Lesson 4

Accounting Process – III

(Capital and Revenue Items)

LESSON OUTLINE
LEARNING OBJECTIVES

– Capital Expenditure The main purpose of accounting is to ascertain

– Revenue Expenditure and present the true results of the business in

terms of profit or loss during a particular accounting
– Difference between Capital and Revenue
Expenditure period. The profit or loss of a business can be
ascertained by matching business revenues
– Deferred Revenue Expenditure
against the cost of the same period. Therefore, a
– Comparison between Capital and Deferred clear understanding between capital and revenue
Revenue Expenditure
(expenditures and receipts) is necessary for the
– Capital and Revenue Receipts correct ascertainment of profit or loss as revenue

– Difference between Capital and Revenue items are included only in income statement and
Receipts capital items form part of balance sheet figures.

– Capital and Revenue Profits The distinction between the capital and revenue
transactions is done by analysing the basic nature
– Capital and Revenue Losses
of transactions. The classification depends upon
– Review Questions the recurringness of the transaction and the

– Contingent Assets relation of the transaction to an accounting period.

– Contingent Liability In this lesson, we will study in detail about basic

concept of capital and revenue receipts and
– Lesson Round Up
expenditure. Herein, we would also touch in brief
– Glossary
about the concept of contingent assets and
– Self-Test Questions liabilities of business.

There is no business like show business, but there are several businesses like accounting.

David Letterman
82 FP-FA&A

CAPITAL EXPENDITURE
Capital expenditure is that expenditure which results in acquisition of an asset or which results in an increase
in the earning capacity of a business. The benefit of such expenditure lasts for a long period of time.
Examples: Purchases of land, buildings, machinery, furniture, patents, etc. All these assets stay in business
and are used again and again. Other examples are money paid for goodwill (like the right to use the
established name of an outgoing firm) since it will attract the old firm’s customers and thus will result in higher
sales and profits; money spent to reduce working expenses like conversion 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 reduction of day-to-day expenses is not capital
expenditure, unless there is a tangible asset to show for it.
All sums spent up to the point an asset is ready for use should also be treated as capital expenditure.
Examples are: fees paid to lawyer for drawing a purchase deed of land, overhauling expenses of second
hand machinery, cartage paid for bringing machinery to the factory from supplier’s premises and money spent
to install a machinery; and even interest on loans taken to acquire fixed assets only for the period before the
asset becomes operational.

REVENUE EXPENDITURE
Expenses whose benefit expires within the year of expenditure and which are incurred to maintain the earning
capacity of existing assets are termed as revenue expenditure. Amounts paid for wages, salary, carriage of
goods, repairs, rent and interest, etc., are items of revenue expenditure. Depreciation on fixed assets is also a
revenue expenditure. To the extent the materials are used up, they will be revenue expenditure. Similarly,
cost of goods sold is revenue expenditure. Costs incurred to acquire an asset are capital but costs incurred to
keep them in working condition or to defend their ownership are revenue. Fee paid to a lawyer for checking
whether all the papers are in order before land is purchased is capital expenditure. But if later a suit is filed
against the purchaser, the legal costs will be of revenue type.

DIFFERENCE BETWEEN CAPITAL AND REVENUE EXPENDITURE

The following are the points of distinction between capital expenditure and revenue expenditure:
(i) Capital expenditure is incurred in acquiring or improving permanent assets which are not meant for
resale. But revenue expenditure is a routine expenditure incurred in the normal course of business and
includes cost of sales as also the upkeep of fixed assets etc.
(ii) Capital expenditure seeks to improve the earning capacity of the business whereas revenue
expenditure is incurred to maintain the earning capacity of the business.
(iii) Capital expenditure is normally a non-recurring outlay but revenue expenditure is usually a recurring
item.
(iv) Capital expenditure produces benefits over several years. Hence, only a small part is charged as
depreciation to income statement and the rest appears in the balance sheet. But revenue expenditure
is consumed within an accounting year and the entire amount is charged to the (current year’s) income
statement. Hence, it does not appear in the balance sheet. Deferred revenue expenditure is however
an exception to this rule.

DEFERRED REVENUE EXPENDITURE

There are certain expenses which may be in the nature of revenue but their benefit may not be consumed in
the year in which such expenditure has been incurred; rather the benefit may extend over a number of years.
All such expenditures are basically in the nature of revenue expenditure, eg. heavy advertising expenditure
incurred in introducing a new line or developing a new market. Charges of these expenses are deferred
because such expenses benefit more than one accounting period. The matching principle demands this. The
basis of charge is usually proportionate to the benefit consumed/reaped.
 Lesson 4  Accounting Process-III 83
The practice which varies considerably is to write off the amount over the period of years in which the benefit
is expected to accrue say 3 to 5 years. If the expenditure can be ear-marked as being in respect of a specified
object, the expenditure should be written off during the life of that object. Example: Heavy advertising
expenses on a new product, accidental losses like loss arising from a fire or an earthquake; the loss may be
spread over a few years. The deferred revenue expenditure not yet written off is shown on the assets side of
the balance sheet.
Thus, deferred revenue expenditure is revenue in character but —
(i) the benefit of which is not exhausted in the same year, or
(ii) is applicable either wholly or in part of the future years, or
(iii) is accidental with heavy amount and it is not prudent to charge against the profit of one year.
The deferred revenue expenditure may be classified into the following three categories:
(i) Expenditure partly paid in advance, where a portion of the benefit has been derived within the
accounting period and the balance will be reaped in a number of future years. Therefore, the benefit to
be reaped in future is shown in the balance sheet as an asset e.g. special advertising expenditure for a
new product.
(ii) Expenditure in respect of service rendered which for any sound reason is considered as an asset or
more properly not considered to be allocable to the one accounting period e.g. cost of experiments,
discount on issue of debentures etc.
(iii) Amounts representing loss of an exceptional nature e.g. property confiscated in a foreign country, loss
on uninsured assets, etc.

COMPARISON BETWEEN CAPITAL AND DEFERRED REVENUE EXPENDITURE

The main feature of capital expenditure is that it results in a benefit which will accrue to the business enterprise
for a long time, say 10 or 15 years. Deferred revenue expenditure also results in a benefit which will accrue in
future period but generally for 3 to 5 years.
The capital expenditure or the resulting asset is usually capable of being reconverted into cash though may be
at a loss. This is not possible in the case of deferred revenue expenditure. At times, heavy loss such as loss
due to earthquake is treated as deferred revenue expenditure in the sense that they are written off over a
period of 3 to 5 years. Such a loss cannot be treated as a capital expenditure.

CAPITAL AND REVENUE RECEIPTS

Capital receipts comprise of payments or contributions into the business by the proprietor, partners or
shareholders towards the capital of the firm and also any sum received from debenture-holders, any loans
and the proceeds of sale of any fixed assets of a business enterprise.
Revenue receipts is the outcome of a firm’s activity in the accounting period, part of its rewards for offering
goods or services to the public e.g. sales, commission, fees received for services, interest on investment, etc.
Revenue receipts must be set off against the revenue expenses in order to calculate the profit or loss of the
business in an accounting period. Capital receipts and expenditure have no bearing on the profit or loss for the
accounting period. The distinction between capital receipts and revenue receipts can be drawn as follows:

DEFFERENCE BETWEEN CAPITAL RECEIPTS AND REVENUE RECEIPTS

Capital Receipts Revenue Receipts

(i) Amount realised by the sale of fixed assets or by (i) Amount realised by sale of goods or rendering
issue of shares or debentures is a capital receipt. services is always revenue receipt.

(ii) A receipt in substitution of a source of income is (ii) A receipt in substitution of an income is a

a capital receipt. revenue receipt.
84 FP-FA&A

(iii) Amount received for surrender of certain rights (iii) Amount received as compensation under an
under an agreement is a capital receipt, because agreement for the loss of future profits is a
a capital asset is being given up in the form of revenue receipt.
these rights.

(iv) Instead of lump sum payment if the payment is (iv) If an income is received in a lump sum it is a
received in installments, it is a capital receipt. revenue receipt.

(v) Amount realised from the sale of a capital asset (v) Amount realised from the sale of an asset kept
or investment is capital receipt. for sale is revenue receipt.

CAPITAL AND REVENUE PROFITS

While preparing the final accounts, distinction has to be made between capital profits and revenue profits.
Revenue profits are earned in the ordinary course of business. They appear in the profit and loss account and
are available for distribution as profit, or for creating reserves and funds, or for being used in the business.
However, capital profits are those which are earned as a result of selling some fixed assets, or in connection
with raising capital for the firm. For instance, a building purchased for ` 1,50,000 was subsequently sold for `
1,75,000, this ` 25,000 will be profit of capital nature. Similarly, when a company issues its shares of the face
value ` 100 for ` 105 each, it is said that shares have been issued at a premium, which is capital profit.
Capital profits are either capitalized i.e. transferred to capital account or transferred to capital reserve account
which may be utilized for meeting capital losses.

CAPITAL AND REVENUE LOSSES

Revenue losses are the losses which arise during the normal course of business whereas capital losses are
those which occur when selling fixed assets or raising share capital. If a building purchased for ` 50,000 is sold
for ` 45,000, there will be capital loss of ` 5,000. Similarly, when shares of the face value of ` 100 are issued at
` 95 i.e. at a discount of ` 5, the amount of discount will be a capital loss.
Treatment of capital losses is not different from that of capital profits. Just as capital profits are not shown in the
profit and loss account, similarly capital losses are not shown in the profit and loss account. They are shown in
the balance sheet on the assets side. As and when capital profits arise, capital losses are gradually written off
against them. If however, capital losses are huge, the common practice is to spread them over a number of
years and charge a part thereof to profit and loss account of each such year. But if they are negligible, they are
debited to profit and loss account of the year in which they occur.

REVIEW QUESTIONS
1. Expenses whose benefit expires within the year are _________.
2. _________ profits are earned in the ordinary course of business.
3. Payment into the business by proprietor is_________ receipt.
4. White washing charges of office building is an example of _______
expenditure.

Illustration 1:

State which of the following expenditures are capital, revenue, deferred revenue expenditures and capital loss:
(i) Cost of overhauling and painting a second hand truck newly purchased.
(ii) Cost of making more exits in a cinema hall under order of the Government.
(iii) ` 25,000 were spent on air conditioning the office of the General Manager.
(iv) An old machine which stood in the books at ` 15,000 was sold for ` 13,000.
 Lesson 4  Accounting Process-III 85
(v) ` 2,000 were paid as municipal tax in connection with a building which was purchased last year for `
2,00,000.
(vi) ` 30,000 were spent on heavy advertising in connection with the introduction of a new product.
(vii) ` 500 was paid out in connection with carriage on goods purchased.
(viii) A temporary room constructed for ` 25,000 for storing raw material for the construction of a big
building.
(ix) ` 50,000 was spent on putting up a gallery in a theatre hall.
(x) Freight and cartage amounting to ` 4,000 were paid on purchase of a new plant and a sum of ` 2,000
was spent as erection charges of that plant.

Solution:
(i) When a second hand machine is purchased, the entire expenditure incurred in the beginning to make
it fit for working is treated as capital expenditure. The value of the machine is increased by the amount
spent. Therefore, the cost of overhauling and painting the truck will be treated as capital expenditure.
(ii) Making more exits in a cinema hall does not increase the capacity of the hall and therefore, it should
be treated as revenue expenditure.
(iii) The sum of ` 25,000 spent on air conditioning the office of General Manager is capital expenditure
because it represents a fixed asset. Moreover, the effect of air conditioning will be available for several
years to come, and it can possibly be disposed of, if desired, at a future date, when it will fetch some
amount.
(iv) The old machine costing ` 15,000 was sold for ` 13,000 only, and the loss of ` 2,000 is clearly a
capital loss.
(v) ` 2,000 paid by way of municipal tax on a building purchased is an item of revenue nature. It is an
expenditure of routine nature, which was necessary for using the building.
(vi) Since the benefit of ` 30,000 spent on advertising will occur for several years, it is of capital nature. It
may be treated as a deferred revenue expenditure and be written off against the profit and loss
account of a number of years.
(vii) The expenditure of ` 500 incurred on carriage on goods purchased is of revenue nature because the
goods are meant for resale.
(viii) ` 25,000 spent on construction of temporary room should be treated as capital expenditure because it
was necessary for the construction of the main building. The cost of the room will be added to the cost
of the building.
(ix) When a new gallery is put up, it will increase the number of seats (capacity) of the hall. Therefore, this
cost of ` 50,000 should be treated as a capital expenditure.
(x) The expenditure incurred by way of freight and cartage amounting to ` 4,000 and the erection
charges of ` 2,000 are both of capital nature. The former has been incurred in connection with the
receipt of a capital asset while the latter has been incurred for erecting it so that it may be used for
business purposes.

Illustration 2:
State whether the following expenses are capital, revenue or deferred revenue expenditure:
(i) A Ltd. spent ` 2,00,000 for overhauling the machinery which improved the capacity utilization and
saved running expenditure by ` 15,000 p.a.
(ii) M/s Capital Properties, property dealers, purchased ten flats @` 7,00,000 each.
(iii) A firm incurred ` 10,000 to retain the title of a land purchased for business in litigation with third party.
(iv) Compensation paid to undesirable employees.
86 FP-FA&A
(v) M/s Durga & Co. spent ` 2,50,000 for organizing an Inter-school Cricket Tournament in Delhi. This
was held for advertising their new school bag and certain books and stationery which they wanted to
market.
(vi) ` 12,000 paid to Mahanagar Telephone Nigam Ltd. for installing a telephone in the office.
(vii) Damages paid on account of breach of contract to supply certain goods.
(viii) ` 25,000 has accrued during the year on term loan obtained and utilized for the construction of factory
building and purchase of machinery, however, the production did not commence till the last date of the
year.
(ix) Imported goods worth ` 1,75,000 confiscated by customs authorities for non-disclosure of material facts.
(x) ` 20,000 spent for the trial run of newly installed machinery.

Solution:
(i) Expenses for overhauling the machinery increased capacity utilization which contributes to increase
the revenue generating capacity. Also, saving in revenue expenditure for more than one accounting
period will accrue from this overhauling which will increase future profits. Hence, this expense is
capital in nature.
(ii) Purchase of flats in the ordinary course of business by property dealers is revenue expenditure as flats
are stock in trade for them.
(iii) Legal expenses incurred to retain the title of land are expenses for maintaining the asset. The
expenses will not generate any revenue in future directly. Hence, it is revenue in nature.
(iv) Compensation paid to retrench undesirable employees is expected to increase revenue earning
capacity of the business because such undesirable employees would either waste resources or time
with adverse effect on profit. The expenditure is capital in nature.
(v) The purpose of expenses incurred for organizing the Inter-School Cricket Tournament is to advertise
for some new products. This advertisement has some enduring effect so far as the marketability of the
new products is concerned. The expense may be treated as deferred revenue expenditure.
(vi) The money deposited with Mahanagar Telephone Nigam Ltd. for acquiring a telephone connection is
treated as an asset; hence it is a capital expenditure.
(vii) Damages paid on account of the breach of contract to supply certain goods are treated as revenue
expenditure incurred in the ordinary course of the business.
(viii) Interest accrued on term loan obtained and utilized for the construction of factory building and
purchase of machinery should be treated as capital expenditure since commercial production did not
start till the last date of the accounting year.
(ix) The confiscation of imported goods by the customs authorities is a loss arisen on account of
negligence and is of abnormal nature. It is appropriate to write it off to profit and loss account over a
period of 2 to 5 years treating it as a deferred revenue expenditure.
(x) Expenses incurred for trial-run of newly installed machinery is capital expenditure in nature.

CONTINGENT ASSETS AND CONTINGENT LIABILITY

(i) CONTINGENT ASSETS: “A contingent asset is a possible asset

that arises from past events the
The assets in which the possibility of an economic
benefit depends solely upon future events that can't be existence of which will be confirmed
controlled by the company are contingent assets. Due to the only by the occurrence or non-
uncertainty of the future events, these assets are not placed on occurrence of one or more uncertain
the balance sheet. However, they are presented in the future events not wholly within the
company's financial statement notes. These assets are often control of the enterprise.”
simply rights to a future potential claim based on past events.
 Lesson 4  Accounting Process-III 87
Contingent assets usually arise from unplanned or other unexpected events that give rise to the possibility of
an inflow of economic benefits to the enterprise.
Contingent assets are not recognized in financial statements since this may result in the recognition of income
that may never be realised. It is usually disclosed in the report of the approving authority where an inflow of
economic benefits is probable. However, when the realisation of income is virtually certain, then the related
asset is not a contingent asset and its recognition is appropriate.
Example: A potential settlement from a lawsuit or legal processes. The company does not have enough
certainty to place the settlement value on the balance sheet, so it can only mention about the potential in the
notes. This improves the accuracy of financial statements.

(ii) CONTINGENT LIABILITY

The possibility of an obligation to pay certain sums dependent

“A contingent liability is a possible
on future events is known as contingent liability. Contingent
liabilities are liabilities that may or may not be incurred by an obligation that arises from past events
entity depending on the outcome of a future event. and the existence of which will be
confirmed only by the occurrence or
They are defined obligations by a company that must be met,
but the probability of such payment is minimal. An enterprise non-occurrence of one or more
does not recognize a contingent liability. These liabilities are uncertain future events not wholly
recorded in a company's accounts and shown in the balance within the control of the enterprise. It is
sheet only when both probable and reasonably estimable. The a present obligation that arises from
nature and extent of the contingent liabilities is described in the past events but is not recognised
footnote to the balance sheet. because it is not probable that an
Some good examples of a contingent liability would be an outflow of resources embodying
outstanding lawsuit, bank guarantee etc. Suppose, if a company economic benefits will be required to
is sued by a former employee for `500,000 for age settle the obligation or a reliable
discrimination, the company will have a liability if it is found
estimate of the amount of the
guilty. However, if the company is not found guilty, the company
will not have an actual liability. Such a liability is known as a obligation cannot be determined”.
contingent liability.

LESSON ROUND UP
– All items of capital expenditure are taken in the balance sheet while all items of revenue nature are
taken in the profit and loss account.
– Deferred revenue expenditure is revenue in character but the benefit of it is not exhausted in the
same year, or is applicable either wholly or in part of the future years, or is accidental with heavy
amount and it is not prudent to charge against the profit of one year.
– Revenue receipts must be set off against the revenue expenses in order to calculate the profit or
loss of the business in an accounting period.
– Capital receipts and expenditure have no bearing on the profit or loss for the accounting period.
– Revenue profits appear in the profit and loss account and are available for distribution as profit, or
for creating reserves and funds, or for being used in the business.
– Capital profits are either capitalized i.e. transferred to capital account or transferred to capital
reserve account which may be utilized for meeting capital losses.
– Contingent assets are not recognized in financial statements since this may result in the recognition
of income that may never be realised.
– Contingent liabilities are recorded in a company's accounts and shown in the balance sheet only
when both probable and reasonably estimable.
88 FP-FA&A
GLOSSARY
Capital Expenditure Expenditure incurred in acquiring or improving an asset which is not meant for sale.
Revenue Expenditure of a routine nature and incurred to maintain an asset.
Expenditure
Deferred Revenue Heavy expenditure of revenue nature
Expenditure
Capital Receipts Payments or contributions into the business by the sole proprietor, partners or other
shareholders towards the capital of the firm.
Revenue Receipts Outcome of a firm’s activity as rewards for offering goods or services to the public.
Revenue Profits Earned in the ordinary course of business.
Capital Profits Earned as a result of selling some fixed assets or raising capital for the firm.
Revenue Losses They arise during the normal course of business
Capital Losses They occur on selling the fixed assets or in raising of share capital.
Contingent Assets They are rights to a future potential claim based on past events.
Contingent These are defined obligations by a company that must be met, but the probability of
Liabilities such payment is minimal.

SELF-TEST QUESTIONS

1. State the considerations which would guide you in deciding whether any particular expense should
be regarded as capital expenditure or revenue expenditure.
2. Explain deferred revenue expenditure with examples.
3. What are contingent assets and contingent liabilities? Give examples.
4. Distinguish between capital receipts and revenue receipts.
5. Differentiate between capital expenditure and deferred revenue expenditure.
6. State in each of the following cases whether the expenditure is (a) capital expenditure, (b) revenue
expenditure, or (c) deferred revenue expenditure.
–Repairs to furniture.
–Legal expenses incurred to defend a suit for breach of contract to supply goods.
–Custom duty paid on imported machinery.
–Heavy expenditure incurred on advertising a new product.
– Carriage paid on goods purchased.
–Amount spent to overhaul a motor truck purchased second-hand.
–Wages paid to workers for setting up new machinery.
–Preliminary expenses incurred in setting up a joint stock company.
–Wages paid to workers for converting raw material into finished goods.
–Office rent paid in advance for three years.
Lesson 4  Accounting Process-III 89
90 FP-FA&A