BCom 3rd Year Capital and Revenue Notes Study Material

BCom 3rd Year Capital and Revenue Notes Study Material

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BCom 3rd Year Capital and Revenue Notes Study Material
BCom 3rd Year Capital and Revenue Notes Study Material

BCom 3rd Year Capital and Revenue Notes Study Material

Business transactions may be put into two categories, viz., capital and revenue, a brief description of which will not be out of place here. It is very essential to know exactly the nature of a transaction so that it may be recorded accordingly in the financial books.

If the correct allocation is not made between capital and revenue, the Profit & Loss Account will reveal a misleading figure of profits or losses and the Balance Sheet will not exhibit a true and fair picture of the financial affairs of a business. A variety of errors may arise in the books of accounts if transactions are distinguished as capital and revenue carelessly.

After all, the auditors have to report:

“In our opinion and to the best of our information and according to the explanations given to us, the annual accounts give the information required by the Companies Act, 2013, in the manner so required, and give a true and fair view:

(i) in the case of the Balance Sheet, of the state of affairs of the company as at the close of the year, and

(ii) in the case of the Profit and Loss Account, of the profit (or loss) for the year ended on that date.”

For this purpose, a clear-cut distinction has to be made between capital and revenue.

But what are capital and revenue items? It is very difficult to discriminate between the two types and there are no hard and fast rules in this connection. It is just possible to distinguish items as capital and revenue as a matter of principle, but in practice, it is rather difficult to fully abide by the principles. Whether a particular item of profit or loss would be treated as capital or revenue depends upon the nature of the source from which it has been derived. (BCom 3rd Year Capital and Revenue Notes Study Material)

Classification

All capital and revenue items may be put into different categories as stated below:

(1) Capital Income and Revenue Income.

(2) Capital Expenditure and Revenue Expenditure.

(3) Capital Receipt and Revenue Receipt.

(4) Capital Payment and Revenue Payment.

(5) Capital Profit and Revenue Profit.

(6) Capital Loss and Revenue Loss.

With this classification, we may now proceed to examine the various principles which govern the distinction between capital and revenue. In brief, it may be laid down that all expenditure which is incurred in the acquisition of assets of permanent nature which are meant for continual use in business for the purpose of earning revenue is capital expenditure.

Besides this, if some amount is so expended from time to time to extend or improve existing assets that results in increasing the revenue-earning capacity. It may also be treated as capital expenditure. (BCom 3rd Year Capital and Revenue Notes Study Material)

All expenditure incurred in the conduct and administration of the business is revenue expenditure. Besides this, all expenses incurred in connection with repairs, renewals, and replacements are kept in this category. Such expenses do not in any way increase the earning capacity but maintain the asset in its original position and in working order.

Whether an expenditure should be charged to revenue or to capital depends mainly upon the following factors:

(1) The nature of business and also the nature of the transaction in relation to the business;

(2) Whether such expenditure has resulted in increasing earning capacity or efficiency; and

(3) Financial Policy and exigencies, if there are doubts.

Items Chargeable to Capital

  1. Cost of land, buildings, plant and machinery, motor-lorries, tools, lease acquired. furniture & fixtures, goodwill, trademarks, patents and copyright, patterns and designs, or cost of any other asset acquired by way of equipment.
  2. Expenses on the erection of plant and machinery.
  3. Actual additions and extensions to existing assets.
  4. Structural improvements resulting in enhancing the revenue-earning capacity.
  5. Administrative expenses incurred during the period of construction and equipment.

Items Chargeable to Revenue

  1. All expenses incurred in connection with the conduct and administration of the business, e.g., salaries, wages, rents and taxes, printing, stationery and advertising, travel expenses, etc.
  2. Expenses incurred for repairs, renewals, and replacement for the purpose of maintaining the existing fixed assets in proper working order.
  3. Cost of goods meant for resale, e.g., raw materials, stores, etc.
  4. All other expenses incurred in the manufacturing and distribution of the products, e.g., advertising expenses, commission paid to agents, etc.
  5. Maintenance Expenses.
  6. Loss arising from the sale of fixed assets or from wear and tear and obsolescence of assets utilized in business.

How to Allocate?

This is a big question but is quite significant. There are a variety of expenses that, by nature, seem to be revenue but are treated as capital. These all depend upon the particular circumstances and purposes for which they are actually incurred. For example, legal expenses, carriage, stamp duty, brokerage, wages, repair, etc., are rightly the items of revenue expenditure. But when they are incurred in connection with the acquisition and development of fixed assets, they are treated as capital expenditure.

The factor to be considered is that if an expenditure relates to some improvements in the earning capacity of an asset, it is a capital item but if it is incurred simply to maintain it in efficient working order, it is a revenue expenditure. Ordinary repairs are treated as of a revenue nature, but if an old property has been acquired in a dilapidated state and expenditure is incurred to bring it into a tenantable condition, it will form part of the cost and will be capitalized as such. (BCom 3rd Year Capital and Revenue Notes Study Material)

Similarly, changes made in the furniture held by a cinema-house for making improvements so as to attract more customers will be a capital expenditure as it will help in enhancing the revenue of the cinema-house. (BCom Capital and Revenue Notes Study Material)

Sometimes, there are expenses that can neither be treated as capital nor as revenue. For example, if a building is reconstructed after dismantling it, its book value plus expenditure incurred in its dismantling, less its residual value will be a revenue loss. The cost of new construction will be a capital expenditure. Thus, it can be put like this:

(i) the entire cost of new construction is capitalized, and

(ii) the book value of the asset + the cost of dismantling proceeds from the sale of old materials and also the value of the old material utilized in new construction is charged to revenue.

A Few Rules

  1. The entire capital expenditure is represented by an asset or some improvements in it so as to enhance its profit-earning capacity. Revenue expenditure is incurred simply to maintain it.
  2. An expenditure not representing an asset should not be capitalized permanently.
  3. 3. Only the actual cost of additions or extensions should be capitalized.
  4. An abnormal loss arising from obsolescence should not be charged to revenue in the year in which it has taken place but should be spread over a reasonable number of years. (BCom 3rd Year Capital and Revenue Notes Study Material)
  5. Heavy revenue expenditure may be capitalized temporarily and be carried forward in the Balance Sheet. Thus, a firm may prepare its advertising campaign for new season goods in advance of the accounting year and the cost thereof may be carried forward. It is treated as Deferred Revenue Expenditure. (BCom 3rd Year Capital and Revenue Notes Study Material)

Other Items

So far as other items classified as capital receipts and payments, revenue receipts and payments, etc., are concerned, it is quite simple to distinguish. The receipt of capital from the owner of a business is a capital receipt and the income from the sale of goods will be a revenue receipt. Premium received on the issue of shares and debentures is a capital profit while profit earned from the sale of products is a revenue profit. These are the various examples found in daily business and need no further elaboration.

Capital or revenue payment is always made in connection with an expenditure of capital or revenue nature respectively. If, for example, furniture is acquired for Rs.5,000 and payment made is Rs.2,000; Rs.5,000 is a capital expenditure and Rs.2,000 is a capital payment. Similarly, revenue items can be illustrated with similar examples. (BCom 3rd Year Capital and Revenue Notes Study Material)

Auditor’s Duty

(1) The auditor should fully acquaint himself with the nature and working of the business so that he can check easily the allocations of items treated as Revenue and Capital, e.g., the Purchase of Machinery for a manufacturer is a capital expenditure but for a dealer in purchase and sale of machinery, its purchase is not capital expenditure but a revenue one.

Similarly, furniture is a floating asset and its purchase is a revenue item for a dealer in furniture while it is a capital expenditure for manufacturers or industrial concerns. (BCom 3rd Year Capital and Revenue Notes Study Material)

(2) He should also know the circumstances in which an item of expenditure has been classified as Revenue or Capital, e.g., legal charges paid for acquiring some property of a permanent nature or for preparation of legal documents such as Memorandum of Association and Articles of Association or some Deed is a capital expenditure while legal charges paid in the ordinary course of business is a revenue expenditure.

(3) He should see that Principles of Accountancy have been fully observed in making this distinction, e.g., all the expenses directly attributable to the construction of an asset such as cost of materials and stores issued for construction of a building, wages paid m this connection, etc., should be capitalized. (BCom 3rd Year Capital and Revenue Notes Study Material)

Similarly, in the case of the purchase of an asset, the purchase price, transportation costs, and expenditure incurred on its installation should be capitalized. (BCom 3rd Year Capital and Revenue Notes Study Material)

(4) If there are some controversial items, he should enquire about them from responsible officers of the business and take decisions very carefully.

To sum up, it can be submitted that this part of an auditor’s duty is very significant as only on this very basis, he has to certify the accounts as correct and report that the Profit and Loss Account and the Balance Sheet exhibit a true and fair view of the state of financial affairs of the business in hand. The correct allocation of expenditure as capital and revenue is most vital from both accountancy and auditing point of view. (BCom 3rd Year Capital and Revenue Notes Study Material)

Deferred Revenue Expenditure

This is a clear example of revenue expenditure. But if a heavy expenditure is incurred, it should be extended beyond the year in which it has taken place. Hence, as a matter of practice, it is quite legitimate to capitalize on it temporarily and should be spread over the number of years for which the benefits are to be enjoyed by the business. The treatment is quite justifiable as the full benefits of expenditure have not yet expired. (BCom 3rd Year Capital and Revenue Notes Study Material)

The heavy expenditure incurred by a firm in connection with the advertising campaign of new products is another example of Deferred Revenue Expenditure, le., an amount of Rs.5 crore incurred in connection with the advertising campaign may well be spread over, say, 10 years and thus, Rs.50 lakh may be charged to the Profit & Loss Account. Thus, a Deferred Revenue Expenditure involves some considerable exceptional expenditure and should be treated as such. (BCom 3rd Year Capital and Revenue Notes Study Material)

Examples

  1. Preliminary expenses, brokerage on shares.
  2. Cost of issue of Debentures or discount on issue of Debentures.
  3. Cost of removal of business to a more convenient place.
  4. Cost of removal of works and incidental expenses are incurred in connection with the dismantling, removal, and re-erection of plant and machinery. (BCom 3rd Year Capital and Revenue Notes Study Material)
  5. Exceptional repairs to any particular asset.

The auditor should call for the detailed computation of the amount carried forward and see that the charge made to the Revenue Account is quite reasonable. A proper distinction has to be made between normal and exceptional expenditure and also between normal trading and incremental trading resulting from exceptional expenditure. He should examine the bases on which the estimates have been made and ensure that they are reasonable. (BCom 3rd Year Capital and Revenue Notes Study Material)

Exceptional losses have to be spread over a number of years. They have to be distinguished from Deferred Revenue Expenditure and treated accordingly. (BCom 3rd Year Capital and Revenue Notes Study Material)

The auditor cannot have any objection to the treatment of expenditure as Deferred Revenue Expenditure as it will all depend upon the nature and circumstances of a particular business. (BCom 3rd Year Capital and Revenue Notes Study Material)

BCom 3rd Year Capital and Revenue Notes Study Material

BCom 3rd Year Capital and Revenue Notes Study Material

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