Capital and Revenue Profits and Losses Explained

Understand Capital and Revenue Profits and Losses

Key formulas to remember

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.

How to solve Capital and Revenue Profits and Losses questions

1. 1Identify the business and what it normally does (trades in goods, provides services, and so on).
2. 2Ask whether the transaction is part of that normal activity or relates to fixed assets, share capital or long-term funds.
3. 3Mark it as revenue if it is normal activity and capital if it relates to fixed assets or capital funds.
4. 4If it involves sale of an asset, compute book value and compare with the sale price to see if there is profit or loss.
5. 5Decide the place: revenue items go to the Profit and Loss Account; a realised capital profit is usually transferred to capital reserve; an unrealised revaluation gain goes to revaluation reserve; premium on shares goes to securities premium.
6. 6For a capital loss, set it off against capital reserve only if the question says so. Otherwise show it, net of any insurance claim, in the Profit and Loss Account as a non-operating or exceptional item.
7. 7Check the answer options for the one that matches both the nature and the place.

Quickest way: Two-question shortcut

Common mistakes in Capital and Revenue Profits and Losses

• Treating profit on sale of a fixed asset as normal business income.

  It is a gain, so students assume it belongs with other 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.

  Students link capital with big values.

  Fix: Nature decides the class, not size. A large stock loss is still revenue.

• Ignoring the type of business.

  Students memorise that machinery sale is capital.

  Fix: If a machinery dealer sells machines from stock, the profit is revenue. Always check what the business deals in.

• Computing capital profit using cost instead of book value.

  Depreciation already charged is forgotten.

  Fix: Use book value, which is cost less accumulated depreciation, to find profit or loss.

• Showing a capital reserve on the assets side of the Balance Sheet.

  Reserve is confused with an asset because it looks like money held.

  Fix: A capital reserve is a credit balance, so it sits on the liabilities side under owners' funds.

• Putting revaluation gain or share premium into capital reserve.

  All of them look like capital gains.

  Fix: Revaluation gain goes to revaluation reserve and share premium goes to securities premium. Capital reserve takes a capital profit only where the question or convention requires the transfer, as an appropriation.

Worked examples