Lesson-7 Basic Principles of Preparing Final Account (Capital and Revenue) Learning Objectives To understand the meaning of capital expenditure To understand the meaning of revenue expenditure Capital Expenditure 1. Capital expenditure is that expenditure the benefits of which are not fully consumed in a year but spread over several years. 2. It is the expenditure which results in the purchase or acquisition of asset or property. 3. It is the expenditure incurred in connection with the purchase of asset. 4. It is the expenditure incurred to bring an old asset into working condition. 5. It is the expenditure incurred for extending or improving an existing asset to increase its productivity or to increase the earning capacity of business or to decrease working expenditure. It can be said that the capital expenditure benefits not only in the current accounting year but also many years in the future. The expenditure is generally non-recurring and the amount spent is normally large. However, it should be noted that not every big expenditure is capital expenditure. Capital expenditures are shown in balance sheet. Revenue Expenditure 1. Revenue expenditure is the expenditure which benefits in the current accounting year. It is not carried forward to the next year or years. 2. It is the expenditure which is incurred in the normal course of business to run the business and to maintain the fixed assets of business. 3. It is the expenditure which is incurred on purchase of goods meant for resale or to purchase materials which will be used to convert them into final product. Therefore, revenue expenditure is a recurring expenditure made to maintain the business. The amount spent is generally small and the benefit is for a short period which is not more than a year. All revenue expenditure are charged to trading and profit and loss account. Deferred Revenue Expenditure Deferred revenue expenditure is the expenditure which is originally revenue in nature but the amount spent is so large that the benefit is received for not a year but for many years. A proportionate amount is charged to profit and loss account of each year and balance is carried forward to subsequent years as deferred revenue expenditure. It is shown as an asset in the balance sheet, e.g., heavy expenditure incurred on advertisements. Capital Receipts 65
Capital receipts are the receipts which are not received in the ordinary course of business. These are non-recurring receipts. Money obtained from the sale of fixed assets or investments, issue of shares or debentures, loans taken are some of the examples of capital receipts. Capital receipts are shown as liability reduced from assets appearing in the balance sheet. Revenue Receipts Revenue receipts are receipts obtained in the normal course of business. It is a receipt against supply of goods or services. The money obtained from sales, interest, dividend, transfer fees etc. are examples of revenue receipts. Revenue receipts are credited to profit and loss account. Capital Profit Those profits which are not earned during the regular course of business and which are not earned on account of the day-to-day trading activities of the business are capital profits. For example, profit on sale of asset and premium received on issue of shares. These types of profits are normally not taken to profit and loss account but are shown in the liabilities side of the balance sheet. Capital Losses The losses which are not suffered during the regular course of business are called capital losses. For example, discount on issue of shares. Problem 1 1. An old machinery is purchased for Rs. 1,00,000 and Rs. 25,000 has been spent to bring it in working condition. Answer-- Both the above expenses are capital expenditures as Rs. 1,00,000 has been spent to acquire the asset and Rs. 25,000 has been spent to make the machinery productive. The machinery will now be used for many years and its cost is Rs. 1,25,000. 2. A building is purchased for Rs. 10,00,000 and Rs. 1,00,000 has been spent as expenses like brokerage, stamp duty, registration charges and on other legal expenses. Answer-- Both the above expenditures are capital expenditures as Rs. 10,00,000 has been spent for the purchase of asset and Rs. 1,00,000 for all the incidental expenses for buying the asset. The cost of the building is now Rs. 11,00,000. 3. Repairs to building Answer-- It is revenue expenditure because it is incurred for maintaining the building. Both the reason for repairs and the amount are not important. 4. Amount spent for the replacement of defective and worn out parts of an old plant Answer-- It is revenue expenditure as it is incurred to keep the plant in normal working condition. No new asset comes into existence. 66
5. Heavy expenditure incurred on advertisements. Answer-- Normally, advertisement is revenue expenditure. But, as heavy expenditure is incurred, it will be treated as deferred revenue expenditure. The benefits of it will be received for many years. Proportionate amount will be written off every year by debiting profit and loss account and the remaining amount will be shown in the balance sheet on the asset side. Problem 2 1. A machinery costing Rs. 5,00,000 is imported on which freight and insurance of Rs. 7,000, custom duty of Rs. 13,000, clearing charges of Rs. 5,000 and installation charges of Rs. 10,000 were incurred. Answer-- Rs. 5,00,000 spent on the purchase of asset and Rs. 35,000 spent on other incidental expenses should be considered as capital expenditure until the machinery comes in working condition. The cost of machinery will be Rs. 5,35,000. 2. New equipment for existing machinery were bought for Rs. 30,000 to increase the production by 25% Answer-- The above expenditure is capital expenditure as it increases the production capacity and thereby increases the earning capacity of the business. It is a nonrecurring expense and should be added to the value of asset. 3. Taxes paid Answer-- It is revenue expenditure as it is a regular expense of the business. It is a recurring expense. The benefit is only for one year. 4. Expenditure for repainting the factory shed Answer-- As repainting is a normal expenditure made for maintenance of the factory, it is revenue expenditure. It is a recurring expense and no new asset comes into existence. 5. Traveling expenses of directors for a trip abroad for purchasing imported machinery Answer-- As the traveling expenses is incidental expenditure to purchase machinery, it should be treated as capital expenditure and should be added to the cost of machinery. In this case, if directors purchase the machinery, it would be deferred revenue expenditure and would be written off over a reasonable period of say 3 to 5 years. Problem 3 Following is the summarized trading account of Kinnar Co. Ltd., an iron manufacturing company, for the year ended on March 31, 1980. Dr. Cr. Particulars Rs. Particulars Rs. 67
To (Opening) Stock (500 tons) To Materials Consumed To Wages To Other Mfg. Exp. To Gross Profit c/d 30,000 2,10,000 95,000 92,000 11,500 4,38,500 By Sales (5,500 tons) By (Closing) Stock (400 tons) 4,12,500 26,000 4,38,500 The total production during the year was 6,000 tons out of which some amount was used for the construction of company s building. Wages include Rs. 5,000 and other manufacturing expenses include Rs. 2,000 for the construction of building. Recast the trading account and ascertain the amount to be capitalized to the building account. Solution Dr. Trading A/c for the year ended on 31 st March 1980 Cr. Particulars Rs. Particulars Rs. To (Opening) 30,000 By Sales 4,12,500 Stock (5,500 tons) (500 tons) By building a/c 39,000 To Materials 2,10,000 (Amount of cost of Consumed 95,000 iron to be To Wages _5,000 90,000 capitalized) Less for Building 92,000 By (Closing) Stock 26,000 to other Mfg. Exp. Less for Building _2,000 90,000 57,500 (400 tons) to Gross Profit c/d 4,77,500 4,77,500 Working Notes Dr. Quantity Cr. Particulars Tons Particulars Rs. To (Opening) Stock To Production 500 6,000 Cost per ton 6,500 By Sales By (Closing) Stock By Building (bal. fig.) 5,500 400 600 6,500 Particulars Materials Consumed Wages Manufacturing Expenses Total Cost for Manufacturing 6,000 tons Rs. 2,10,000 90,000 90,000 3, 90,000 Therefore, cost per ton = 3,90,000 = Rs. 65 6,000 Cost of 600 tons of iron used for building = 600 x 65 = 39,000 68
Amount Capitalized to Building A/c Particulars Wages Manufacturing Expenses Iron Rs. 5,000 2,000 39,000 Total 46,000 Problem 4 1. A cinema theatre spent Rs. 10,000 for additional features Answer-- The above expenditure is not increasing the earning capacity of business. Also, no new asset comes into existence. Therefore, the above expense should be considered as revenue expenditure. 2. Cost of goodwill purchased Answer-- It is capital expenditure. The amount spent will give benefit for many years. 3. A petrol driven engine of a passenger bus replaced by a diesel engine Answer-- It is capital expenditure as it is a non-recurring expense and will improve the efficiency of the bus. It will also increase the earning capacity of the bus as diesel will cost less than petrol. It decreases the working expenditure. 4. Customs duty paid on import of raw materials Answer-- It is revenue expenditure as raw materials are trading goods and all expenses related to the purchase of trading goods are revenue. It is a usual expense. 5. Purchase of uniforms, umbrellas and raincoats for staff and employees Answer-- It is a normal expenditure incurred on staff welfare and should be considered as revenue expenditure. Problem 5 1. Legal expenditure incurred in connection with the issue of share capital. Answer-- Any expenditure incurred at the time of formation of company is debited to preliminary expense account. Legal expenses are also debited to preliminary expenses. The preliminary expenses come under the head miscellaneous expenses on the assets side of the balance sheet. It is an example of deferred revenue expenditure and is written off over a period of many years. 2. Cost of replacement of defective part of the machinery Answer-- When a machine is purchased, the cost spent is debited to the machinery account. But, when any part of the machine is replaced on subsequent occasion, the expenses incurred are debited to machinery repairs account. Such expenses are known as revenue expenditure. It is spent to maintain the asset. 3. Expenditure incurred to prepare a project report 69
Answer-- Anytime when the project report is being prepared, certain expenses are required to be incurred such as market survey expenses. When expenses are incurred, it is not certain as to whether the project would materialize or not. If the project materializes and expenses incurred are sizeable, they are treated as capital expenditure. And in case of a project which does not materialize, the project expenses are treated as revenue expenditure. 4. Expenditure incurred to train employees for better running of machinery Answer-- Expenditure incurred to train employees for the better running of machinery will result into greater efficiency and hence will increase the profit of the business. However, such expenses are treated as revenue expenditure as they do not result into acquisition of any tangible assets. 5. Expenditure incurred for repairing cinema screen Answer-- When the cinema screen is first constructed, the expenses incurred are capitalized. On a subsequent date, when the screen is repaired, expenditure incurred for repairs is treated as revenue expenditure. The case would be different if the cinema screen is replaced by a wider screen. In such a case, part of the expenses will be treated as revenue expenditure and the balance amount will be treated as capital expenditure. Problem 6 1. Damages paid for breach of contract Answer-- It is revenue expense because such expenses are ordinary and normal expenses are incurred in the ordinary course of business. 2. Stock of Rs. 5,000 destroyed by fire and Rs. 3,500 received from insurance company Answer-- The recovery of Rs. 3,500 from insurance company is revenue receipt because it is on account of trading asset. The loss is revenue loss as stock is a trading asset and this loss will be debited to profit and loss account. 3. Profit on sale of investment Answer-- If the investments are trading assets, the profit on sale will be treated as revenue receipt and will be shown on the credit side of profit and loss account. If investments are not trading assets, the profit will be treated as capital gain. 4. Legal expenses incurred in income tax appeal Legal expenses incurred in connection with income tax appeal are revenue expenses because they are normal business expenses incurred while doing business. Problem 7 1. Compensation for loss of goodwill Answer-- It is capital receipt as goodwill is an asset. Hence, any amount received on loss of an asset should be treated as capital receipt. 2. Dividend on investment Answer-- As it is a regular income, it is categorized as revenue receipt. 70
3. Sale of old machinery Answer-- The amount received on sale of old machinery should be considered as capital receipt as it is not a receipt that arises in the ordinary course of business. 4. Wages paid for the extension of building Answer-- If wages are paid for the construction work resulting in the extension of building, they are treated as capital expenditure as they create fixed assets. Such expenses will be capitalized. 5. Import duty on raw materials purchased Answer-- It is revenue expenditure. Raw materials are trading assets. Import duty paid on materials purchased is an expenditure relating to the purchase of trading assets. It is an ordinary business expenditure and hence revenue expenditure. Summary 1. Capital expenditure is generally non-recurring and the amount spent is normally large. 2. Capital expenditure are shown in balance sheet. 3. Revenue expenditure is a recurring expenditure made to maintain the business. 4. All revenue expenditure are charged to trading and profit and loss account. 5. The following are the examples of five revenue expenditure that can be treated as capital expenditure in certain circumstances. i) Carriage Carriage inward on goods purchased is revenue expense. But carriage inward paid on the purchase of plant, furniture etc. should be capitalized and treated as part of the cost of the assets. ii) Repairs Repairs to fixed assets to maintain them in a state of working efficiency is revenue expenditure. However, when the amounts are spent by way of repairs to put second hand machinery in working order, such repairs should be capitalized. iii) Wages Wages paid to workers engaged in the production of goods is revenue expense. But where workers are engaged in extension of buildings, manufacture of tools or erection of plant, the wages paid should be capitalized and treated as a part of the plant or the cost of the asset concerned. iv) Legal Charges Legal charges paid in the normal course of business are revenue expenses. However, legal charges paid in connection with the purchase of properties should be added to the cost of property, i.e. they should be capitalized. 71
Questions v) Brokerage Brokerage paid on purchase of properties, fixed assets or investments should be capitalized. 1. What is capital expenditure? 2. What is revenue expenditure? 3. What is deferred revenue expenditure? 4. What do you mean by capital receipts? 5. What do you mean by revenue receipts? 6. What is capital profit? 7. What is capital loss? 8. State with reasons whether the following items are capital, revenue or deferred revenue: (a) Expenditure incurred in overhauling machinery (b) Amount brought by proprietor as capital (c) Building of cost Rs. 2,00,000 sold for Rs. 1,50,000 (d) White washing of office building (e) Expenditure incurred for training employees (f) Received a gift from parents and introduced the amount in business (g) Insurance of godown (h) Renewal of license (i) Expenses incurred on research of a product not resulting in success (j) Bad debts recovered (k) Depreciation on assets (l) Shares purchased and brokerage paid on purchase (m) Loss on sale of plant (n) Preliminary expenses (o) Cost of dismantling, removing and reinstalling the old plant (p) Machinery of value Rs. 10,000 sold for Rs. 10,500 (q) Charges paid to workers for erecting new machinery (r) Rs. 2,00,000 received from issue of shares out of which Rs. 10,000 are issue expenses 72