Lesson-7

Basic Principles of Preparing Final Account (Capital and Revenue)

Learning Objectives

To understand the meaning of capital expenditure

To understand the meaning of revenue expenditure

Capital Expenditure
1. Capital expenditure is that expenditure the benefits of which are not fully consumed
in a year but spread over several years.
2. It is the expenditure which results in the purchase or acquisition of asset or property.
3. It is the expenditure incurred in connection with the purchase of asset.
4. It is the expenditure incurred to bring an old asset into working condition.
5. It is the expenditure incurred for extending or improving an existing asset to increase
its productivity or to increase the earning capacity of business or to decrease working
expenditure.
It can be said that the capital expenditure benefits not only in the current accounting year
but also many years in the future. The expenditure is generally non-recurring and the
amount spent is normally large. However, it should be noted that not every big
expenditure is capital expenditure. Capital expenditures are shown in balance sheet.
Revenue Expenditure
1. Revenue expenditure is the expenditure which benefits in the current accounting
year. It is not carried forward to the next year or years.
2. It is the expenditure which is incurred in the normal course of business to run the
business and to maintain the fixed assets of business.
3. It is the expenditure which is incurred on purchase of goods meant for resale or to
purchase materials which will be used to convert them into final product.
Therefore, revenue expenditure is a recurring expenditure made to maintain the business.
The amount spent is generally small and the benefit is for a short period which is not
more than a year. All revenue expenditure are charged to trading and profit and loss
account.
Deferred Revenue Expenditure
Deferred revenue expenditure is the expenditure which is originally revenue in nature but
the amount spent is so large that the benefit is received for not a year but for many years.
A proportionate amount is charged to profit and loss account of each year and balance is
carried forward to subsequent years as deferred revenue expenditure. It is shown as an
asset in the balance sheet, e.g., heavy expenditure incurred on advertisements.
Capital Receipts

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Capital receipts are the receipts which are not received in the ordinary course of
business. These are non-recurring receipts. Money obtained from the sale of fixed assets
or investments, issue of shares or debentures, loans taken are some of the examples of
capital receipts. Capital receipts are shown as liability reduced from assets appearing in
the balance sheet.
Revenue Receipts
Revenue receipts are receipts obtained in the normal course of business. It is a receipt
against supply of goods or services. The money obtained from sales, interest, dividend,
transfer fees etc. are examples of revenue receipts. Revenue receipts are credited to profit
and loss account.
Capital Profit
Those profits which are not earned during the regular course of business and which are
not earned on account of the day-to-day trading activities of the business are capital
profits. For example, profit on sale of asset and premium received on issue of shares.
These types of profits are normally not taken to profit and loss account but are shown in
the liabilities side of the balance sheet.
Capital Losses
The losses which are not suffered during the regular course of business are called capital
losses. For example, discount on issue of shares.
Problem 1
1. An old machinery is purchased for Rs. 1,00,000 and Rs. 25,000 has been spent to
bring it in working condition.
Answer-- Both the above expenses are capital expenditures as Rs. 1,00,000 has been
spent to acquire the asset and Rs. 25,000 has been spent to make the machinery
productive. The machinery will now be used for many years and its cost is Rs.
1,25,000.
2. A building is purchased for Rs. 10,00,000 and Rs. 1,00,000 has been spent as
expenses like brokerage, stamp duty, registration charges and on other legal
expenses.
Answer-- Both the above expenditures are capital expenditures as Rs. 10,00,000 has
been spent for the purchase of asset and Rs. 1,00,000 for all the incidental expenses
for buying the asset. The cost of the building is now Rs. 11,00,000.
3. Repairs to building
Answer-- It is revenue expenditure because it is incurred for maintaining the
building. Both the reason for repairs and the amount are not important.
4. Amount spent for the replacement of defective and worn out parts of an old plant
Answer-- It is revenue expenditure as it is incurred to keep the plant in normal
working condition. No new asset comes into existence.

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5. Heavy expenditure incurred on advertisements.

Answer-- Normally, advertisement is revenue expenditure. But, as heavy expenditure
is incurred, it will be treated as deferred revenue expenditure. The benefits of it will
be received for many years. Proportionate amount will be written off every year by
debiting profit and loss account and the remaining amount will be shown in the
balance sheet on the asset side.
Problem 2
1. A machinery costing Rs. 5,00,000 is imported on which freight and insurance of Rs.
7,000, custom duty of Rs. 13,000, clearing charges of Rs. 5,000 and installation
charges of Rs. 10,000 were incurred.
Answer-- Rs. 5,00,000 spent on the purchase of asset and Rs. 35,000 spent on other
incidental expenses should be considered as capital expenditure until the machinery
comes in working condition. The cost of machinery will be Rs. 5,35,000.
2. New equipment for existing machinery were bought for Rs. 30,000 to increase the
production by 25%
Answer-- The above expenditure is capital expenditure as it increases the production
capacity and thereby increases the earning capacity of the business. It is a nonrecurring expense and should be added to the value of asset.
3. Taxes paid
Answer-- It is revenue expenditure as it is a regular expense of the business. It is a
recurring expense. The benefit is only for one year.
4. Expenditure for repainting the factory shed
Answer-- As repainting is a normal expenditure made for maintenance of the factory,
it is revenue expenditure. It is a recurring expense and no new asset comes into
existence.
5. Traveling expenses of directors for a trip abroad for purchasing imported machinery
Answer-- As the traveling expenses is incidental expenditure to purchase machinery,
it should be treated as capital expenditure and should be added to the cost of
machinery. In this case, if directors purchase the machinery, it would be deferred
revenue expenditure and would be written off over a reasonable period of say 3 to 5
years.
Problem 3
Following is the summarized trading account of Kinnar Co. Ltd., an iron manufacturing
company, for the year ended on March 31, 1980.
Dr.
Particulars

Rs.

Particulars

Cr.
Rs.

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To (Opening) Stock
(500 tons)
To Materials Consumed
To Wages
To Other Mfg. Exp.
To Gross Profit c/d

30,000
2,10,000
95,000
92,000
11,500
4,38,500

By Sales (5,500 tons)

By (Closing) Stock
(400 tons)

4,12,500
26,000

4,38,500

The total production during the year was 6,000 tons out of which some amount was used
for the construction of companys building. Wages include Rs. 5,000 and other
manufacturing expenses include Rs. 2,000 for the construction of building. Recast the
trading account and ascertain the amount to be capitalized to the building account.
Solution
Trading A/c for the year ended on 31st March 1980
Particulars
Rs.
Particulars
To
(Opening)
30,000
By Sales
Stock
(5,500 tons)
By building a/c
(500 tons)
To
Materials
2,10,000
(Amount of cost of
95,000
Consumed
iron
to
be
_5,000
To Wages
90,000
capitalized)
By (Closing) Stock
Less for Building
92,000
to other Mfg. Exp. _2,000
90,000
(400 tons)
Less for Building
57,500
to Gross Profit c/d
4,77,500

Dr.

Cr.
Rs.
4,12,500
39,000

26,000
4,77,500

Working Notes
Dr.
Particulars
To (Opening) Stock
To Production

Quantity
Tons
Particulars
By Sales
500
By (Closing) Stock
6,000
By Building (bal. fig.)

Cr.
Rs.
5,500
400
600

6,500

6,500

Cost per ton

Particulars
Materials Consumed
Wages
Manufacturing Expenses
Total Cost for Manufacturing 6,000
tons

Rs.
2,10,000
90,000
90,000
3, 90,000

Therefore, cost per ton = 3,90,000 = Rs. 65

6,000
Cost of 600 tons of iron used for building = 600 x 65 = 39,000

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Amount Capitalized to Building A/c

Particulars
Wages
Manufacturing Expenses
Iron

Rs.
5,000
2,000
39,000
Total

46,000

Problem 4
1. A cinema theatre spent Rs. 10,000 for additional features
Answer-- The above expenditure is not increasing the earning capacity of business.
Also, no new asset comes into existence. Therefore, the above expense should be
considered as revenue expenditure.
2. Cost of goodwill purchased
Answer-- It is capital expenditure. The amount spent will give benefit for many
years.
3. A petrol driven engine of a passenger bus replaced by a diesel engine
Answer-- It is capital expenditure as it is a non-recurring expense and will improve
the efficiency of the bus. It will also increase the earning capacity of the bus as diesel
will cost less than petrol. It decreases the working expenditure.
4. Customs duty paid on import of raw materials
Answer-- It is revenue expenditure as raw materials are trading goods and all
expenses related to the purchase of trading goods are revenue. It is a usual expense.
5. Purchase of uniforms, umbrellas and raincoats for staff and employees
Answer-- It is a normal expenditure incurred on staff welfare and should be
considered as revenue expenditure.
Problem 5
1. Legal expenditure incurred in connection with the issue of share capital.
Answer-- Any expenditure incurred at the time of formation of company is debited to
preliminary expense account. Legal expenses are also debited to preliminary
expenses. The preliminary expenses come under the head miscellaneous expenses on
the assets side of the balance sheet. It is an example of deferred revenue expenditure
and is written off over a period of many years.
2. Cost of replacement of defective part of the machinery
Answer-- When a machine is purchased, the cost spent is debited to the machinery
account. But, when any part of the machine is replaced on subsequent occasion, the
expenses incurred are debited to machinery repairs account. Such expenses are
known as revenue expenditure. It is spent to maintain the asset.
3. Expenditure incurred to prepare a project report

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Answer-- Anytime when the project report is being prepared, certain expenses are
required to be incurred such as market survey expenses. When expenses are incurred,
it is not certain as to whether the project would materialize or not. If the project
materializes and expenses incurred are sizeable, they are treated as capital
expenditure. And in case of a project which does not materialize, the project
expenses are treated as revenue expenditure.
4. Expenditure incurred to train employees for better running of machinery
Answer-- Expenditure incurred to train employees for the better running of
machinery will result into greater efficiency and hence will increase the profit of the
business. However, such expenses are treated as revenue expenditure as they do not
result into acquisition of any tangible assets.
5. Expenditure incurred for repairing cinema screen
Answer-- When the cinema screen is first constructed, the expenses incurred are
capitalized. On a subsequent date, when the screen is repaired, expenditure incurred
for repairs is treated as revenue expenditure. The case would be different if the
cinema screen is replaced by a wider screen. In such a case, part of the expenses will
be treated as revenue expenditure and the balance amount will be treated as capital
expenditure.
Problem 6
1. Damages paid for breach of contract
Answer-- It is revenue expense because such expenses are ordinary and normal expenses
are incurred in the ordinary course of business.
2. Stock of Rs. 5,000 destroyed by fire and Rs. 3,500 received from insurance company
Answer-- The recovery of Rs. 3,500 from insurance company is revenue receipt because
it is on account of trading asset. The loss is revenue loss as stock is a trading asset and
this loss will be debited to profit and loss account.
3. Profit on sale of investment
Answer-- If the investments are trading assets, the profit on sale will be treated as
revenue receipt and will be shown on the credit side of profit and loss account. If
investments are not trading assets, the profit will be treated as capital gain.
4. Legal expenses incurred in income tax appeal
Legal expenses incurred in connection with income tax appeal are revenue expenses
because they are normal business expenses incurred while doing business.
Problem 7
1. Compensation for loss of goodwill
Answer-- It is capital receipt as goodwill is an asset. Hence, any amount received on loss
of an asset should be treated as capital receipt.
2. Dividend on investment
Answer-- As it is a regular income, it is categorized as revenue receipt.

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3. Sale of old machinery

Answer-- The amount received on sale of old machinery should be considered as capital
receipt as it is not a receipt that arises in the ordinary course of business.
4. Wages paid for the extension of building
Answer-- If wages are paid for the construction work resulting in the extension of
building, they are treated as capital expenditure as they create fixed assets. Such
expenses will be capitalized.
5. Import duty on raw materials purchased
Answer-- It is revenue expenditure. Raw materials are trading assets. Import duty paid on
materials purchased is an expenditure relating to the purchase of trading assets. It is an
ordinary business expenditure and hence revenue expenditure.
Summary
1. Capital expenditure is generally non-recurring and the amount spent is normally
large.
2. Capital expenditure are shown in balance sheet.
3. Revenue expenditure is a recurring expenditure made to maintain the business.
4. All revenue expenditure are charged to trading and profit and loss account.
5. The following are the examples of five revenue expenditure that can be treated as
capital expenditure in certain circumstances.
i)

Carriage

Carriage inward on goods purchased is revenue expense. But carriage inward

paid on the purchase of plant, furniture etc. should be capitalized and treated as
part of the cost of the assets.
ii)

Repairs

Repairs to fixed assets to maintain them in a state of working efficiency is

revenue expenditure. However, when the amounts are spent by way of repairs to
put second hand machinery in working order, such repairs should be capitalized.
iii)

Wages

Wages paid to workers engaged in the production of goods is revenue expense.

But where workers are engaged in extension of buildings, manufacture of tools or
erection of plant, the wages paid should be capitalized and treated as a part of the
plant or the cost of the asset concerned.
iv)

Legal Charges

Legal charges paid in the normal course of business are revenue expenses.
However, legal charges paid in connection with the purchase of properties should
be added to the cost of property, i.e. they should be capitalized.

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v)

Brokerage

Brokerage paid on purchase of properties, fixed assets or investments should be

capitalized.
Questions
1.
2.
3.
4.
5.
6.
7.
8.

What is capital expenditure?

What is revenue expenditure?
What is deferred revenue expenditure?
What do you mean by capital receipts?
What do you mean by revenue receipts?
What is capital profit?
What is capital loss?
State with reasons whether the following items are capital, revenue or deferred
revenue:
(a) Expenditure incurred in overhauling machinery
(b) Amount brought by proprietor as capital
(c) Building of cost Rs. 2,00,000 sold for Rs. 1,50,000
(d) White washing of office building
(e) Expenditure incurred for training employees
(f) Received a gift from parents and introduced the amount in business
(g) Insurance of godown
(h) Renewal of license
(i) Expenses incurred on research of a product not resulting in success
(j) Bad debts recovered
(k) Depreciation on assets
(l) Shares purchased and brokerage paid on purchase
(m) Loss on sale of plant
(n) Preliminary expenses
(o) Cost of dismantling, removing and reinstalling the old plant
(p) Machinery of value Rs. 10,000 sold for Rs. 10,500
(q) Charges paid to workers for erecting new machinery
(r) Rs. 2,00,000 received from issue of shares out of which Rs. 10,000 are issue
expenses

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