Capital & Revenue – Income & Expenses
Based on these concepts, and according the to the benefits derived and accruing over each Financial Accounting period, the Income & Expenses may be divided into Capital & Revenue.
- Going Concern : As per Going Concern concept, it is considered that a business will go on over a long period of time.
- Periodicity : Further, as per Periodicity concept, for accounting purpose, the life of business is split over equal time intervals, called Financial Accounting Year, to measure the performance of the business for each Financial Accounting Year separately (i.e Profit & Loss Account), and reveal the status of the business at the end of each Financial Accounting Year (i.e Balance Sheet).
In India, normally the Financial Accounting Year is considered from 1st day April to 31st day March of the next calendar year (e.g 1st April 2016 to 31st march 2017).
Revenue Income & Expenses
- Revenue Income : Revenue Income are those amount of Income which are considered to be fully earned for the period of the respective financial year (e.g Sales, Service Income, Professional Income) etc.
- Revenue Expenses : Revenue Expenses are those amount of Expenses which are considered to be fully consumed for the period of the respective financial year (e.g Purchases, Wages, salary, Travelling Expenses etc)
Hence Revenue Income & Expenses are taken into Profit & Loss Account, being squared up during the financial year to compute the net profit / loss for the financial year. So, no part of revenue Income or expenses are carried to the next financial year and hence Revenue Income or expenses are not carried in the Balance Sheet
Capital Income & Expenses
- Capital Income : Capital Income (or Capital Profits) are sudden unusual Income not resulting from regular operations of the business. Hence they are not taken into the Profit & Loss Account of the current year, and are carried in the Balance Sheet as Reserves (e.g Government Grants, Sale of Fixed Asset, Share premium received on issue of shares)
- Capital Expenses : Expenses incurred (referred as Deferred Revenue Expenses) during the year whose benefit would extend to subsequent Financial Year. So, unexpired amount of Capital Expenses are carried to Balance Sheet to written over subsequent periods (e.g Preliminary expenses on Incorporation of Company, Heavy product promotional campaign expenses, loss due to natural calamity like Flood, Earthquake etc)
Hence Capital Income & Expenses are not taken into Profit & Loss Account, as they are not consumed during the financial year. So, such amount are carried to the next financial year in Balance Sheet
Nature / Purpose of Business
We have viewed Income / Expenses according to the nature of Income / Expenses. For example expenses paid for acquisition of Furniture / Motor Car is Capital Expenses. But we will see, that an Income / Expenses should be treated as Capital / Revenue according the nature / purpose of business, rather than the nature of Income / Expenses itself.
- Asset acquired for use in business : If the asset is acquired for use of business, it is related as Capital Expenses and the asset is treated as Fixed Asset for running the business. Such asset produce benefit beyond the current financial year enabling to increase the efficiency of the business to earn more profit.
- Asset acquired for Business Trade / Consumption : If the asset is considered for trade / consumption, it is revenue expenses. So, a Motor car purchase for Business use is considered as Fixed Asset, while a Motor Car purchased by Car Dealer, for resale is treated as Purchases and considered as revenue expenses.
In the same way, repairs, overhauling charges etc., to install a new machinery, increasing the capacity of machinery, would be treated as Capital Expenses, through Repairs / Overhauling charges are normally considered as Revenue Expenses
As per materiality concept, small expenditure, whose benefit may accrue in subsequent year, may be treated as Revenue. For example, a calculator purchased, or small tools purchased, may be treated as Revenue, though both items purchased may last beyond the current years and produce the benefits. In general practice, items valued upto rupees 5000 may be considered as revenue expenses.
Impact of Capital / Revenue Income / Expenses
- Capital Income : Increases the liability of the Business, carried in Balance Sheet at the end of current financial year
- Revenue Income : Increases the current Profit of the Business, accounted for in P L Account of the current year
- Capital / Deferred Revenue Expenses : Increases the Assets of the Business, carried in Balance Sheet at the end of current financial year
- Revenue Expenses : Reduces current year Profit of the Business, accounted for in P L Account of the current year
Capital and Revenue Expenditure
To calculate net profit, only revenue income and expenditure are to be considered. To ascertain the financial position of the business, capital expenditure and income or receipts are to be considered. For example, cash introduced in business by proprietor is a Capital Receipt but cash received on sale of goods is Revenue Receipt.
Revenue means the aggregate exchange value received for goods or providing services whereas Receipt means inflow of money into business.
If the benefit of expenditure is not exhausted in one accounting period, but it is spread over future accounting periods, the expenditure is known as Capital Expenditure. Capital expenditure increases earning capacity of business (and not incurred to meet day-to-day expenditure). The benefit of its usage is spread over a number of future accounting periods.
Examples of Capital Expenditure
- Acquisition of asset: Expenditure incurred to acquire fixed assets intended to be used in the business beyond the current financial year, and not meant for resale (for instance, a plant bought during the current accounting period, intended to be used over and over several years).
- Additions or Improvement of Asset: An additional item of plant or machinery bought to improve the capacity, efficiency, life span or economy of operation (for example, more spindles added in a ring frame in a spinning mill. Cost of such spindles added is a capital expenditure).
- Expenditure of right or benefit of Asset: Expenditure incurred for acquiring benefit or right of an enduring nature, (for example, goodwill, copyright, trademark, patent, etc).
- Expenditure incurred to acquire Asset: Expenditure incurred in the course of acquiring a fixed asset, and directly connected with it, (for example, machinery construction and installation expenses, stamp duty and registration charges in the acquisition of land, etc).
- Extension of Asset: Expenditure incurred to extend capacity of business (for example, a new room is constructed to increase the capacity of the business).
Revenue Expenditure affects profit of business for the current period and it is deducted from revenue income to determine net income of a business.
Example of Revenue Expenditure
- Day-to-day expenses: Day-to-day expenses in the conduct and administration of business and gives benefit less than a year e.g. rent, taxes, insurance, wages salaries, carriage etc.
- Expenditure of Current assets: Expenditure of current asset for conversion into finished products, e.g. raw materials and stores.
- Expenditure incurred to maintain fixed asset: To maintain fixed asset in working order, e.g. repairs and renewal, depreciation, cost of spares, etc.
Deferred Revenue Expenditure
Sometimes, business enterprises incur exceptional kind of huge amount of Expenses, or suffer exceptional kind of huge loss, which are spread over several years. Such kind of exceptional expenses or losses are known as Deferred Revenue Expenditure.
Deferred Revenue Expenses are kind of exceptional revenue expenses, or loss, not borne fully in the year in which it is spent or loss incurred, but is spread over a period in future.
- Exceptional Expenses : Sometimes, a heavy expenditure of revenue nature is incurred which gives benefit beyond the current period. Such expenditure is classified as Deferred Revenue Expenditure. A portion of such expenses are treated as revenue in current year and balance is carried forward and gradually written off in future accounting period.
- Exceptional Loss : Sometimes losses of exceptional nature that involves a huge sum are treated as Deferred Revenue Expenditure. For example, Damage of property due to natural calamity, project work not materialized.
Instances of Deferred Revenue Expenditure
Preliminary expenses, brokerage on issue of shares and debentures, discount on issue of shares or debentures, exceptional repairs, heavy advertisement, expenses incurred for product promotion, underwriting commission, research and development expenses etc.
Characteristics of Deferred Revenue Expenditure
- Deferred revenue expenditure is of revenue nature (i.e. for expenses incurred and not for acquisition of any asset). The benefit of deferred revenue expenditure is not exhausted in the year in which it is incurred, but extends over a number of years.
- It is occasional in nature, and normally heavy in amount. Only a part of deferred revenue expenditure is charged against the profit and loss account of the year in which it is incurred. Its unwritten portion is shown in the Balance Sheet on the asset side as miscellaneous expenditure.
Revenue Expenditure treated as Capital Expenditure
Revenue expenses closely associated to a Capital Expenditure to become a part of Capital Expenditure, or to put a Capital Asset into use, (recognized as capital expenses), may be treated as Capital Expenditure (called Capitalisation of Revenue Expenses).
Instances of Revenue Expenses treated as Capital Expenses
- Legal Expenses: Legal expenses incurred in connection with purchase of fixed assets (like registration charges of land, building, motor car etc).
- Repairs: Second hand plant is purchased and immediate repairs are made to bring it in working order. Such repair become capital expenditure and is added to the plant as part of its cost.
- Wages: Wages Paid to workers to erect and install / construct new machinery or any other fixed asset is capital expenditure and should be treated as the part of cost of the asset.
- Transport Expenses: ExpensesIncurred for transporting any fixed asset is added to the cost of acquisition of the fixed asset.
- Interest on capital: During construction work, Interest paid on money borrowed for the capital project may be added to the cost of project, in some specific cases.
- Raw Material and stores: Materials Consumed for making of a fixed asset, is treated as a part of the cost of the asset.
- Development Expenses: Initial phase development expenses (e.g. development of land and tea plants, projects of long gestation period etc.) may be treated as ‘Capital Expenses’.
Capital Expenditure vs Revenue Expenditure
|Capital Expenditure||Revenue Expenditure|
|Benefit Period : The benefit of Capital expenditure is not exhausted in one accounting period, but extends over future accounting periods.||Revenue Expenditure affects earning of business for one financial year.|
|Accounting Treatment : Items of Capital expenditure, to the extent not written off, are shown in the Balance Sheet as assets.||All revenue expenses, the benefit of which has exhausted during the year, are transferred to Trading, P & L A/c and so not carried forward to Balance Sheet.|
|Purpose : Capital expenditure involves acquisition of fixed asset meant for use and not to resale.||Revenue expenses does not involve in acquisition of any fixed asset.|
|Earning Capacity : Capital expenditure is incurred for improving the earning capacity of fixed asset||Revenue expenses is incurred for maintenance of the earning capacity of business assets.|
|Time : Capital expenditure may be incurred before or after commencement of business.||Revenue expenses are incurred only after commencement of business.|
|Matching : Capital expenditures are not matched with Capital receipts.||Revenue expenditures are matched with revenue receipts.|
|Nature : Capital expenditure are of non-recurring nature.||Revenue expenditures are normally of recurring nature.|
Capital Expenditure vs. Deferred Revenue Expenditure
|Capital Expenditure||Deferred Revenue Expenditure|
|Creation of Asset : Capital Expenditure results in permanent and long-term benefit in the form of an asset.||Deferred Revenue Expenditure is primarily of a revenue nature and does not result in acquisition of any asset.|
|Realisable Value : If the business does not continue, some value may be realized from out of Capital Expenditure,||If the business discontinues, no value will be realized out of deferred expenses.|
|Accounting Treatment : Capital Expenditure Mostly relates to acquisition of tangible asset and is shown under fixed asset in the Balance Sheet.||Deferred Revenue Expenditure is shown on the asset side of the Balance Sheet under Miscellaneous Expenditure, as it does not bring in tangible asset|
|Depreciation : Capital Expenditure is depreciated over the assets working life.||Deferred Revenue Expenditure is written off.|
Revenue Receipt refers to amount received in the course of normal business activities.
Examples: Sales, interest & dividend received, etc. Such receipts are of recurring nature and for general purpose. They are shown on the credit side of Profit & Loss A/c.
Capital Receipt vs Revenue Receipt
|Capital Receipts||Revenue Receipts|
|Profit Distribution : Capital Receipts can not be distributed as profit.||Revenue receipts may be distributed as profit after deducting revenue expenses.|
|Nature : Capital Receipts are of non-recurring nature.||Revenue Receipts are of recurring nature.|
|Reserve : Capital Receipts create Capital Reserve.||Revenue Receipts create Revenue Reserve.|
|Reserve Fund : Capital Receipts can not be used to create Reserve Fund.||Revenue Receipts can be used to create Reserve Fund after deducting revenue expenses.|
Capital Profit vs Revenue Profit
|Capital Profits||Revenue Profits|
|Nature : Capital Profit arises out of some casual or non-recurring transaction.||Revenue profits arise out of ordinary and normal business operations and are of recurring nature.|
|Profit Distribution : Capital profits are transferred to Capital Reserve and are shown in Balance Sheet (e.g. Profit on sale of fixed assets, premium on issue of debentures), and are not available for distribution as dividend.||Revenue profits are available for distribution as dividend.|
Instances of Capital Expenditures
Cost on acquiring Assets, expenses incurred on acquiring Assets, bringing & putting the asset into use is considered Capital Expenditure.
- Assets Acquired : Cost of Machine Purchased. Acquisition of machine means for use of machine in business and not for resale. It will increase earning capacity of business and hence treated as Capital Expenditure.
Expenses on Construction of factory premises . The benefit will extend over period and capacity of business and will also increase. So it is to be treated as Capital Expenditure.
- Expenditure on Acquiring Assets : Repairing and freight charges incurred on a Second Hand machine purchased, to bring into working condition. Such Repairing and freight charges would be treated as capital expenditure and will be added to the acquisition cost of the second hand machine. So, Repairing and freight charges would be treated as Capital Expenditure
Carriage spent on the machinery purchased and installed are to be added to cost of acquisition. So it is to be treated as Capital Expenditure
- Expenses related to Construction of Asset : Cost of temporary huts built for providing accommodation to labours for construction of Shopping mall. As it is a part of construction cost of new asset, the expenditure will be treated as Capital Expenditure, though the huts will be demolished after construction of the shopping mall.
Instances of Deferred Revenue Expenditure
Unusual Heavy loss incurred to be spread over several accounting period, or unusual heavy expenses of Revenue Nature, whose benefit is to be reaped for consecutive periods, is considered as Deferred Revenue Expenditure.
- Heavy advertisement expenditure to launch of new product: It is expenses of revenue nature (as no asset acquired). However, launch of a new product will reap benefit over a number of years. So such expenditure will be carried forward and written off in future accounting period. So it is to be treated as Deferred Revenue Expenditure.
- Expenses incurred on project which did not materialise : This is exceptional type of loss involving a large sum amount. Though it will not provide any future benefit, as the nature of expenditure is unusual, and the amount is heavy, the entire amount would not be charged to current year but will be spread over a period in future. So, it will be treated as Deferred Revenue Expenditure
Instances of Capital Income & Receipt
Receipt & Income of casual nature, which are not related to regular trade of the enterprise are Capital Income / Receipt
– Income from Sale of Fixed Asset : Old motor Car of Book Value 25000, sold at Rs 40,000. Profit on sale of Motor vehicle (fixed assets) is not a regular activity of business. Out of 40000 received, receipt of Rs 25000 is Capital Receipt and the profit (40,000 – 25,000)=15,000 is Capital Profit.
- Shares Issued at Premium : Proceeds received on issue of share of Shares of face value Rs 2,00,000, at premium of 60,000 The amount received on issue of shares (face value) is treated as Capital Receipt (Rs.2,00,000) and the Premium received (Rs 60000) is treated as Capital Profit, as the amount received are not from regular business operation.
- Loan taken : Loan taken is a liability to be repaid, and is not an Income. It is to be treated as Capital Receipt.
- Amount Received from Debtor : This is realization of an asset, and not Income. Hence it is to be treated as Capital Receipt.
- Amount brought into business by proprietor : For the business, it is liability to Proprietor. Hence it is treated as Capital Receipt.
Impact of wrong Accounting of Revenue & Capital Income / Expenses
Often mistake occurs in properly recording the transactions under Capital / Revenue heads. The concept of Capital & Revenue has been explained and illustrated with various examples. The impact of wrong recording is summarized below for convenience and ease of understanding
|Type of Accounting mistake||Impact|
|Capital Expense / Deferred Revenue expenses wrongly recorded as Revenue Expense (e.g Product launching promotional expenses are charged as advertising Expenses for the year)||Profit understated, Assets understated (Entire product promotional amount, instead of being taken as deferred revenue expenses, is charged as advertising expenses for the year. So, the revenue expenses for the year are overstated, resulting profit for the year understated. Further, the deferred revenue amount should have been shown as Asset in Balance Sheet. So, the assets in the balance sheet is understated.|
|Revenue Expense recorded as Capital / Deferred Revenue expenses (Research & Development expenses for a new product development incurred treated as Deferred Revenue Expenses, while there is no chance of the product launched)||Profit overstated, Assets overstated. (Product development expenses, which has no future value, should have been charged as expenses during the year, instead of being taken as deferred revenue expenses. So, the revenue expenses for the year have been understated stated, resulting profit for the year overstated. Further, the deferred revenue amount have been shown as Asset in Balance Sheet. So, the assets in the balance sheet is overstated|
|Capital Income wrongly recorded as Revenue Income (Sales of old machinery treated as sales)||Profit overstated, Liabilities understated / asset overstated (As the sales of old machinery (fixed Asset) is considered as Revenue, the current profit is overstated). The fixed asset is overstated|
|Revenue Income wrongly recorded as Capital Income||Profit understated, Liabilities overstated|
To see PDF file Click Here