Capital and Revenue Transactions: formula sheet

Key formulas

Capital expenditure test

Spending that acquires an asset, or increases its earning capacity or life = Capital expenditure

Shown in the Balance Sheet. Depreciation is charged on it later.

Revenue expenditure test

Spending that maintains the business or the existing earning capacity = Revenue expenditure

Charged in full to the Trading or Profit and Loss Account of the year.

Cost of a fixed asset

Cost of asset = Purchase price + Freight + Installation + Legal fees on purchase + Other costs to make it ready for use

All these are capitalised. Trade discount is deducted from the price.

Effect of wrong classification

Capital treated as revenue: profit understated. Revenue treated as capital: profit overstated

Use this to check any question on errors of classification.

Repairs rule

Ordinary repairs = Revenue. Repairs at purchase to make the asset usable = Capital. Major improvement or extension = Capital

The purpose of the repair decides the class.

Capital receipt test

Owner's capital, loans taken, sale of fixed assets, sale of investments held as fixed assets → Capital receipt

Shown in the Balance Sheet. Any profit on sale of a fixed asset is a capital profit, not trading income. Sale of investments is capital only if they are held as a fixed asset. For a dealer in securities it is revenue.

Revenue receipt test

Sales, service income, interest, rent, commission, discount received from normal operations → Revenue receipt

Credited to the Trading or Profit and Loss Account.

Dealer rule

Item sold in the ordinary course of business = Revenue receipt

Nature depends on the business. Look at what the business does. Revenue receipts do not create a liability or change the capital structure.

Annual write-off (equal instalments)

Annual write-off = Total deferred expenditure ÷ Number of years of benefit

Use when the question says to write off in equal instalments over a given period.

Balance carried forward

Balance in Balance Sheet = Total expenditure − Amount written off so far

This unwritten-off amount is shown as an asset (Miscellaneous Expenditure) until it becomes nil.

Journal entry at spending

Deferred Revenue Expenditure A/c Dr. To Cash/Bank A/c

The full amount is first debited to an asset-type account, not to the Profit and Loss Account.

Journal entry at write-off

Profit and Loss A/c Dr. To Deferred Revenue Expenditure A/c

Passed each year for the instalment being written off.

Capital profit on sale of fixed asset

Capital profit = Sale proceeds − Book value (cost − depreciation)

Positive result. A capital item, usually transferred to capital reserve unless the question says otherwise. It is not normal trading income.

Capital loss on sale of fixed asset

Capital loss = Book value − Sale proceeds

Positive result. Set off against capital reserve only where the question says so. Otherwise the loss, net of any insurance claim, is shown in the Profit and Loss Account as a non-operating or exceptional item.

Revenue profit

Revenue profit = Revenue income − Revenue expenses

Taken to the Profit and Loss Account for the year.

Test of nature

Normal business activity = revenue; change in fixed assets or capital = capital

Always ask whether the item is bought or sold to use in the business or to deal in.

Cost of a fixed asset

Cost = Purchase price + Freight and carriage inwards + Installation cost + Initial repairs + Legal/registration charges + Trial run costs

Every cost needed to get the asset ready for use is capitalised. Trade discount is deducted first.

Capital test

Capital if cost acquires, improves or extends the asset's life or earning capacity

Shown in the Balance Sheet. Depreciation is charged on it later.

Revenue test

Revenue if cost only maintains the asset or earns this year's income

Debited to Profit and Loss Account or Trading Account of the year.

Effect of wrong classification

Capital treated as revenue: profit understated. Revenue treated as capital: profit overstated

Use this to check any adjustment question.

Second-hand asset repairs

Repairs before first use = Capital. Later routine repairs = Revenue

Timing decides the class.

Raising capital expenses

Underwriting commission, brokerage on shares/debentures = capital in nature (often deferred revenue)

Follow the question's instruction if it asks to write off.

Quick revision

• Capital expenditure gives benefit beyond one year or adds to the earning capacity of the business.
• Revenue expenditure is incurred to run the business and earn the current year's profit.
• Capital items go to the Balance Sheet. Revenue items go to the Profit and Loss Account.
• Purchase of machinery is capital. Purchase of goods for resale is revenue.
• Cost of installing a new machine and carriage on it are added to the machine cost.
• Ordinary repairs are revenue. Repairs that extend the life or capacity of an asset are capital.
• Sale of a fixed asset is a capital receipt. Sale of goods is a revenue receipt.
• Capital introduced by the owner and loans received are capital receipts.
• Deferred revenue expenditure is a revenue item whose benefit lasts several years, so it is written off over those years.
• The unwritten-off part of deferred revenue expenditure is shown in the Balance Sheet.
• Profit on sale of a fixed asset is a capital profit. Trading profit is a revenue profit.
• Wrongly treating capital as revenue understates profit and assets. Treating revenue as capital overstates both.

Common mistakes

• Treating all repairs as revenue. Fix: Repairs made to put a second-hand asset into working condition after purchase are capital. Only routine upkeep is revenue.
• Leaving out freight and installation from the asset cost. Fix: Add every cost needed to bring the asset to its place and make it ready for use.
• Treating a loan received as income. Fix: A loan creates a liability that must be repaid. It is a capital receipt and goes to the Balance Sheet.
• Treating sale proceeds of a fixed asset as revenue. Fix: Sale of a fixed asset is a capital receipt unless the business deals in that asset.
• Treating deferred revenue expenditure as capital expenditure Fix: Remember it is an expense by nature. It does not create a fixed asset and is written off completely over time.
• Charging the whole amount to the Profit and Loss Account in the first year Fix: If the question says the benefit is spread over years, charge only one year's instalment.
• Treating profit on sale of a fixed asset as normal business income. Fix: A gain on sale of a fixed asset is a capital profit. Look at the asset first, not the word profit.
• Classifying by amount, calling large items capital and small items revenue. Fix: Nature decides the class, not size. A large stock loss is still revenue.
• Treating installation wages as revenue because they are wages. Fix: Ask what the wages were for. Installation of a new asset is capital.
• Treating repairs on a second-hand machine bought for use as revenue. Fix: Repairs made to put a purchased asset in working order are capital. Later routine repairs are revenue.

Exam tips

• Read the wording for clues such as 'new', 'initial', 'extension', 'improvement' (capital) versus 'routine', 'annual', 'maintenance' (revenue).
• In profit-correction questions, write two lines: add back capital items charged, deduct revenue items capitalised. This avoids sign errors.
• Remember that all costs to bring an asset into use form part of its cost, so look for freight, installation and legal fees.
• Check whether the business buys the item for use or for resale before answering.
• With no negative marking, always answer. Eliminate options that clearly create a lasting asset when the item is revenue.
• Read the business type in the question stem first. It decides whether the item is stock-in-trade.
• If two options look revenue-like, check for a loan, owner's capital or fixed asset sale hidden in the wording.
• Questions often ask for totals. Classify each item first, then add only the type asked for.