What leads to an increase in capital in the course of business operations is income; what leads to a reduction in capital is expense or loss. But transactions also cover the acquisition of assets, like the purchase of an office building, raising a loan, payment of liabilities, etc.; all transactions are not expenses or incomes. To know the net profit earned or loss suffered, the expenses, losses, and incomes must be assembled in the Profit and Loss Account; the transactions concerning assets and liabilities will affect items in the Balance Sheet which portrays the financial position. So, what has discussed this article: Understand Capital and Revenue Expenditure in Accounting.
The Concept of Capital and Revenue Expenditure, in the Accounting, explains why they exist in Financial Management.
The following expenditures below are;
What is Capital Expenditure? Capital expenditures (CAPEX) refer to funds that are used by a company for the purchase, improvement, or maintenance of long-term assets to improve the efficiency or capacity of the company. Capital expenditure can be tangible, such as a copy machine, or it can be intangible, such as a patent. In many tax codes, both tangible and intangible capital expenditures are counted as assets because they have the potential to be sold if necessary.
What is Revenue Expenditure? A revenue expenditure (REVEX) is a cost that is charged to expense as soon as the cost is incurred. By doing so, business is using the matching principle to link the expense incurred to revenues generated in the same reporting period. The amount incurred on maintaining the earning capacity of the business, The benefit of which is direct and would be in the same accounting year itself in which such expenditure has been incurred is termed as revenue expenditure.
The Concept of Capital and Revenue Expenditure:
Expenses, losses, and incomes are also known as revenue items since they together will show up the net profit or revenue earned. Other transactions are of capital nature. One must be clear in one’s mind regarding the nature of an item of expenditure. This is an important aspect of the matching principle and without it; financial statements cannot be properly prepared.
Capital expenditure is that expenditure which results in the acquisition of an asset, tangible or intangible, which can be later sold and converted into cash or which results in an increase in the earning capacity of a business or which affords some other advantage to the firm.
In a nutshell, if the benefits of expenditure are expected to accrue for a long time, the expenditure is capital expenditure. Obvious examples of capital expenditure are land, building, machinery, patents, etc. All these things stay with the business and can be used over and over again.
Other examples are money paid for goodwill (the right to use the established name of an outgoing firm) since it will attract the old firm’s customers and, thus, result in higher sales and profits; money spent to reduce working expenses.
For example, conve$ion of hand-driven machinery to power-driven machinery and expenditure enabling a firm to produce a large quantity of goods. Expenditure which does not result in an increase in capacity or in the reduction of day-to-day expenses is not the capital expenditure unless there is a tangible asset to show for it.
It should be noted that all amounts spent up to the point an asset is ready for use should be treated as capital expenditure. Examples are fees paid to a lawyer for drawing up the purchase deed of land, overhaul expenses of second-hand machinery, etc. Interest on loans raised to acquire a fixed asset is particularly noteworthy.
Such interest can be capitalized, i.e., added to the cost of the asset but only for the period before the asset is ready for use interest paid for the subsequent period cannot be capitalized. An item of expenditure whose benefit expires within the year or expenditure which merely seeks to maintain the business or keep assets in good working condition is revenue expenditure
Examples are salaries and wages, fuel used to drive machinery, electricity used to light the factory or offices, etc. Such expenditure does not increase the efficiency of the firm, nor does it result in the acquisition of something permanent.
The following items of expenditure seem to be revenue expenditure, but in actual practice, these are treated as capital expenditure since they lead to the business being established and run efficiently:
- Expenses for the formation of a company—preliminary expenses.
- Cost of issuing shares and debentures and raising loans, such as legal expenses underwriting commission, etc.
- Interest on capital up to the point production is ready to commence, where the nature of the business is such that construction work must go on for a long period before production can start.
- Expenses on acquisition and installation of assets, for example, legal fees to acquire property, or expenses incurred to renovate machinery bought secondhand or wages of workmen who install the machinery.
Diminution in the value of assets due to wear and tear or passage of time is the revenue loss. For instance, a piece of machinery is bought at the beginning of the year for $ 1, 00,000; at the end of the year, its value to the business may only be $ 90,000. The diminution—known as depreciation—is a revenue loss. Stocks of materials bought will be an asset unless consumed—to the extent, the materials are used up, they will be revenue expenditure, so also the cost of goods sold.
However, the distinction is not always easy. In actual practice, there is a good deal of difference of opinion as to whether a particular item is capital or revenue expenditure. A cinema converts its ordinary screen into one for cinemascope. Is the expenditure-revenue or capital?
One may say that since the eating capacity of the hall does not change, the expenditure is revenue expenditure. On the other hand, it may be argued that since cinemascope pictures attract large audiences, the hall will be full oftener. Therefore, the expenditure will result in higher earnings and should be classified as capital expenditure. There is truth on both sides.