Unit 3: Capital and Revenue Expenditures and Receipts Chapter Notes | Accounting for CA Foundation PDF Download

Introduction

Accounting seeks to determine and present the business results for a specific accounting period. To ascertain the periodic business outcomes, it is essential to analyze the nature of transactions to identify whether they are capital or revenue in nature. Revenue expenses are linked to the operations of the business within an accounting period or to the revenue earned during that period; they pertain to expenditures whose benefits do not extend beyond that timeframe. In contrast, capital expenditures provide lasting benefits and contribute to revenue generation across multiple accounting periods. Revenue expenses must relate to a physical activity of the entity. Thus, while production and sales generate revenue during the earning process, the use of goods and services to support these functions leads to the occurrence of expenses. 

Expenses are recognized in the Profit & Loss Account through the matching principle, which indicates when and how much of the expenses should be charged against revenue. Expenditures can be capitalized only if they can be directly linked to identifiable streams of future benefits. The classification of transactions into revenue and capital is intended for their placement in the Profit and Loss account or the Balance Sheet. For instance, revenue expenditures are recorded in the profit and loss account since their benefits are confined to one accounting period, i.e., the period in which they are incurred. In contrast, capital expenditures are listed on the asset side of the balance sheet because they provide benefits over multiple accounting periods and will be transferred to the profit and loss account based on the utilization of that benefit in a specific accounting year. Thus, both capital and revenue expenditures eventually affect the profit and loss account. Revenue expenditures are recorded in the profit and loss account in the year they are spent, while capital expenditures are reflected in the profit and loss account of the year their benefits are utilized. Therefore, it can be concluded that the timing is the key factor determining when expenditures are transferred to the profit and loss account. Additionally, expenses are recognized in the profit and loss account through the matching concept, which specifies when and how much of the expenses should be charged against revenue. However, differentiating between capital and revenue can be quite challenging, as the boundary between the two is often very subtle.

Considerations in Determining Capital and Revenue Expenditures

The basic considerations in distinguishing between capital and revenue expenditures are:

• Nature of business: For a trader dealing in furniture, the purchase of furniture is considered a revenue expenditure, whereas for other trades, it should be classified as capital expenditure and recorded as an asset on the balance sheet. Thus, the nature of the business is a crucial factor in differentiating between capital and revenue expenditures.
• Recurring nature of expenditure: Expenses that occur frequently within an accounting year are categorized as revenue expenditures, while infrequent, nonrecurring expenses are considered capital expenditures. For example, monthly salaries or rent are revenue expenditures due to their regular occurrence, while asset purchases are not done regularly and are classified as capital expenditures unless the materiality criteria indicate otherwise.
• Purpose of expenses: Expenses related to routine maintenance, such as repairs of machinery, are classified as revenue in nature. Conversely, expenditures aimed at significant repairs that enhance the asset's productive capacity are capital in nature. However, determining which maintenance costs should be expensed versus those that should be capitalized can be complex.
• Effect on revenue generating capacity of business: Expenses that contribute to income generation in the current period are considered revenue expenditures and should be matched against current period revenue. In contrast, expenditures that generate revenue over multiple accounting periods are typically classified as capital expenditures. For improvements and repairs to fixed assets, if the expected future benefits remain unchanged, these should be charged to the Profit and Loss Account; however, if the benefits increase, they should be included in the asset's book value.
• Materiality of the amount involved: The relative size of the expenditure is another key consideration in distinguishing between revenue and capital expenditures.

Capital Expenditures and Revenue Expenditures

Capital expenditure enhances a business's revenue-generating ability over multiple accounting periods, while revenue expenses are incurred to produce revenue within a specific accounting period. Revenue expenses may either directly relate to revenue or pertain to accounting periods, such as the cost of goods sold, salaries, and rent. For instance, the cost of goods sold is directly tied to sales revenue, while rent corresponds to a particular accounting period. Capital expenditure typically involves the acquisition of tangible or intangible fixed assets that provide long-term benefits. Consequently, the advantages of capital expenditure extend beyond a single accounting period, whereas the benefits of revenue expenses are confined to the same accounting period.

Key differences between Capital and Revenue Expenditures

Illustration 1: State with reasons whether the following statements are ‘True’ or ‘False’. 

1. Overhaul expenses of second-hand machinery purchased are Revenue Expenditure. 
2. Money spent to reduce working expenses is Revenue Expenditure. 
3. Legal fees to acquire property is 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. 
5. Amount spent for replacement of worn out part of machine is Capital Expenditure. 
6. Expense incurred on the repairs and white washing for the first time on purchase of an old building are Revenue Expenses. 
7. Expenses in connection with obtaining a license for running the cinema is Capital Expenditure. 
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.

Sol:

1. 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. 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. 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. False: Legal expenses incurred to defend a suit claiming that the firm’s factory site belongs to the plaintiff is maintenance expenditure of the asset. By this expense, neither any endurable benefit can be obtained in future in addition to that what is presently available nor the capacity of the asset will be increased. Maintenance expenditure in relation to an asset is revenue expenditure. 
5. 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. 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. True: The Cinema Hall could not be started without license. Expenditure incurred to obtain the license is pre-operative expense which is capitalised. Such expenses are amortised over a period of time. 
8. 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:

1. Expenses incurred in connection with obtaining a license for starting the factory for ₹ 10,000.
2. ₹ 1,000 paid for removal of Inventory to a new site.
3. Rings and Pistons of an engine were changed at a cost of ₹ 5,000 to get fuel efficiency.
4. Money paid to Mahanagar Telephone Nigam Ltd. (MTNL) ₹ 8,000 for installing telephone in the office.
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.

Sol:

1. Money paid ₹ 10,000 for obtaining license to start a factory is a 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 is revenue expenditure. This is neither bringing enduring benefit nor enhancing the value of the asset.
3. ₹ 5,000 spent in changing Rings and Pistons of an engine to get fuel efficiency is 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 deposited with MTNL for installation of telephone in office is not expenditure. This is treated as an asset and the same is adjusted over a period of time against actual telephone bills. 
5. Cost of construction of building including cost of temporary huts is capital expenditure. Building is fixed asset which will generate enduring benefit to the business over more than one accounting period. 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? 
Sol: 
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 x 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.

Capital Receipts And Revenue Receipts

Just as it is important to differentiate between Capital and Revenue expenditure, it is equally crucial to distinguish capital receipts from revenue receipts. Revenue receipts are those obtained through regular business operations (e.g., income from the sale of goods or services, interest income, etc.). Conversely, capital receipts are not considered revenue in nature (e.g., proceeds from the sale of fixed assets or investments, secured or unsecured loans, owner contributions, etc.). Both revenue and capital receipts are recognized on an accrual basis once the entitlement to receive is established. Revenue receipts should not be confused with actual cash receipts. Revenue receipts are recorded in 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 as follows:

Illustration 4: State with reasons whether the below items relating to the business of AB td are capital or revenue receipts? 
(a) A machine with a book value of ₹ 10 lakh is sold for ₹ 12 lakh. 
(b) Premium amounting to ₹ 1 Lakh received on issue of shares 
(c) An amount of ₹ 20,000 received from goods sold in cash. 
(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. 
Sol:
(a) The amount of ₹ 12 lac is a capital receipt. There is a profit on sale of the machine to the extent of ₹ 2 lac (12 – 10)
(b) Premium received on issue of shares is an example of capital receipt.
(c) Amount received from cash sale is a revenue receipt.
(d) Amount received on the maturity of fixed deposit is the recovery of the deposit amount, and is a capital receipt. Interest income is an example of revenue receipt. 

Illustration 5: Good Pictures Ltd., constructs a cinema house and incurs the following expenditure during the first year ending 31st March, 2022.

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. 
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. 
3. Fire insurance, ₹ 1,000 was paid on 1st October, 2021 for one 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. Point out how you would classify the above items. 

Sol:

1. The total cost of the furniture should be treated as ₹ 10,200 i.e., all the amounts mentioned should be capitalised since without such expenditure the furniture would not be available for use. If ₹ 1,000 and ₹ 200 have been respectively debited to the Repairs Account and the Wages Account, these accounts will be credited to the Furniture Account. 
2. License for running the cinema house is necessary, hence its cost should be capitalised. But the fine of ₹ 1,000 is revenue expenditure. The renewal fee for the next year is also revenue expenditure but pertains to the next year; hence, it is a prepaid expense. 
3. 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. 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: 

1. Overhauling expenses of ₹ 25,000 for the engine of a motor car to get better fuel efficiency. 
2. Inauguration expenses of ₹ 25 lacs incurred on the opening of a new manufacturing unit in an existing business. 
3. Compensation of ₹ 2.5 crores paid to workers, who opted for voluntary retirement. 

Sol: 

1. Overhauling expenses are incurred for the engine of a motor car to derive better fuel efficiency. These expenses will reduce the running cost in future and thus the benefit is in form of endurable long-term advantage. So this expenditure should be capitalised. 
2. Inauguration expenses incurred on the opening of a new unit may help to explore more customers This expenditure is in the nature of revenue expenditure, as the expenditure may not generate any enduring benefit to the business over more than one accounting period. 
3. The amount paid to workers on voluntary retirement is in the nature of 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: 
(i) ₹ 10,000 spent as travelling expenses of the directors on trips abroad for purchase of capital assets. 
(ii) Amount received from Trade receivables during the year. 
(iii) Amount spent on demolition of building to construct a bigger building on the same site. 
(iv) Insurance claim received on account of a machinery damaged by fire. 
Sol: 
(i) Capital expenditure.
(ii) Revenue receipt.
(iii) Capital expenditure.
(iv) Capital receipt. 

Illustration 8: Are the following expenditures capital in nature?
(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.
(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.
(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. The year ending is 31st Dec, 2022. 

Sol:
(i) Renovation of cabins increased the number of cabins. This has an effect on the future revenue generating capability of the business. Thus, the renovation expense is capital expenditure in nature.
(ii) Expense incurred to recover installments due from customer do not increase the revenue generating capability in future. It is a normal recurring expense of the business. Thus, the legal expenses incurred in this case is revenue expenditure in nature.
(iii) Expenses incurred on account of transportation of fixed asset is capital expenditure in nature.

Summary

• Revenue expenditures are recorded in the profit and loss account, while capital expenditures appear on the asset side of the balance sheet as they provide benefits over multiple accounting periods.
• Prepaid expenses refer to future expenses that have been settled in advance and are listed as assets on the balance sheet.
• Receipts received should be categorized into revenue receipts and capital receipts.