First of all, you can recollect from your daily activities that you incur expenditure on various items every day. You buy food items, stationery, cosmetics, furniture, etc. Some of them are consumables and some are durables.
The benefits of expenditure on consumables like stationery, cosmetics, food items, etc., are derived over a short period, but in case of durables like furniture, utensils, etc., the benefit spreads over a number of years. The same is true of business organizations.
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Distinction Between Capital and Revenue Expenditure
Business organizations, also incur expenses on two types of items i.e routine items like stationery, and fixed items like machinery, building, and furniture… The benefits of the first category are available over one accounting period while the benefits of the second category are available over a number of years.
In accounting terminology, the first category of expenditure is called revenue expenditure and the second one is called capital expenditure. Let us now study the exact nature of capital and revenue expenditures.
As stated above, when the benefit of an expenditure is not exhausted in the year in which it is incurred but is available over a number of years, it is considered as capital expenditure. The following expenditures are usually treated as capital expenditures.
(1) An expenditure which results in the acquisition of fixed assets such as land, buildings, plant and machinery, furniture and fixtures, office equipment and copyright. You should note that such capital expenditure includes not only the purchase price of the fixed assets but also the expenses incurred in connection with their acquisition. Thus, the brokerage or commission paid in connection with the acquisition of an asset, the freight and cartage paid for the transport of machinery, the expenses incurred on its installation, the legal fees and registration charges incurred in connection with the purchase of land and buildings are also treated as capital expenditure.
(2) Any expenditure incurred on a fixed asset which results in (i) expansion, (ii) substantial increase in its life, or (iii) improvement in its revenue earning capacity. Improvement in the revenue earning capacity can be in the form of:
- Increased product capacity
- Reduced cost of production, or
- Increased sales of the firm.
Thus, the costs of making additions to buildings and the amount spent on the renovation of the old machinery are also regarded as capital expenditure. If you buy a piece of second-hand machinery and incur heavy expenditure on reconditioning it, such expenditure is also to be treated as capital expenditure. Similarly, expenditure on structural improvements or alterations to existing fixed assets whereby their revenue earning capacity is increased it is also treated as capital expenditure.
Treatment of Various Expenditure
When the benefit of an expenditure is not likely to be available for more than one year, it is treated as revenue expenditure so all expenses which are incurred during the regular course of business are regarded as revenue expenditures. The examples of such expenses are:
- Expenses incurred in the day-to-day conduct of the business such as wages, salaries, rent, postage, stationery, insurance, and electricity.
- Expenditure incurred for buying goods for resale or raw materials for manufacturing.
- Expenditure incurred for maintaining the fixed assets such as repairs and renewals of buildings and machinery.
- Depreciation of fixed assets. This can also be termed as revenue loss.
- Interest on loans borrowed for running the business. You should note that any interest on the loan paid during the initial period before production commences, is not treated as revenue expenditure. It is treated as capital expenditure.
- Legal charges incurred during the regular course of business such as legal expenses incurred on collection from debtors and legal charges incurred in defending a suit for damages.
Deferred Revenue Expenditure
Sometimes, certain expenditure which is normally treated as revenue may be unusually heavy and its benefit is likely to be available for more than one year. In such a situation, it is considered appropriate to spread the cost of the expenditure over a number of accounting years. Hence, it is capitalized and only a portion of the total amount spent is charged to the Profit and Loss Account of the current year. The balance is shown as an asset that will be written off during the subsequent accounting years. Such expenditure is called a Deferred Revenue Expenditure because its charge to Profit and Loss Account has been deferred to future years.
Some examples of such expenditure are:
- Expenditure incurred in the advertising campaign to introduce a new product in the market.
- Expenditure incurred on the formation of a new company (preliminary expenses)
- Brokerage charges, underwriting commission paid and other expenses incurred in connection with the issue of shares and debentures.
- Cost of shifting the plant and machinery to a new site that may involve dismantling, removing and re-erection of the plant and machinery.
Let us take the case of expenditure on an advertising campaign. It is not a routine advertisement and the amount involved is unusually heavy. Its benefits will not be completely exhausted in one accounting year but will continue over two to three years. Hence, it is not proper to charge such expenditure to the Profit and Loss Account of one year. It is better to distribute it carefully over three years. So, in the first year, we may charge one-third of the amount spent on the Profit and Loss Account and show the balance on the Balance Sheet as an asset. In the second year again, we may charge a similar amount to the Profit and Loss Account and show the balance as an asset. In the third year, we may charge this balance to the Profit and Loss Account.
Every expenditure which is regarded as deferred revenue is treated in this way in the final accounts. Check our Financial Accounting Playlist on YouTube for Financial Accounting Videos.