Financial accounting mgt101 power point slides lecture 21

Financial Accounting

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Lecture – 21

Recap

• Up to now we have covered following areas in this course We started off with the basic concepts of accounting, Then we covered the basic book keeping and learnt how

to record transactions, After this basic overview we started detailed study of

different items reported in the financial statements an to date we have covered following areas:

o Stocks

o Cost of Goods Sold, and

o Fixed Assets


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Lecture – 21

Areas Covered in This Lecture

• In this lecture we will study in detail about Capital and Revenue Expenditure, and Capital and Revenue Receipts

• We will also establish rules to distinguish between Capital and Revenue and see if there are any exceptions to these rules.


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Lecture – 21

• While preparing Profit and Loss we take into account only Revenue Expenditure and Revenue Receipts.

• Whereas Capital Expenditure and Capital Receipts effect the Balance Sheet

• Therefore to present a proper Profit and Loss Account it is important to distinguish between Capital and Revenue items.

• First we will deal with Capital and Revenue Expenditure.


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Lecture – 21Capital Expenditure

• Capital Expenditure can be defined as the expenditure incurred to benefit future periods.

• The term of capital expenditure is generally restricted to the expenditure that adds fixed asset units or adds Life, Capacity or Efficiency of existing fixed assets units.

Revenue Expenditure

• Revenue expenditure is the expenditure that benefits the current period.

• Revenue Expenses are those expenses that are: Incurred on the day to day running of the business, Incurred to maintain fixed assets in their original / useable

condition.


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Lecture – 21

• For Capital Expenditure the term “Capitalized” is used.

• For Revenue Expenditure the term “Charged” or “charged to Profit and Loss” is used.

• For Capital Expenditure we have said that it is generally incurred to Acquire an asset or Improve an asset and that it benefits future period.

• This means that capital expenditure can be incurred at two stages, When an asset is acquired, and When an improvement is made in an existing asset.


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Lecture – 21

Acquiring an Asset

• Whenever a new asset is acquired, all the expenditure incurred up to the point of bringing the asset to its intended use is capitalized as the initial cost of asset.

• Following payments other than purchase price are included in the initial cost of an asset: Cost of bringing the assets to business premises, Legal costs incurred to acquire them, Carriage and other charges paid to bring them to the

place of their intended use, Any other costs needed to get the asset ready for use


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Lecture – 21

Subsequent Expenditure

• Classifying the expenditure incurred in acquiring an asset is simple, as compared to subsequent expenditure.

• In case of subsequent expenditure we have to distinguish between Capital and Revenue Expenditure.

• If the expenditure is incurred on the maintenance of the asset then it is treated as Revenue Expense.

• This means that all the expenditure incurred to keep an asset in good operating condition. For example fuel, routine repairs and maintenance like oil, filter etc. in case of vehicles or white wash, repairing of roof, windows and doors in case of building.

• Whereas when an expenditure is incurred so that it improves the performance of an asset from its originally


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Lecture – 21

Subsequent Expenditure

assessed level of performance then it should be treated as capital expenditure. For example if a room is added to a building or a new part is added to a machinery that increases its utility then the expenditure incurred should be treated as capital expenditure.

Day to Day Business Expenses

• The day to day business expenses like salaries, utilities and other administrative costs all benefit in the current period and are therefore treated as revenue expenditure.


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Lecture – 21

Examples

• Consider following examples:

• Purchase of a Car, Machine, Piece of Land or a Building

Capital – A simple example of purchase of an asset

• Fuel, Oil, Batteries for car, Lubricants, Nut, Bolts for Machine, Gardening Expense on Land and whitewash, repairs of building

Revenue – All these expenses are incurred to keep the asset in its desired operational condition.

• Additional Room in the building or on land

Capital – This Expenditure will increase the utility of the asset.


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Lecture – 21

Examples

• Overhaul of Car, Machine

This is a tricky area. Now we have to decide that whether this Expenditure has increased the performance of the asset from it’s originally assessed performance or not.

If the life of machine or car was say five years and due to this overhaul the life is increased beyond this life then this expenditure should be capitalized.


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Lecture – 21

Difference Between Capital and Revenue Expenditure

Capital Expenditure Revenue Expenditure

The effect / utility of these lasts for a long time.

The utility is drawn immediately.

Usually spent to acquire an asset

Incurred to maintain an asset in a usable condition

These are in most of the cases non-recurring.

These are mostly of recurring nature.

This expenditure increases the future earning capability of the organization.

These are incurred to for the current earning of the organization.

These appear in the balance sheet until benefit is drawn from them

These are charged to profit and loss account.


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Lecture – 21

Capitalized or Deferred Revenue Expense

• The nature of some expenses is such that though they do not create an asset but their benefit is spread over more than one accounting period.

• These are mostly non-recurring and large in amount.

• In such circumstances instead of debiting the entire amount of these expenses to Profit and Loss of the year, it may be spread over a number of years with a proportionate amount being charged each year to P&L Account.

• The portion that is still not charged to Profit and Loss is shown in the balance sheet on the asset side after Capital Work in Progress and is called Deferred Expenditure.

• Examples are Expenses incurred to start a business, Initial marketing cost to launch a product etc.


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Lecture – 21

Importance of Distinguishing Between Capital & Revenue Expense

• The whole purpose of accounting is that at the end of the day one can produce such results that reflect a true picture of the state of the business and its performance.

• This means that if the revenue is of one month than expense that is being deducted from it should also be of one month. This concept is called the Matching Concept in accounting.

• So if a payment is made that will provide benefit to the business for period longer than one accounting period then it should be matched or deducted from the income of the same number of years for which it benefits the business.

• therefore it is extremely important to distinguish between capital and revenue expense.


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Lecture – 21

The General Rule

• So the general rule can be devised as: The expense whose benefit lasts for a period longer than

an accounting period is called capital expenditure, and The expenses whose benefit is obtained within an

accounting period is termed as a revenue expense.


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Lecture – 21

Exceptions to the General Rule

• A business may acquire several small items whose benefit is drawn for a longer period, such as batteries, wastepaper baskets, pencil sharpeners etc.

• But capitalizing these will mean that a proper record will have to be kept and depreciation will be charged.

• Here the question rises that, is it really worth going through all the trouble for such small amounts? (Cost Benefit Analysis).

• Therefore we draw an exception to the rule i.e. depending upon the size of expenditure and organization such expenses can be “Charged” instead of “Capitalizing”


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Lecture – 21

Exceptions to the General Rule

• Legal Charges – are as rule charged to P & L but when these are incurred to acquire an asset these should be capitalized with the asset.

• Repairs – are also charged to P&L but when it is of such a nature that it enhances the performance of an asset from its original performance than it should be capitalized.

• Wages – are normally revenue expense but when these are paid to men employed to create an asset these should be capitalized as the cost of asset.

• Freight and Carriage – normally a revenue expense, but when paid to bring an asset to its intended use then it is treated as capital.

• Interest on Loan – is normally a revenue expenditure but when the loan is taken to purchase an asset its interest is treated as Capital and added to cost of the asset.


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Lecture – 21

Capital and Revenue Receipts

• It is as important to distinguish between capital and revenue receipts as it is for capital and revenue expenditure.

• A simple rule for receipts is that, a receipt against an item of capital nature is termed as Capital Receipts. Examples are sale of a Fixed Asset, Sale of an Investment etc.

• Whereas receipts from day to day business activities are termed as revenue receipts. Examples are sale of goods that purchased for resale (stock), rendering of services.