Capital and Revenue | ICSE Class 10 Commercial Studies Notes

This note covers capital and revenue receipts, capital and revenue expenditure (their meaning, differences and examples), and deferred revenue expenditure (meaning and examples), with definitions, comparison tables, worked examples and exam-style practice for ICSE Class 10 Commercial Studies.

What is the difference between an outlay and an expense?

Every business spends money. Some of that money buys things that will serve the firm for years, such as a building or a machine. Other money is spent on the everyday running of the business, such as wages, rent and electricity. Accounting treats these two kinds of spending very differently.

Expenditure and expense

Whenever a payment is made, or a liability is incurred, for a purpose other than settling an existing liability, it is called expenditure. The firm spends because it expects a benefit.

That benefit may last for one accounting year or for many years. The length of the benefit is the key test that separates capital from revenue.

Definition: expenditure. Any outlay made or incurred by a business for a purpose other than the settlement of an existing liability, made in the expectation that it will give benefit to the business.

Expenditure is a wider term than expense. The part of an expenditure that is used up or consumed in the current year is called an expense of the current year.

For example, a firm buys furniture for ₹50,000 and expects to use it for five years. The whole ₹50,000 is expenditure, but only ₹10,000 is treated as an expense in each of the five years. The name given to that yearly expense is depreciation.

So expenditure is the whole outlay, counted once, on the day it is made, while an expense is the slice of that outlay that belongs to one year.

The cost not yet used up sits in the balance sheet as an asset. The test is always the same: how long does the benefit last, and how much of it has been used up by the end of the year?

Why the distinction decides the accounts

This distinction matters because it decides where an item appears. Revenue items go into the trading and profit and loss account, which measures profit or loss. Capital items go into the balance sheet, which shows financial position.

Classifying an item wrongly therefore distorts both the profit figure and the assets figure.

What is capital expenditure?

Capital expenditure is expenditure whose benefit extends beyond one accounting period. It is normally incurred to acquire fixed assets, or to make additions and extensions to fixed assets, that will be used in the business for many years.

Definition: capital expenditure. Expenditure incurred to acquire a fixed asset or to add to or extend a fixed asset, whose benefit extends over more than one accounting period.

Examples of capital expenditure

Common examples of capital expenditure are:

• Purchase of land, building, plant, machinery, furniture or vehicles.
• Cost of installing a new machine, such as erecting the platform on which it is fixed.
• Extension of an existing building, or construction of an extra room.
• Registration fees and legal charges paid to acquire a building.
• Money spent to make a newly purchased old building usable, such as repairs and whitewashing done at the time of purchase.

Features of capital expenditure

Capital expenditure increases the earning capacity of the business. It is non-recurring in nature: a firm does not buy a new factory every month. It is shown in the balance sheet on the assets side, and its cost is spread over its useful life through depreciation.

Outlays that look like running costs

Two further examples are worth noting because they look like running costs but are not.

Money spent to provide one more exit in a cinema hall in compliance with a government order is capital expenditure, because it is a permanent addition to the building.

Money spent on the maintenance of a tea garden that will produce tea only after four years is also capital expenditure, because the benefit lies four years ahead.

Capital expenditure is not always a single large payment. It includes every cost needed to bring the asset into a working condition and to the place where it will be used.

A machine that costs ₹2,00,000, needs ₹15,000 of freight and ₹10,000 of erection charges, has a capital cost of ₹2,25,000. All three amounts are capital, because none of them would have been spent if the machine had not been bought.

What is revenue expenditure?

Revenue expenditure is expenditure whose benefit is used up within one accounting period. It is incurred for the day-to-day conduct of the business, to keep the business running and to maintain its existing earning capacity.

Definition: revenue expenditure. Expenditure incurred in the ordinary course of business whose benefit is consumed within one accounting period, and which is charged to the trading and profit and loss account.

Examples of revenue expenditure

Common examples of revenue expenditure are:

• Salaries and wages paid to staff and workers.
• Rent, rates and taxes of office and godown.
• Electricity, water, fuel and power used in the ordinary course.
• Repairs and renewals that keep an asset in working condition.
• Carriage inwards on goods purchased and carriage outwards on goods sold.
• Insurance premium, postage, stationery and telephone charges.
• Ordinary advertising and sales promotion.
• Interest paid on loans and bank overdraft.

Features of revenue expenditure

Revenue expenditure is generally recurring: it comes back every month or every year. It is transferred to the trading and profit and loss account, after adjusting for outstanding and prepaid amounts, and so it reduces the profit of the period.

Take salaries as the standard case. Salaries paid this year will not help the firm next year, because the workers have put in their effort this year.

If the same workers are kept on, they must be paid again next year. The benefit has been fully used up, so the whole amount is an expense of this year.

Depreciation charged on a plant is also revenue expenditure, even though it is not a cash payment. It is the portion of the plant's cost that has been consumed during the year, and it is charged against the year's income.

Repairs that merely keep an old asset in working condition belong here too, because they maintain the asset in its former state and create nothing new.

How do capital and revenue expenditure differ?

The two kinds of expenditure can be compared on five clear points: purpose, nature of spending, frequency, period of benefit, and place in the final accounts. The table below sets out each point side by side.

Note: a useful test. Ask how long the benefit will last. If it lasts more than one accounting year, the outlay is capital expenditure. If it is used up within the year, it is revenue expenditure.

Applying the tests

Each row of the table is one test, and a single outlay is judged on all five rows together.

A new machine passes the purpose test (it raises earning capacity), the frequency test (it is bought once) and the benefit test (it serves for years), so it is capital expenditure.

A monthly electricity bill fails every one of these tests, so it is revenue expenditure.

Most items are easy to place. The difficulty arises at the edges, where a revenue-type payment is made in a large amount for a long-lasting benefit, or where a capital-type payment is made to keep an old asset working.

The next sections deal with these borderline cases and with receipts, which follow the same logic.

What are capital receipts?

Receipts are treated in the same way as expenditure. A capital receipt is money received that creates an obligation to return it, or that arises from the sale of a fixed asset.

Definition: capital receipt. A receipt which either creates an obligation to return the money, or which arises from the sale of a fixed asset, and which is therefore shown in the balance sheet.

Examples of capital receipts

Examples of capital receipts are:

• Additional capital brought in by the owner. This creates an obligation to the owner, called equity.
• A loan taken from a bank. This creates an obligation to an outsider, called a liability.
• Sale of a fixed asset, such as old machinery or old furniture.
• Issue of shares or debentures by a company, which brings in long-term funds.

Capital receipts are not treated as income of the period. They are shown on the liabilities side of the balance sheet (for capital and loans) or are used to reduce the relevant asset (for sale of a fixed asset).

Owner's capital, loans and asset sales

Notice that the obligation may be to the owner or to an outsider. Money brought in by the owner is owed back to the owner in the sense that the owner's stake in the firm rises by that amount; this stake is called equity.

Money borrowed from a bank is owed to an outsider and is called a liability. In both cases the firm has not earned the money, so it cannot be counted as income.

The sale of a fixed asset is the second route to a capital receipt. When a firm sells old machinery, it is not trading in machinery; it is converting one form of asset into another.

The money received replaces the asset that has gone, so it belongs in the balance sheet and not in the profit and loss account.

What are revenue receipts?

A revenue receipt is money received in the ordinary course of business that creates no obligation to return it and does not come from the sale of a fixed asset.

Definition: revenue receipt. A receipt which does not create an obligation to return the money and is not the sale of a fixed asset, and which is therefore treated as income of the period.

Examples of revenue receipts

Examples of revenue receipts are:

• Cash and credit sales made by the firm.
• Interest on investments received by the firm.
• Commission received, discount received and rent received.
• Dividend received on shares held as investments.

Revenue receipts are shown on the credit side of the trading and profit and loss account and increase the profit of the period.

Why these receipts are income

Sales are the clearest case. The firm has sold goods, the buyer owes nothing back, and the money is the reward for the year's trading. Interest, dividend, commission and discount received are smaller but similar: they are earned incomes, not borrowings, and no one can ask for them back.

How do capital and revenue receipts differ?

The test for a receipt is the obligation it creates. Money that must be returned, or that comes from selling a fixed asset, is capital.

Money that is earned and kept, and does not come from selling a fixed asset, is revenue. The table below compares the two on five bases.

The key question

An exam answer can be built by walking down the rows of the table. The single most useful question is: must this money be given back? A bank loan must be repaid with interest, so it is a capital receipt.

A sale is complete once the goods are delivered, so it is a revenue receipt.

Where the answer is unclear, ask the second question: has a fixed asset left the business? If yes, the receipt is capital even though no repayment is involved.

What is deferred revenue expenditure?

Sometimes it is difficult to decide whether an item is capital or revenue. Advertising is the standard example. In normal usage, advertising expenditure is revenue expenditure. But heavy expenditure on advertising is likely to benefit the firm for more than one accounting period.

Such revenue expenditure, which is likely to give benefit for more than one accounting period, is called deferred revenue expenditure. The word deferred means postponed: the expense is postponed to future years.

Definition: deferred revenue expenditure. Revenue expenditure which is likely to give benefit for more than one accounting period, and which is therefore written off over its expected period of benefit instead of being charged wholly in the year of payment.

Treatment over the years

The treatment of deferred revenue expenditure is the same as that of capital expenditure. It is written off over its expected period of benefit.

For example, if a firm spends ₹1,20,000 on a launch advertising campaign expected to help sales for three years, it may write off ₹40,000 in each of the three years.

Worked example 1. A company spends ₹1,20,000 on advertising to launch a new product. The benefit is expected to last three years. Show the treatment in each year.

Answer: This is deferred revenue expenditure. Amount written off each year = ₹1,20,000 ÷ 3 = ₹40,000. In year 1, ₹40,000 is charged to the profit and loss account and ₹80,000 is carried forward.

In year 2, another ₹40,000 is charged and ₹40,000 is carried forward. In year 3, the last ₹40,000 is charged and nothing remains.

Examples of deferred revenue expenditure

Examples of deferred revenue expenditure are:

• Heavy advertising expenditure to launch a new product, whose benefit will last several years.
• Expenditure on research and development, whose benefit will be received in future years.
• Cost of shifting a factory or office to a new location.
• Preliminary expenses of a company, such as expenses of forming the company.
• Discount and other costs of issuing debentures, written off over the life of the debentures.

Revenue in nature, spread in timing

Keep the nature of the item clear. Deferred revenue expenditure is still revenue expenditure; it has not become capital expenditure. What changes is only the timing of the charge.

Instead of hitting one year's profit with the whole amount, the firm spreads the charge so that each year bears its fair share of a benefit it enjoys.

The amount still unwritten off is shown on the assets side of the balance sheet, often under a heading such as miscellaneous expenditure.

It is a fictitious asset: it cannot be sold, but it represents a benefit still to come, and it is carried forward until it has been fully charged.

Note: present-day company accounts. Accounting standards now used by companies in India (AS 26 and Ind AS 38) require most such costs, including advertising, research, relocation and start-up (preliminary) costs, to be charged as an expense in the year they are incurred.

The idea of deferred revenue expenditure is still the standard way to explain how a long-lasting revenue outlay differs from an ordinary one.

Why does the distinction between capital and revenue matter?

The distinction has important implications for preparing the trading and profit and loss account and the balance sheet.

All items of revenue nature must appear in the trading and profit and loss account, and all items of capital nature in the balance sheet. If any item is wrongly classified, the ascertainment of profit or loss will be incorrect.

Effect of wrong classification

Suppose a revenue item is treated as capital. It is left out of the expenses of the year, so profit is overstated and assets are overstated.

Suppose a capital item is treated as revenue, for example furniture purchase shown as purchases. Then profit is understated and assets are understated.

In either case the financial statements will not reflect a true and fair view of the affairs of the business.

The distinction also matters for taxation, because capital profits are taxed differently from revenue profits.

Worked example 2. A firm earned revenues of ₹10,00,000 during the year and showed expenses of ₹8,00,000, giving a profit of ₹2,00,000.

On scrutiny it was found that a revenue item of ₹20,000, being repairs to machinery, had been treated as capital expenditure and added to the cost of machinery instead of being debited to repairs account.

Answer: The ₹20,000 repairs must be included in the expenses of the year. Actual expenses = ₹8,00,000 + ₹20,000 = ₹8,20,000. Correct profit = ₹10,00,000 − ₹8,20,000 = ₹1,80,000. The profit originally shown, ₹2,00,000, was overstated by ₹20,000.

How are these items classified in practice?

Classification follows a simple procedure. Work through each outlay and each receipt in turn.

1. Identify the outlay or receipt and the amount involved.
2. Ask whether the outlay creates a benefit that lasts more than one accounting year. If yes, it is capital expenditure; if no, it is revenue expenditure.
3. Ask whether a receipt creates an obligation to return the money or comes from the sale of a fixed asset. If yes, it is a capital receipt; if no, it is a revenue receipt.
4. If a revenue outlay gives benefit over several years, treat it as deferred revenue expenditure and write it off over its expected period of benefit.
5. Post revenue items to the trading and profit and loss account and capital items to the balance sheet.

Note: borderline cases. Repairs and whitewashing done at the time of purchase of an old building to make it usable are capital expenditure, because they are part of the cost of getting the asset ready. Repairs done later to keep the building in working condition are revenue expenditure.

Worked examples

Worked example 3. A trader buys furniture for ₹40,000 and pays ₹2,000 for its carriage and ₹1,500 for repairs to an old table used in the office. Classify each item and state where it will appear.

Answer: Furniture ₹40,000 is capital expenditure, shown in the balance sheet as a fixed asset.

Carriage of ₹2,000 paid to bring the new furniture to the business is also capital expenditure, because it is part of the cost of acquiring the asset, so the furniture is recorded at ₹42,000.

Repairs of ₹1,500 to the old table merely maintain an existing asset, so it is revenue expenditure and is debited to the profit and loss account.

Worked example 4. From the following, state which are capital receipts and which are revenue receipts: (a) ₹50,000 cash sales, (b) ₹1,00,000 bank loan taken, (c) ₹8,000 interest on investment received, (d) ₹15,000 from sale of old machinery, (e) ₹20,000 additional capital brought in by the owner.

Answer: Capital receipts are (b) bank loan ₹1,00,000, because it must be repaid; (d) sale of old machinery ₹15,000, because it is the sale of a fixed asset; and (e) additional capital ₹20,000, because it creates an obligation to the owner.

Revenue receipts are (a) cash sales ₹50,000 and (c) interest on investment ₹8,000, because neither creates an obligation to return the money nor comes from sale of a fixed asset.

Glossary

• Expenditure: Any outlay made or incurred by a business for a purpose other than settling an existing liability, made in the expectation of benefit.
• Expense: The part of an expenditure that is used up or consumed in the current accounting year.
• Capital expenditure: Expenditure to acquire or extend a fixed asset, whose benefit lasts more than one accounting year.
• Revenue expenditure: Expenditure on the day-to-day running of the business, whose benefit is used up within one accounting year.
• Capital receipt: A receipt that creates an obligation to return the money or arises from the sale of a fixed asset.
• Revenue receipt: A receipt that creates no obligation to return the money and is not the sale of a fixed asset.
• Deferred revenue expenditure: Revenue expenditure whose benefit lasts more than one year, written off over its expected period of benefit.
• Depreciation: The yearly expense that spreads the cost of a fixed asset over its useful life.
• Fixed asset: An asset held on a long-term basis for use in the business and not for resale.
• Equity: The owner's stake in the business, created when the owner brings in capital.
• Liability: An amount owed by the business to outsiders, such as a bank loan.
• Write off: To charge an amount as an expense over one or more accounting periods.

Common errors and misconceptions

• Misconception: All money spent is an expense of the year. Correct: Only the part of an expenditure consumed in the year is an expense; capital expenditure is spread over its useful life.
• Misconception: Buying furniture is a revenue item because it is a small amount. Correct: Size does not decide the matter; the period of benefit does. Furniture used for years is capital expenditure.
• Misconception: A bank loan is income because cash comes in. Correct: A loan creates an obligation to repay, so it is a capital receipt, not income.
• Misconception: Sale of old machinery is a revenue receipt because cash is received. Correct: It is the sale of a fixed asset, so it is a capital receipt.
• Misconception: Deferred revenue expenditure is the same as capital expenditure. Correct: It is revenue in nature but is written off over several years, like capital expenditure.
• Misconception: Repairs to a newly bought old building are always revenue expenditure. Correct: Repairs and whitewashing done at the time of purchase to make the building usable are capital expenditure.
• Misconception: Wrong classification only affects the balance sheet. Correct: It affects profit as well; treating a revenue item as capital overstates profit.

Exam-style questions with model answers

Q1. Define capital expenditure and revenue expenditure. [2 marks]

1. Capital expenditure is expenditure incurred to acquire a fixed asset or to add to or extend it, whose benefit extends over more than one accounting period.
2. Revenue expenditure is expenditure incurred on the day-to-day conduct of the business, whose benefit is normally used up within one accounting period.

Q2. State any two examples each of capital receipts and revenue receipts. [2 marks]

1. Capital receipts: a loan taken from a bank, and additional capital brought in by the owner.
2. Revenue receipts: cash sales made by the firm, and interest on investment received.

Q3. Distinguish between capital expenditure and revenue expenditure on any three bases. [3 marks]

1. Purpose: capital expenditure increases the earning capacity of the business, while revenue expenditure maintains the existing earning capacity.
2. Frequency: capital expenditure is non-recurring by nature, while revenue expenditure is generally recurring.
3. Place in final accounts: capital expenditure is recorded in the balance sheet subject to depreciation, while revenue expenditure is transferred to the trading and profit and loss account.

Q4. What is deferred revenue expenditure? Give two examples. [3 marks]

1. Deferred revenue expenditure is revenue expenditure which is likely to give benefit for more than one accounting period.
2. It is written off over its expected period of benefit, in the same way as capital expenditure.
3. Examples: heavy advertising to launch a new product, and expenditure on research and development.

Q5. A firm's revenues for the year are ₹5,00,000 and its expenses are ₹3,50,000. Later it is found that ₹30,000 spent on repairs to machinery was wrongly treated as capital expenditure. Calculate the correct profit and state the effect of the error. [4 marks]

1. Profit as originally shown = ₹5,00,000 − ₹3,50,000 = ₹1,50,000.
2. The ₹30,000 repairs are revenue expenditure and must be included in the expenses of the year.
3. Correct expenses = ₹3,50,000 + ₹30,000 = ₹3,80,000.
4. Correct profit = ₹5,00,000 − ₹3,80,000 = ₹1,20,000. The original profit was overstated by ₹30,000.

Q6. Explain why the distinction between capital and revenue items is important for a business. [5 marks]

1. Revenue items must appear in the trading and profit and loss account and capital items in the balance sheet, so the distinction decides where each item is shown.
2. If a revenue item is treated as capital, it is left out of expenses, so profit and assets are overstated.
3. If a capital item is treated as revenue, profit and assets are understated.
4. In either case the financial statements fail to show a true and fair view of the affairs of the business.
5. The distinction also matters for taxation, because capital profits are taxed differently from revenue profits.

Q7. Classify the following and give a reason for each: (a) ₹60,000 paid for a new delivery van, (b) ₹4,000 paid as insurance premium on the van, (c) ₹25,000 received as loan from a bank, (d) ₹9,000 received as commission. [4 marks]

1. (a) Capital expenditure, because the van is a fixed asset that will benefit the business for several years.
2. (b) Revenue expenditure, because the insurance premium covers one period and is used up within the year.
3. (c) Capital receipt, because the loan creates an obligation to return the money.
4. (d) Revenue receipt, because commission received creates no obligation to return the money and is ordinary income.

Key takeaways

• Expenditure is any outlay other than settlement of a liability; the part consumed in the year is an expense.
• Capital expenditure buys or extends a fixed asset and benefits more than one accounting year.
• Revenue expenditure runs the business day to day and is used up within one accounting year.
• Capital expenditure increases the earning capacity of the business, while revenue expenditure only maintains the existing earning capacity.
• A capital receipt creates an obligation to return money or comes from selling a fixed asset.
• A revenue receipt creates no obligation and is treated as income of the period.
• Deferred revenue expenditure is revenue in nature but written off over several years.
• Wrong classification distorts both profit and assets, so the accounts lose their true and fair view.

Test yourself

Is purchase of machinery capital or revenue expenditure?

Capital expenditure, because machinery is a fixed asset whose benefit extends over more than one accounting year.

Is a bank loan a capital receipt or a revenue receipt?

A capital receipt, because it creates an obligation to return the money to the bank.

What is meant by deferred revenue expenditure?

Revenue expenditure whose benefit is likely to last more than one accounting period, and which is therefore written off over its expected period of benefit.

Give one example of a capital receipt arising from sale of an asset.

Sale of old machinery or old furniture, because it is the sale of a fixed asset and not ordinary business income.

Why is depreciation charged on capital expenditure?

Because the cost of a fixed asset is spread over its useful life, so a part of the cost is treated as an expense each year.

What happens to profit if a revenue item is wrongly treated as capital?

Profit is overstated, because the item is left out of the expenses of the year, and assets are also overstated.

Are repairs and whitewashing done at the time of buying an old building capital or revenue?

Capital expenditure, because they are part of the cost of making the building usable for the business.