Revenue vs Capital Expenditure

Revenue vs Capital Expenditure

Q. Define Revenue Expenditure and Capital Expenditure. State the principles governing the allocation of expenditure between Capital & Revenue. Indicate the importance of making such a distinction.

Ans.

Capital expenditure is that expenditure, which is incurred for the purpose of acquiring, expanding or improving assets, by which, the earning capacity of the business is increased.

Revenue Expenditure is that expenditure incurred, in carrying on the business and in maintaining the capital assets in a state of efficiency and hence maintaining the revenue earning capacity of the business. Salaries, Wages, Lighting, Stationary, repairs & renewals required to maintain assets in a state of efficiency - are the examples of Revenue Expenditure.

There is no definite principle governing allocation of expenditure of a business between capital & revenue. As a general rule, all expenditures incurred for the following purposes should be allocated to capital, whereas all other expenses should be charged to revenue :-

1. Acquisition of assets for more or less continuous use in the business,

2. Placing new assets required in a revenue earning condition,

3. Increasing the revenue earning capacity of the business, or

4. Diminishing the cost of manufacture, administration and distribution.

Let us consider that a farm has an old machine running below it's efficiency level. The management decided to repair the existing machine & purchased a latest machine for the business. The cost of repairing the old machine shall be treated as a Revenue Expenditure and is to be charged in the P&L A/C (Profit & Loss Account) of the farm and the cost incurred for purchasing the new machine with motive to raise the productivity of the farm, shall be treated as a Capital Expenditure.

The distinction between capital & revenue expenditure is vital as it affects the amount of profit or loss and the correctness of the Balance Sheet. As the Auditor is liable to represent "A true and fair view" of the Balance Sheet, he should exercise reasonable skill in making the distinction betwen the two expenditures. Wages during ordinary course of business is of revenue by nature. But wages paid for erecting a new machine should be treated as Capital Expenditure. If this is not done, it will result in the under valuation of assets and it will show less profit. It would also indulge in the creation of secret reserve, which is forbidden by the Companies Act, 1956.

On the contrary, if a revenue expenditure is treated as Capital Expenditure, there will be an over valuation of assets and the accounts will show inflated profits. In such case, dividends & taxes will be paid more out of capital and as a consequence, there will be erosion of capital, which is against the provision of the Companies Act, 1956.