety of such assets such as amount spent on increasing the seating capacity of a cinema hall.
All amount spent upto the point an asset is put to use is treated as capital expenditure. Thus, legal fees and brokerage paid to acquire a property and interest paid on loans taken to acquire the asset for the period before the asset is put to use is capital expenditure and is added to the cost of such asset. But interest on loan after the asset is put to use is treated as revenue expenditure.
Expenditure incurred for establishing the business, eg, the cost of a patent, preliminary expenses, goodwill etc.
Interest on capital upto the point production is ready to commence or during the period of formation of company.
Expenditure incurred on the purchase of second-hand asset and on putting such asset into working condition.

Other examples of capital expenditure are:

Expenses incurred on issuing shares and debentures, as the benefit of these expenses will be available in future years also.
Expenses incurred on raising loans for the business.
Development Expenditure-In certain type of businesses such as tea and rubber plantations, horticulture etc. a log period of development process is needed before they start to earn any income. Such expenditure is termed as development expenditure and is treated as capital expenditure.
Money spent to reduce working expenses, for example, conversion of hand- driven machinery.

Revenue Expenditure: Any expenditure, the benefit of which is received during the current year itself is termed as revenue expenditure. As such, all the revenue expenditures are debited to Trading and Profit and Loss Account. Such expenditure does not result in an increase in the earning capacity of the business but only helps in maintaining the existing earning capacity. Examples are:

Expenses incurred for the purpose of day to day running of business such as manufacturing expenses, office expenses, selling expenses etc.
E penses incurred on the ordinary repairs and maintenance of fixed assets, white-washing of building etc.
Payment of goods purchased for resale.
Depreciation on fixed assets.
Purchase of raw materials for converting it into finished goods.
Interest on loan and interest on capital for the period after the asset is put to use.
Replacement of worn-out part of an existing machine.
Loss from sale of fixed assets.

Revenue Expenditure becoming Capital Expenditure

Although the following expenses are revenue expenditure in nature but they are treated as capital expenditure in the following circumstances:

1. Wages : It is usually revenue expenditure but wages paid for the construction or erection of a building or for the installation of a plant is treated as a capital expenditure and should be added to the cost of such asset.

2. Carriage and Freight : When such expenses are paid on the transportation of a newly acquired asset these become capital expenditure.

3. Raw Materials and Stores : When these are used to manufacture a fixed asset these are treated as capital expenditure.

4. Repairs : These are usually revenue expenditure but when a second-hand asset is purchased and repair expenses are incurred to make it usable, the repair expenses will become capital expenditure.

5. Legal Expenses : These are usually revenue expenditure but when these are incurred in connection with the acquisition of fixed assets, these are treated as capital expenditure.

6. Interest on Loan and Interest on Capital : Such interest is treated as capital expenditure if paid during the construction period.

7. Preliminary or Formation Expenses : Such expenses are incurred for the formation of a company. Since the benefit of such expenses will be available in future years also, these are treated as capital expenditure.

8. Brokerage and Stamp Duty : If such expenses are paid on the purchase of assets these are treated as capital expenditure.

9. Advertising : Advertising expenses incurred for it.troducing a new product in the market are treated as capital expenditure.

10. Development Expenditure : In certain businesses such as tea and rubber plantations, horticulture etc. a long period must elapse before they begin to earn. any income. The expenditure incurred during this period is termed as development expenditure.

II. DEFERRED REVENUE EXPENDITURE

A heavy expenditure of revenue nature, the benefit of which will be available over a number of years is classified as Deferred Revenue Expenditure. For example, while introducing a new product in the market a firm may spend a huge amount on advertising. The benefit of this advertising campaign will last for quite a few years. Hence it will be proper to spread the expenses over the years for which benefit is likely to last and write off only a part of the total advertisement cost of the each year's Profit and Loss Account. The unwritten off portion will be carried forward and shown on the asset side of the balance sheet as deferred revenue expenditure. Examples of deferred revenue expenditures are:

Heavy advertisement expenses
Heavy repairs
Expenses incurred in removing the business to more convenient place
Research expenses.

III. DIFFERENCE BETWEEN CAPITAL EXPENDITURE AND REVENUE EXPENDITURE

S.NO.	Basis of Difference	Capital Expenditure	Revenue Expenditure
1.	Purpose of expenses	Such expenses are incurred for the acquisition or erection of a permanent asset.	Such expenses are incurred on purchases of goods (eaut for sale) and the expesses incurred for the day to day running of the business,
2.	Increase in Earning Capacity	Such expenses increa se the earning capacity of the business.	Such expenditure do not intrease the earning capacity. The are incurred to maintain the existing earning expacity.
3.	Recurring or Non Recurring	These expenses are of non- recurring nature, ie, they are incurred whenever need for incurring them is felt	These are of recurring nature because they are incurred for the conduct of business
4.	Period	Such expenditure yields benefit normally over a long period.	Such expenditure yields benefit for a maximum period of one year.
5.	Effect on final Account	Such expenditure in shown in the Balance Sheet.	Such expenditure is shown in the Trading and Statement af Profit & Loss Account.
6.	Increase in the value of assets	Such expenses result in the increase in the value of assets	Such expenses are incurred to keep the assets in good working condition
7.	Object	The main object of capital expenditure is to increase expenditure is to help in present earning capacity of the business	The object of Revenue expenditure is to help in present earning.
8.	Costs	Capital Expenditure indicates unexpired cost.	Revenue expenditure indicates expired costs.
9.	Right of Property	Capital Expenditure is concerned with the property right.	In Revenue Expenditure no such right is seen
10.	Interest	Interest paid on capital borrowed at the time of establishment of any busnens in capital expenditure.	Commonly interest paid in revenue interest.
11.	Development expenditure	Expenditure incurred on executing planning for development is capital expenditure.	Whereas it includes wages, salaries rent etc. are generally treated as revenue expenditure.
12.	Legal expenditure	Legal expenses incurred in respect of establishment of business and purchase of purchase etc. are considered as capital expenditure.	Whereas commonly the amount of legal expenses is treated as revenue expenditure.

IV. CAPITAL AND REVENUE ITEMS AND THE AUDITOR

It is the duty of the Auditor to verify the Profit and Loss Account and the Balance Sheet. In this context, the allocation of trading expenses is not of less importance. The Auditor should see that these expenses have been properly allocated. In case these are not properly a scated, Profit and Loss Account and the Balance Sheet will not represent true and fair view of the business. An Auditor should always keep in mind the following points while allocating these expenses:

The Auditor should see that trading expenses have been properly allocated in capital and revenue expenditure;
These expenses have been allocated on the basis of the nature of the expenses and the business or not;
These capital expenditure which become revenue expenditure on the basis of time should be properly verified by the auditor;
Capital losses have been properly written off out of previous year's profits or not;
Capital losses and revenue losses have been properly allocated, this should be examined;
He should see that capital profit have been kept separately from general profits or not;
Revenue expenditure in Profit and Loss Account and capital expenditure in Balance Sheet have been properly shown or not;
He should also see that mixed expenditure are properly allocated or not; and
The Auditor should pay special attention on deferred revenue expenditure and should see that proportionate share between capital and revenue have been shown in Profit and Loss Account and the Balance Sheet as well.