EL SUBDIRECTOR GENERAL DE TECNICA TRIBUTARIA DE LA DIRECCION GENERAL DE RENTAS

--- 2.1.1 INTRODUCTION

In the lessons under Unit-I pertaining to the preparation of Profit and Loss Account the reader would have had an exposure to the concepts relating to expenses, expenditure and incomes. The term expenditure is a broad term and it is classified into capital expenditure, revenue expenditure and deferred revenue expenditure. All incomes are not receipts and all receipts are not incomes. For eg. under accrual or mercantile system of accounting even income earned but not received is treated as income. Similarly all receipts are not recognised as incomes. This lesson deals with the classification of capital and revenue expenditure and receipts.

2.1.2 OBJECTIVES

After reading this lesson the reader should be able to: (i) Understand capital expenditure

(ii) Distinguish capital expenditure from revenue expenditure (iii) Identify Capital receipts and Revenue receipts

2.1.3 CONTENTS

2.1.3.1. Capital Expenditure 2.1.3.2. Revenue Expenditure

2.1.3.3. Distinction between Capital and Revenue Expenditure 2.1.3.4. Deferred Revenue Expenditure

2.1.3.5. Capital and Revenue Profits, Receipts and Losses 2.1.3.6. Illustrations

2.1.3.8. Key Words

2.1.3.9. Self Assessment Questions

2.1.3.10. Key to Self Assessment Questions 2.1.3.11. Case Analysis

2.1.3.12. Books for Further Reading

2.1.3.1 CAPITAL EXPENDITURE: Capital expenditure is that expenditure the benefit of which is not fully consumed in one period but spread over periods i.e. the benefits are expected to accrue for a long time. Any expenditure which gives the following outcomes is a capital expenditure:

(i) Increases the capacity of an existing asset. (ii) Increases the life of an existing asset.

(iii) Increases the earning capacity of the concern. (iv) Results in the acquisition of a new asset. (v) Decreases the cost of production.

Following are the examples of capital expenditure:

(i) Expenditure resulting in the acquisition of fixed assets e.g. land, building, machines, etc.

(ii) Expenditure resulting in extension or improvement of fixed assets e.g. amount spent on increasing the seating accommodation in the picture hall.

(iii) Expenditure in connection with installation of a fixed asset.

(iv) Expenditure incurred for acquiring the right to carry on a business e.g. patents, copyright, etc.

(v) Major repairs and replacements of parts resulting in increased efficiency of a fixed asset.

An expenditure cannot be said to be a capital expenditure only because: (i) The amount is large.

(ii) The amount is paid in lump sum.

(iii) The amount is paid out of that fund which has been received out of the sale of fixed asset.

(iv) The receiver of the amount is going to treat it for the purchase of fixed asset.

2.1.3.2 REVENUE EXPENDITURE: An expenditure which is consumed during the current period and which affects the income of the current period is called revenue expenditure. Also an expenditure which merely seeks to maintain the business of high assets in good working conditions is revenue expenditure. Following are the examples of revenue expenditure:

(i) Expenses of administration, expenses incurred in manufacturing and selling products.

(ii) Replacements for maintaining the existing permanent assets. (iii) Costs of goods purchased for resale.

(iv) Depreciation on fixed assets, interest on loans for business, etc. 2.1.3.3 DISTINCTION BETWEEN CAPITAL AND REVENUE EXPENDITURE:

The proper distinction between capital and revenue as regard to expenditure, payments, profits, receipts and losses is one of the fundamental principles of correct accounting. It is very essential that in all cases this distinction should be rigidly observed and amounts rightly allocated between capital and revenue. Failure or neglect to discriminate between the two will falsify the whole of the results of accounting. However the distinction is not always easy. In actual practice there is a good deal of difference of opinion as to whether a particular item is capital or revenue expenditure. However the rules mentioned above may serve as a guide for making distinction between capital and revenue expenditure.

2.1.3.4 DEFERRED REVENUE EXPENDITURE: A heavy expenditure of revenue nature incurred for getting benefit over a number of years is classified as deferred revenue expenditure. In some cases the benefit of revenue expenditure may be available for a period of two or three or even more years. Such expenditure is to be written off over a period of two or three years and not wholly in the year in which it is incurred. For example a new firm may advertise very heavily in the beginning to capture a position in the market. The benefit of this advertisement campaign will last quite a few years. It will be better to write off the expenditure in three or four years and not only in the first year. Some other examples of deferred revenue expenditure: Preliminary expenses, brokerage on issue of shares and debentures, exceptional repairs, discount on issue of shares or debentures, expenses incurred in removing the business to more convenient premises, etc.

2.1.3.5 CAPITAL AND REVENUE PROFITS, RECEIPTS AND LOSSES: Capital and Revenue Profits: Capital profit is a profit made on the sale of a fixed asset or a profit earned on getting capital for the business. For example if the original cost of a fixed asset is Rs.50,00,000 and if it is sold for Rs.60,00,000 then Rs.10,00,000 is capital profit. Similarly if the shares having an original cost of Rs.4,000 are sold for Rs.5,000, the profit of Rs.1,000 thus made is capital profit. Capital profits should not be transferred to the profit and loss account but should be transferred to capital reserve which would appear as a liability in the balance sheet. Revenue profit, on the other hand, is a profit by trading, e.g. profit on sale of goods, income from investments, discount received, commission earned, rent received, interest earned etc. Such profits are taken to profit and loss account.

Capital and Revenue Receipts: The distinction between capital receipts and revenue receipts is also important. Money obtained from the sale of fixed assets

of investments, issue of shares, debentures, money obtained by way of loans are examples of capital receipts. On the other hand revenue receipts are: cash from sales, commission received, interest on investments, transfer fees, etc. Capital receipts are shown in the balance sheet and revenue receipts in the profit and loss account.

Capital and Revenue Losses: Capital losses are those losses which occur at selling fixed assets or raising share capital. For e.g. if investments having an original cost of Rs.20,000 are sold for Rs.16,000, there will be a capital loss of Rs.4,000. Similarly when the shares of the face value of Rs.100 are issued for Rs.90, the amount of discount i.e. Rs.10 per share will be a capital loss. Capital losses should not be debited to Profit and Loss Account but may be shown on the asset side of Balance Sheet. As and when capital profits arise, losses are met against them. Revenue losses are those losses which arise during the normal course of business i.e. in trading operations such as losses on the sale of goods. Such losses are debited to Profit and Loss Account.

2.1.3.6 ILLUSTRATIONS

Illustration 1: State which of the following expenditures are capital in nature