Accounting — Capital and Revenue Expenditures and Receipts
Learning Outcomes
- Learn the criteria for identifying Revenue Expenditure and distinguishing from Capital Expenditure.
- Learn the distinction between capital and revenue receipts.
- Understand the linkage of such distinction with the preparation of final accounts.
3.1 Introduction
- Accounting aims in ascertaining and presenting the results of the business for an accounting period.
- For ascertaining the periodical business results, the nature of transactions should be analyzed whether they are of capital or revenue nature.
- Revenue Expense relates to the operations of the business of an accounting period or to the revenue earned during the period or the items of expenditure, benefits of which do not extend beyond that period.
- Capital Expenditure, on the other hand, generates enduring benefits and helps in revenue generation over more than one accounting period.
- Revenue Expenses must be associated with a physical activity of the entity. Therefore, whereas production and sales generate revenue in the earning process, use of goods and services in support of those functions causes expenses to occur.
KNOWLEDGE NUGGET
- Revenue Expenditure: Benefits do not extend beyond current accounting period
- Capital Expenditure: Generates enduring benefits over more than one accounting period
- Revenue expenditures are shown in Profit & Loss Account
- Capital expenditures are placed on the asset side of Balance Sheet
- Expenses are recognised in the Profit & Loss Account through matching principle which tells us when and how much of the expenses to be charged against revenue.
- A part of the expenditure can be capitalised only when these can be traced directly to definable streams of future benefits.
- The distinction of transaction into revenue and capital is done for the purpose of placing them in Profit and Loss account or in the Balance Sheet.
- Both capital and revenue expenditures are ultimately transferred to profit and loss account. Revenue expenditures are transferred in the year of spending while capital expenditures are transferred when their benefits are utilised.
- It is the time factor which is the main determinant for transferring the expenditure to profit and loss account.
3.2 Considerations in Determining Capital and Revenue Expenditures
The basic considerations in distinction between capital and revenue expenditures are:
- (a) Nature of business: For a trader dealing in furniture, purchase of furniture is revenue expenditure but for any other trade, the purchase of furniture should be treated as capital expenditure and shown in the balance sheet as asset. Therefore, the nature of business is a very important criteria in separating an expenditure between capital and revenue.
- (b) Recurring nature of expenditure: If the frequency of an expense is quite often in an accounting year then it is said to be an expenditure of revenue nature while non-recurring expenditure is infrequent in nature and do not occur often in an accounting year. Monthly salary or rent is the example of revenue expenditure while purchase of assets is not the transaction done regularly therefore, classified as capital expenditure unless materiality criteria defines it as revenue expenditure.
- (c) Purpose of expenses: Expenses for repairs of machine may be incurred in course of normal maintenance of the asset. Such expenses are revenue in nature. On the other hand, expenditure incurred for major repair of the asset so as to increase its productive capacity is capital in nature.
- (d) Effect on revenue generating capacity of business: The expenses which help to generate income/revenue in the current period are revenue in nature. On the other hand, if expenditure helps to generate revenue over more than one accounting period, it is generally called capital expenditure.
- (e) Materiality of the amount involved: Relative proportion of the amount involved is another important consideration in distinction between revenue and capital.
KEY CONSIDERATIONS — SUMMARY
- Nature of Business: Same item can be capital or revenue depending on business type
- Recurring Nature: Frequent expenses → Revenue; Infrequent → Capital
- Purpose: Maintenance → Revenue; Improvement/Enhancement → Capital
- Revenue Generating Capacity: Current period benefit → Revenue; Long-term benefit → Capital
- Materiality: Relative proportion matters
3.3 Capital Expenditures and Revenue Expenditures
- Capital expenditure contributes to the revenue earning capacity of a business over more than one accounting period whereas revenue expense is incurred to generate revenue for a particular accounting period.
- The revenue expenses either occur in direct relation with the revenue or in relation with accounting periods, for example cost of goods sold, salaries, rent, etc.
- Capital expenditure may represent acquisition of any tangible or intangible fixed assets for enduring future benefits.
- Therefore, the benefits arising out of capital expenditure last for more than one accounting period whereas those arising out of revenue expenses expire in the same accounting period.
3.3.1 Key differences between Capital and Revenue Expenditures
| Key Differences | Capital Expenditure | Revenue Expenditure |
|---|---|---|
| Period of benefit | Any expenditure incurred to provide a benefit over a long-term period is capital expenditure. | Any expenditure incurred to provide a benefit during the current period is revenue expenditure. |
| Enhancement vs Maintenance | Capital expenditure is incurred for the purpose of increasing the capacity of the business. Alternatively, it also includes an expenditure to reduce the costs of the business. | Revenue expenditure is incurred to maintain the earning capacity of the business. |
| Examples | Purchase of machine, car, furniture, etc. | Repairs and maintenance, salary of accounting staff, etc. |
Illustration 1
State with reasons whether the following statements are 'True' or 'False'.
SOLUTION
- (1) Overhaul expenses of second-hand machinery purchased are Revenue Expenditure. False — Overhaul expenses are incurred to put second-hand machinery in working condition to derive endurable long-term advantage. So it should be capitalised.
- (2) Money spent to reduce working expenses is Revenue Expenditure. False — It may be reasonably presumed that money spent for reducing revenue expenditure would have generated long-term benefits to the entity. So this is capital expenditure.
- (3) Legal fees to acquire property is Capital Expenditure. True — Legal fee paid to acquire any property is part of the cost of that property. It is incurred to possess the ownership right of the property and hence a capital expenditure.
- (4) Amount spent as lawyer's fee to defend a suit claiming that the firm's factory site belonged to the plaintiff's land is Capital Expenditure. False — Legal expenses incurred to defend a suit is maintenance expenditure of the asset. Maintenance expenditure is revenue expenditure.
- (5) Amount spent for replacement of worn out part of machine is Capital Expenditure. False — Amount spent for replacement of any worn out part of a machine is revenue expense since it is part of its maintenance cost.
- (6) Expense incurred on the repairs and white washing for the first time on purchase of an old building are Revenue Expenses. False — Repairing and white washing expenses for the first time of an old building are incurred to put the building in usable condition. These are the part of the cost of building. Accordingly, these are capital expenditure.
- (7) Expenses in connection with obtaining a license for running the cinema is Capital Expenditure. True — The Cinema Hall could not be started without license. Expenditure incurred to obtain the license is pre-operative expense which is capitalised.
- (8) Amount spent for the construction of temporary huts, which were necessary for construction of the Cinema House and were demolished when the cinema house was ready, is Capital Expenditure. True — Cost of temporary huts constructed which were necessary for the construction of the cinema house is part of the construction cost of the cinema house. Therefore such costs are to be capitalised.
Illustration 2
State with reasons whether the following are Capital or Revenue Expenditure:
SOLUTION
- (1) Expenses incurred in connection with obtaining a license for starting the factory for ₹10,000. — Capital Expenditure. This is an item of expenditure incurred to acquire the right to carry on business.
- (2) ₹1,000 paid for removal of Inventory to a new site. — Revenue Expenditure. This is neither bringing enduring benefit nor enhancing the value of the asset.
- (3) Rings and Pistons of an engine were changed at a cost of ₹5,000 to get fuel efficiency. — Capital Expenditure. This is an expenditure on improvement of a fixed asset. It results in increasing profit-earning capacity of the business by cost reduction.
- (4) Money paid to Mahanagar Telephone Nigam Ltd. (MTNL) ₹8,000 for installing telephone in the office. — Not expenditure. This is treated as an asset and the same is adjusted over a period of time against actual telephone bills.
- (5) A factory shed was constructed at a cost of ₹1,00,000. A sum of ₹5,000 had been incurred in the construction of temporary huts for storing building material. — Capital Expenditure. Building is fixed asset which will generate enduring benefit. Construction of temporary huts is incidental to the main construction. Such cost is also capitalised with the cost of building.
Illustration 3
Best Tech Solutions buys and sells computers as a part of its business. It purchased 20 computers for resale to its customers. Cost of each computer is ₹20,000. It also purchased a computer costing ₹24,000 for its accountant to be able to maintain the accounting records and printing of invoices. Suggest whether above transactions qualify as capital expenditure or revenue expenditure transactions?
SOLUTION
- Best Tech Solutions is in the business of buying and selling of computers. Any computers purchased for resale to its customers will qualify as revenue expenditure. Hence, a purchase of ₹20,000 × 20 = ₹4,00,000 will be a part of revenue expenditure.
- At the same time, the computer purchased for maintaining the records and invoicing is to be able to operate the business for a longer period of time. Therefore, the purchase of ₹24,000 qualifies as a capital expenditure. This amount will be a part of assets in the Balance Sheet.
3.4 Capital Receipts and Revenue Receipts
- Receipts which are obtained in course of normal business activities are revenue receipts (e.g., receipts from sale of goods or services, interest income etc.).
- On the other hand, receipts which are not revenue in nature are capital receipts (e.g., receipts from sale of fixed assets or investments, secured or unsecured loans, owners' contributions etc.).
- Revenue and capital receipts are recognised on accrual basis as soon as the right of receipt is established.
- Revenue receipts should not be equated with the actual cash receipts. Revenue receipts are credited to the Profit and Loss Account.
- On the other hand, Capital receipts are not directly credited to Profit and Loss Account. For example, when a fixed asset is sold for ₹92,000 (cost ₹90,000), the capital receipts ₹92,000 is not credited to Profit and Loss Account. Profit or Loss on sale of fixed assets is calculated and credited to Profit and Loss Account.
CAPITAL vs REVENUE RECEIPTS
- Revenue Receipts: Obtained in course of normal business — credited to P&L Account
- Capital Receipts: Not revenue in nature — not directly credited to P&L Account
- Examples of Revenue Receipts: Sale of goods, interest income
- Examples of Capital Receipts: Sale of fixed assets, loans, owners' contributions
Illustration 4
State with reasons whether the below items relating to the business of AB Ltd are capital or revenue receipts?
SOLUTION
- (a) A machine with a book value of ₹10 lakh is sold for ₹12 lakh. — Capital Receipt. There is a profit on sale of the machine to the extent of ₹2 lakh (12 - 10).
- (b) Premium amounting to ₹1 Lakh received on issue of shares. — Capital Receipt.
- (c) An amount of ₹20,000 received from goods sold in cash. — Revenue Receipt.
- (d) An amount of ₹5 lac received on the maturity of fixed deposit from bank. Also, an interest of ₹40,000 was received in addition to the maturity amount of the fixed deposits. — Capital Receipt (maturity amount) and Revenue Receipt (interest income).
Illustration 5
Good Pictures Ltd., constructs a cinema house and incurs the following expenditure during the first year ending 31st March, 2022.
SOLUTION
- (1) Second-hand furniture worth ₹9,000 was purchased; repainting of the furniture costs ₹1,000. The furniture was installed by own workmen, wages for this being ₹200. — Capital Expenditure. Total cost ₹10,200 should be capitalised since without such expenditure the furniture would not be available for use.
- (2) Expenses in connection with obtaining a license for running the cinema worth ₹20,000. During the course of the year the cinema company was fined ₹1,000, for contravening rules. Renewal fee ₹2,000 for next year also paid. — License cost is Capital Expenditure; Fine of ₹1,000 is Revenue Expenditure; Renewal fee ₹2,000 is Prepaid Expense.
- (3) Fire insurance, ₹1,000 was paid on 1st October, 2021 for one year. — Half of the insurance premium pertains to the year beginning on 1st April, 2021. Hence such amount should be treated as Prepaid Expense. The remaining amount is Revenue Expense for the current year.
- (4) Temporary huts were constructed costing ₹1,200. They were necessary for the construction of the cinema. They were demolished when the cinema was ready. — Capital Expenditure. Since the temporary huts were necessary for the construction, their cost should be added to the cost of the cinema hall and thus capitalised.
Illustration 6
State with reasons, how you would classify the following items of expenditure:
SOLUTION
- (1) Overhauling expenses of ₹25,000 for the engine of a motor car to get better fuel efficiency. — Capital Expenditure. These expenses will reduce the running cost in future and thus the benefit is in form of endurable long-term advantage.
- (2) Inauguration expenses of ₹25 lacs incurred on the opening of a new manufacturing unit in an existing business. — Revenue Expenditure. This expenditure may not generate any enduring benefit to the business over more than one accounting period.
- (3) Compensation of ₹2.5 crores paid to workers, who opted for voluntary retirement. — Revenue Expenditure. Since the magnitude of the amount of expenditure is very significant, it may be better to defer it over future years.
Illustration 7
Classify the following expenditures and receipts as capital or revenue:
SOLUTION
- (i) ₹10,000 spent as travelling expenses of the directors on trips abroad for purchase of capital assets. — Capital Expenditure
- (ii) Amount received from Trade receivables during the year. — Revenue Receipt
- (iii) Amount spent on demolition of building to construct a bigger building on the same site. — Capital Expenditure
- (iv) Insurance claim received on account of a machinery damaged by fire. — Capital Receipt
Illustration 8
Are the following expenditures capital in nature?
SOLUTION
- (i) M/s ABC & Co. run a restaurant. They renovate some of the old cabins. Because of this renovation some space was made free and number of cabins was increased from 10 to 13. The total expenditure was ₹20,000. — Capital Expenditure. Renovation increased the number of cabins. This has an effect on the future revenue generating capability of the business.
- (ii) M/s New Delhi Financing Co. sold certain goods on installment payment basis. Five customers did not pay installments. To recover such outstanding installments, the firm spent ₹10,000 on account of legal expenses. — Revenue Expenditure. Expense incurred to recover installments due from customer do not increase the revenue generating capability in future.
- (iii) M/s Ballav & Co. of Delhi purchased a machinery from M/s Shah & Co. of Ahmedabad. M/s Ballav & Co. spent ₹40,000 for transportation of such machinery. — Capital Expenditure. Expenses incurred on account of transportation of fixed asset is capital expenditure in nature.
Summary
- Revenue expenditures are shown in the profit and loss account while capital expenditures are placed on the asset side of the balance sheet since they generate benefits for more than one accounting period.
- Prepaid expenses are future expenses that have been paid in advance. These are shown in the balance sheet as an asset.
- Receipts obtained should be classified between revenue receipts and capital receipts.
Test Your Knowledge
True and False
- 1. The nature of business is not an important criteria in separating an expenditure between capital and revenue. False
- 2. Expenditure incurred for major repair of the asset so as to increase its productive capacity is Revenue in nature. False
- 3. Amount spent as lawyer's fee to defend a suit claiming that the firm's factory site belonged to the plaintiff's land is Capital Expenditure. False
- 4. Amount spent for replacement of worn-out part of machine is Capital Expenditure. False
- 5. Legal fees to acquire property is Capital Expenditure. True
- 6. Amount spent for the construction of temporary huts, which were necessary for construction of the cinema house and were demolished when the cinema house was ready, is Capital Expenditure. True
Multiple Choice Questions
| 1. Money spent ₹10,000 as traveling expenses of the directors on trips abroad for purchase of capital assets is | (a) Capital expenditures (b) Revenue expenditures (c) Prepaid revenue expenditures |
| 2. Amount of ₹5,000 spent as lawyers' fee to defend a suit claiming that the firm's factory site belonged to the plaintiff's land is | (a) Capital expenditures (b) Revenue expenditures (c) Prepaid revenue expenditures |
| 3. Entrance fee of ₹2,000 received by Ram and Shyam Social Club is | (a) Capital receipt (b) Revenue receipt (c) Capital expenditures |
| 4. Subsidy of ₹40,000 received from the government for working capital by a manufacturing concern is | (a) Capital receipt (b) Revenue receipt (c) Capital expenditures |
| 5. Insurance claim received on account of machinery damaged by fire is | (a) Capital receipt (b) Revenue receipt (c) Capital expenditures |
| 6. Interest on investments received is | (a) Capital receipt (b) Revenue receipt (c) Capital expenditures |
| 7. Amount received from IDBI as a medium term loan for augmenting working capital is | (a) Capital expenditures (b) Revenue expenditures (c) Capital receipt |
| 8. Revenue from sale of products, ordinarily, is reported as part of the earning in the period in which | (a) The sale is made (b) The cash is collected (c) The products are manufactured |
| 9. If repair cost is ₹25,000, whitewash expenses are ₹5,000, (both these expenses relate to presently used building) cost of extension of building is ₹2,50,000 and cost of improvement in electrical wiring system is ₹19,000; the amount to be expensed is | (a) ₹2,99,000 (b) ₹44,000 (c) ₹30,000 |
High-Yield Interactive Quiz — Capital and Revenue Expenditures and Receipts
Q1. Which type of expenditure generates enduring benefits and helps in revenue generation over more than one accounting period?
Correct Answer: B. Capital Expenditure generates enduring benefits and helps in revenue generation over more than one accounting period.
Q2. Revenue expenditures are shown in which financial statement?
Correct Answer: B. Revenue expenditures are shown in the profit and loss account as their benefits are for one accounting period.
Q3. For a trader dealing in furniture, purchase of furniture is classified as:
Correct Answer: B. For a trader dealing in furniture, purchase of furniture is revenue expenditure. For any other trade, it would be capital expenditure.
Q4. Overhaul expenses of second-hand machinery purchased are:
Correct Answer: B. Overhaul expenses are incurred to put second-hand machinery in working condition to derive endurable long-term advantage, so they should be capitalised.
Q5. Legal fees to acquire property is classified as:
Correct Answer: B. Legal fee paid to acquire any property is part of the cost of that property. It is incurred to possess the ownership right of the property and hence a capital expenditure.
Q6. Amount spent for replacement of worn out part of machine is:
Correct Answer: B. Amount spent for replacement of any worn out part of a machine is revenue expense since it is part of its maintenance cost.
Q7. Which of the following is an example of a revenue receipt?
Correct Answer: D. Interest income is a revenue receipt obtained in the course of normal business activities. Sale of fixed assets, loans, and owners' contributions are capital receipts.
Q8. Premium received on issue of shares is classified as:
Correct Answer: B. Premium received on issue of shares is an example of a capital receipt.
Q9. Expenses incurred in connection with obtaining a license for starting the factory is:
Correct Answer: B. Money paid for obtaining license to start a factory is a capital expenditure as it is incurred to acquire the right to carry on business.
Q10. Which of the following is NOT a consideration in determining capital and revenue expenditure?
Correct Answer: D. The basic considerations are: Nature of business, Recurring nature, Purpose of expenses, Effect on revenue generating capacity, and Materiality of amount involved. Amount of profit earned is not a consideration.
Q11. If repair cost is ₹25,000, whitewash expenses are ₹5,000, cost of extension of building is ₹2,50,000 and cost of improvement in electrical wiring system is ₹19,000; the amount to be capitalised is:
Correct Answer: C. Capitalised amount = Extension of building ₹2,50,000 + Improvement in electrical wiring ₹19,000 = ₹2,69,000. Repair ₹25,000 and whitewash ₹5,000 are revenue expenses (total ₹30,000 to be expensed).
Q12. Amount spent on demolition of building to construct a bigger building on the same site is:
Correct Answer: B. Amount spent on demolition of building to construct a bigger building on the same site is capital expenditure.