CHAPTER 08 CAPITAL AND REVENUE EXPENDITURE

BEFORE each term is discussed it is sufficient to say that revenue expendi- ture constitutes a charge against profits, and must be charged, i.e. debited to Profit and Loss Account, whereas capital expenditure is treated as a capital charge, and is shown as an asset in the Balance Sheet.

It is a matter of extreme difficulty to lay down a hard and fast rule as to what dividing line separates capital expenditure from revenue expendi ture. There is much divergence of opinion and practice on this matter, and inter alia the following indicia have been laid down as establishing the fact that the expenditure is capital.

1. Any expenditure which is undertaken for the purpose of increasing profits either positively by way of INCREASING earning capacity, or nega- tively by DECREASING working expenditure, is capital expenditure. The formal acquisition of a tangible asset is not a necessary element in this rule. For example, owing to increased demand for seats, a theatre recon- structs the auditorium; such expenditure may be capitalized.

2. If the expenditure, whether increasing the earning capacity or not, produces an asset comparatively permanent in character, it is capital expenditure.

Capital expenditure, therefore, may be described as outlay resulting in the increase or acquisition of an asset or increase in the earning capacity of a business,

Revenue expenditure, on the other hand, is such outlay as is necessary for the MAINTENANCE of earning capacity, including the upkeep of the fixed assets in a fully efficient state, and the normal total cost involved in selling, including the cost of goods and services of the business to which it relates.

In short, if the purpose of expenditure is to MAINTAIN the business it is revenue; if it is to IMPROVE the business it is capital.

Improvements. The judicial view is that the cost of an improvement of an asset is a legitimate capital charge quite irrespective of whether it is by way of mere substitution or is entirely new. The accounting view is that in regard to the former, i.e. the substitution, the EXCESS of the value of the new over the old asset is the only amount that can properly be charged to capital. The former view is that the original asset was necessary before the improvement could be made. Although this view may be tenable in extreme instances, it is not supported by the vast majority of accountants. It is important, however, in that when the question of whether a dividend has been improperly paid out of capital arises in the case of limited com- panies, the procedure of capitalizing an improvement by way of substitu tion, contrary though it be to prudence, may be supported and justified on LEGAL grounds.

Capital Expenses. Certain expenses are recognized as being of a capital nature, although no tangible property may have been acquired as a result. The most important are:

1. Preliminary expenses of a limited company.

2. Cost of issuing shares and debentures: procuration and legal fees on loans and mortgages.

3. The initial outlay as well as the losses in the early years of concerns which by their very nature retquire a very long period of development, e.g. rubber and other plantations, mines, etc.

4. Cost of experiments.

5. Advertising where its nature is to INTRODUCE a line or 'boost' a new business.

6. Interest on construction capital.

7. Renewals in public utility companies, where, for instance, diesel engines of a railway are replaced by electrical equipment.

8. Legal expenses incurred in the acquisition of property.

9. 'Repairs' on purchase of a dilapidated asset to put it into workable condition.

10. Additions to property and other assets.

Capital and Revenue Receipts. Capital receipts may be said to consist solely of additional payments into the business, made either by sharehol- ders of a company or by proprietors of a business, and receipts from the sale of any fixed assets of a business (not being in the nature of a normal sale). Most receipts, with comparatively few exceptions, may be treated as revenue receipts, e.g. sales, income from investments, transfer fees, com- missions and discounts received, etc.

It should be noted that in taxation and double account questions the distinction between capital and revenue receipts and expenses is of extreme importance, and is based on principles that do not necessarily coincide with those already enumerated.

"It is often challenging to differentiate between capital and revenue expenditures by simple observation due to various reasons, the primary one being that:"

1. Certain expenses are in the nature of capital for some businesses and of revenue for others.

2. Some expenses can be considered partly as capital and partly as revenue. If in doubt as to the nature of any item candidates should always make a note at the foot of their solution as to the method of treatment adopted, though the question should always be scrutinized for any information as to the nature and circumstances of the business,

Although in general it may be said that all expenditure laid out in the purchase of land, buildings, plant, and machinery and other assets of a similar type is in the nature of capital expenditure, the actual cir cumstances must be considered in each case. Taking the illustration of an engineering business, some plant and machinery may have been purchased with the object of earning profits (capital expenditure), and other amounts may have been purchased for the purpose of re-sale (revenue expendi- ture). Again, in the case of real estate business, most land and buildings purchased are revenue expenditure, as they may be considered as trading assets, subject to the obvious qualification that (a) purchases for own occupation; and (b) for permanent holding or for letting purposes, are in the nature of capital expenditure.

CAPITAL AND REVENUE EXPENDITURE

In certain cases the policy of those in charge of the business will decide 0803 whether certain expenditure may be classed as revenue or capital. Al- though expenditure will generally be capable of strict classification, yet where the true nature of such expenditure is doubtful, it is preferable to charge it to revenue, as the charging of revenue expenditure to capital may involve very serious consequences. If capital expenditure is wrongly charged to revenue the resulting effect is an understatement of profits, but if revenue expenditure is wrongly charged to capital, the profits will be overstated, resulting maybe in the withdrawal of such inflated profits by the proprietors.

Legal Expenses. These are nearly always a revenue expense, but legal charges incurred in connection with the purchase of property or other assets may be said to be merely an addition to the price of the asset and accordingly may be capitalized.

Wages. Wages which are paid to employees in the construction of the fixed assets of the business are in the nature of part of the cost of the asset and should be transferred from Wages Account to the debit of the asset account, e.g. if a firm of building contractors decides to enlarge its own premises, all the wages and the materials consumed for this purpose should be debited to the Premises Account. Such facts in an examination will readily suggest that in addition a transfer from purchases in respect of materials used is required. The business may, however, charge such expenditure to revenue, thus creating a secret reserve. The charging of capital expenditure of the above nature to revenue will not be allowed as a charge for TAXATION purposes.

Many questions are set involving the problem of a business constructing its own assets, e.g. suppose the cost of a new asset is £10,000, whilst the lowest outside quotation is £12,000; then the question to consider is 'should the latter amount be capitalized?"

n no case can it be considered a sound financial policy to charge up the asset with the additional £2,000, taking credit for profit of that amount, such money saved not being in the nature of profit, since a business cannot make a profit out of itself. On the other hand, if the outside quotation were £8,000, only this lower figure should properly be capitalized, the excess of the cost over this figure (£2,000) being written off as soon as possible.

Repairs. Repairs are usually in the nature of a revenue charge, though an instance of their being capital expenditure may be seen in the purchase of second-hand assets, and the subsequent repair hy the purchaser to put them into an efficient state. Such an expense is capital, and must he transferred to the Asset Account, even if outside labour be employed. The problem often arises where plant and machinery which is still in good working order is sold at a considerable loss, and replaced by new machin- ery of a more modern type. Whether the loss should be written off or added to the cost of the new machinery is a very debatable point. There is no legal compulsion in the case above-mentioned to write off a loss of this type to revenue, though unquestionably the soundest policy is to write oll such loss during the accounting period in which it is incurred, as the profits will have been previously overstated. If no balance remains on Profit and Loss Account (e.g. because all the profits have been withdrawn, the treatment is either to charge future years with the loss or to deduct the amount from capital.

DEFERRED REVENUE EXPENDITURE

There is a class of expenditure known as deferred revenue expenditure, i.e. revenue expenditure incurred during one accounting period which is applicable either wholly or in part to future periods.

There are four distinct types of deferred revenue expenditure:

1. Expenditure wholly paid for in advance, where no service has yet been rendered, necessitating its being carried forward, i.e. the showing of such outlay as an asset on the Balance Sheet as prepaid expenditure, e.g. telephone rental, rent in advance, etc.

2. Expenditure partly paid in advance where a proportion of the benefit has been derived within the period under review, the balance being as yet 'unused,' and therefore shown in the Balance Sheet as an asset, e.g. proportion of rates paid in advance or special advertising expenditure incurred in introducing a new line or developing a new market.

Most items paid in advance will fall either under head (1) or (2), according as the payment relates wholly or partly to future periods.

3. Expenditure in respect of service rendered which for any sound reason is considered as an asset, or more properly, is not considered to be allocable to the period in question, e.g. development costs in mines and plantations; discount on debentures in limited companies and cost of experiments.'

The practice, which varies significantly in its specifics, involves writing off the amount over several years. If the expenditure can be earmarked as being in respect of a specific object, the expenditure should be written off during the life of thai bject, e.g. in the case of debenture discount at the latest by the time the debentures are redeemed..

4. Amounts representing losses of an exceptional nature, e.g. property confiscated in a foreign country, heavy loss of non-insured assets through, say; fire.

An item categorized under this heading is typically considered a fictitious asset. although it is shown as an asset in the Balance Sheet, it is not really an asset at all but a capital or abnormal loss which has not been written off. A few instances will now be given of expenses which, usually of a revenue nature, may occasionally be classed as capital expenditure.

Illustration 1

The sum of £1,000 has been spent on a machine as follows:

(a) £100 for repairs necessitated by negligence and lack of care and

attention.

(b) £200 for replacements of worn parts.

Usually the reason is that the expenditure is so heavy that it is right and proper to spread it over several years.

CAPITAL AND REVENUE EXPENDITURE

State how these items would be dealt with, as between Capital and

Revenue,

Items (a) and (b) are Revenue, being necessary to keep the asset in ficient running order. They add nothing to the original value of the machine, nor to its proper functioning.

Item (c) is a Capital charge because it enhances the earning capacity of the business.

Illustration 2

Haworth & Co. remove their works to more suitable premises, incurring the following expenditure: (a) Cost of dismantling, removing and reinstal- ng plant, etc. £1,720.

(b) Certain old plant standing in the books at £750 was sold for £300 and replaced by new plant costing £1,200.

State how these items should be dealt with, as between Capital and Revenue.

(a) Removal Expenses. (b) Plant:

Capital Revenue

1,720

Loss on sale of old plant Cost of new plant

450

1,200

£1,200 £2,170'

The sum of £2,170 could be written off at once, but it would also be quite legitimate to arite it off over a short period of years, say four or five.

Illustration 3

Carlo. Ltd., a company owning a greyhound racing track, incurs the following expenditure in its first year to 31st December.

1. Purchase of a totalisator costing £80,000, which, owing to legal actions pending, should not really be in operation. Fines have been incurred totalling £100 through continuing to use the machine, and £1,000 legal charges have been incurred to obtain the necessary licence to legalize the use of this totalisator.

2. The stand has been repainted by the track staff, and it is estimated that the wages under this heading, included in general wages, amount to

£2.400.

3. The rates for the year to 31st March amount to £1.680. Nothing has yet been paid.

4. Preliminary expenses were £6,000.

5. Free tickets have been issued during the year to advertise the track. It is estimated that 40,000 of these tickets have been used on the popular side, the usual price being 25p.

6. Fire insurance was paid on 25th December for the year following amounting to £182-50.

7. When the track was being constructed several temporary sheds for workmen were built which were demolished upon the completion of the track, the cost being £290.

ACCOUNTANCY

1. The cost of the totalisator is clearly a capital charge, as are the legal charges incurred. If, however, the totalisator can never be used the expenditure will be sheer loss, to be written off against profits (if any) as expeditiously as is practicable.

The fines incurred, £100, cannot be capitalized. They are a revenue loss, and must be borne in the current period.

2. It is evident that the stand (presumably as taken over by the company) was not newly painted, and this painting may be thus considered as part of the capital cost. A transfer of £2,400 should be made from Wages Account to the debit of the Stand Account.

3. Rates £1,680. Nine months' rates have accrued, and thus £1,680 = £1,260 must be charged to revenue, and shown in the Balance Sheet as a liability.

4. Preliminary expenses £6,000. This item will be capitalized but should be gradually written down, as it is unrepresented by tangible assets.

5. Free tickets £10,000. Although this represents advertising which will probably benefit future periods, it would be difficult to attach any figure of cost to it, it being rather a loss of revenue. It would therefore be imprudent to capitalize the £10,000 and write it off over several years. There will probably be no entry in the books in respect of the item but, if desired, the amount could be credited to Revenue Account to show a full gross profit and then written off to Profit and Loss Account.

6. Fire insurance £182-50. The major part of this item represents a prepayment, as only 6 days out of the 365 covered by the payment can be treated as current expenditure: 385X£182.50 = £3. The balance of £179-50 will be carried forward.

7. Temporary sheds £290. This item may be considered as part of the cost of construction of the track, and thus capitalized. The receipts (if any) in respect of the demolished sheds must be credited to the cost of construction.

Illustration 4.

The following is a summary of the Alpha Brickyard Account for the years 'ended 31st December 19.1 and 19.2, in the books of Brickmakers, Ltd.

19.1

19.2

19.1

19.2

Bricks

Stock, 1st Jan. 250,000 Wages

450 100,000 1,500

Salaries.

250

175 Sales 2,320 Stock, 31st 550 Dec.

Coal, Stores,

Bricks

Plant, etc.

775

2,950

spoiled

1,600,000 100,000 50,000

3.280 850,000 1,785

175 100,000

170

Royalties

Used for

Rates, Head

New Kiln

Office Ex-

Balance

50,000 700,000

penses and

4,394

Sundries

225

354

Profit

255

£3.455

£6,349

£3,455

£6.349

CAPITAL AND REVENUE EXPENDITURE

In 19.2 work began on building a new kiln by the company's own labour 0807 the expenditure being included in the above account. You ascertain:

(a) That no particulars have been kept of the wages incurred in the building; men were sometimes diverted to the work for part shifts, while the foundations were dug in clay, which was used for brick making in the existing kiln.

(b) That it may be taken that the wages-cost per thousand bricks in 19.2 was lower by 5 per cent than in 19.1.

(d) That sundries included Employer's Liability Insurance at a premium of £0.50 per cent of capital wages.

Show the amounts you would transfer to capital expenditure or elsewhere, and construct the Alpha Brickyard Account for the year 19.2.

It is first necessary to appreciate the significance of the question. The expenditures outlined are made up both of capital and revenue, so that the object is to separate them. In constructing the kiln, naturally, the bricks made by the company will be utilized instead of making a purchase.

The cost of making the bricks is made up of materials, labour, and expenses, hence the first objective is the cost per 1,000 bricks. Then it will be observed that some are sold, some retained in stock, and some transferred, as it were, to another department, i.e. the 'Construction' Department.

The cost of bricks is ascertained as follows:

1. Wages-Cost of Making Bricks:

(a) Cost per 1,000 bricks in 19.2-a reduction of 5 per cent on 19.1 cost. Cost per 1,000 bricks in 19.1:

Wages paid

x1,000

Bricks produced

1,500

= £

-x1,000

= £1.

(1,750,000-250,000)

19.2 cost per 1,000 bricks = £1 less 5% thereof,

= £0.95.

(6) Bricks produced are 1,600,000 (i.e. 850,000+100,000+50,000+ 700,000-100,000).

Less used for new kiln

700,000

900,000

ACCOUNTANCY

(d) The wages chargeable to production of bricks for sale are 900,000 at £0.95 per 1,000

855

(e) The wages chargeable to production of bricks for new kiln are 700,000 at £0-95 per 1,000.

Total wages for bricks produced

(f). Wages on construction of kiln (see par 4)

665

1,520

800

Accounting for wages item of

2. Cost of Making Bricks:

£2,320

Stock at commencement

Wages (as above).

Salaries

(£550-£350) (i) (see par. 4)

Coal, Stores, etc. (£2,950-£2,100) (ii) (see par. 4)

Royalties, Rates,

etc.

(£354-£104) (iii) (see par. 4)

Bricks manufactured

Total.

Less Stock at end

Gross Production.

Less Spoilage

Net Production

Bricks

100,000

175

1,520

200

850

250

1,600,000

1,700,000

2,995

100,000

170

1,600,000

2,825

50,000

1,550,000

£2,825

'The item of £104 is Head Office Expenses £100, plus Employer's Liability Insurance of £4 (being £0.50 per cent on capital wages of £800).

3. Transfer Cost of Bricks to Kiln.' After having arrived at cost of bricks, it is now possible to charge out the 700,000 'sold' to the 'Con- struction' Department; i.e.:

700,000 1,550,000

*£2,825 = £1,276 [to nearest £]

4. Cost of Kiln. Inasmuch as the wages (as per 1 (f)), bricks (as per 3). and other capital costs are known, the compilation of the cost of construc- tion of the new kiln is simply as follows:

Wages

(see par. 1 (f))

800

Bricks

Salaries, etc.

Plant

(see par. 3)

1.276

(see par. 2 (i))

350

(see par. 2 (ii))

2,100

Head Office Expenses

(see par. 2 (iii))

100

Employer's Liability Insurance

(see par. 2 (iii))

£4,630

See footnote' on p.

CAPITAL AND REVENUE EXPENDITURE

ALPHA BRICKYARD ACCOUNT (RECONSTRUCTED)

for the Year ended 31st December 19.2

0809

Bricks

Stock (opening)

100,000

Wages

Salaries

1,520 Bricks Spoiled

175 Stock (closing)

100,000

170

Coal, Stores, Plant, etc.

Royalties, Rates, Head Office

850

200 Cost of Usable Bricks pro-

50,000

duced

c/d

Expenses and Sundries

1,550,000 2,825

Bricks Produced

250

1,600,000

1,700,000 £2,995

Cost of Usable Bricks Pro- duced

1,700,000 £2,995

b/d

1,550,000

2.825

Bricks used for New Kiln at Cost Cost of Sales of Bricks

c/d

700,000 1,276 850,000 1,549

Cost of Sales of Bricks Profit.

b/d

1,550,000 £2,825 850,000

1,550,000 £2,825

1,549 Sales. 236

850,000 1,785

850,000 €1,785

850,000 £1,785

The above account discloses the results of the operations of the brick- yard so far as they relate to trading and entirely eliminates the entries relating to capital, viz. the cost of constructing the kiln.

In a question of this character the student should at the first perusal obtain a general idea of what is required and proceed to find the first clue, which in this particular illustration is the wages cost of brick making. Ignoring quantities and intermediate balances carried down, the whole effect may be presented in abridged columnar form:

Revenue Capital Total

£.

Stock Wages

Coal, Plant, etc.

175

175 Sales

1,785

£ 1,785

1,520

800

2,320 Transfer

1,276

Salaries

Royalties, Rates, Head

Office Expenses

200

350

550 Stock

170

850 2,100

2,950 Cost of Kiln

4,630 24,394

and

Sundries

250 104

354

Transfer of Brick Cost

1,276

Profit

236

£3,231 £4,630 £6,349

If the assumption is made that only the bricks actually produced during the year are transferred, i.e. leaving the opening stock of 100,000 still on hand, the transfer will be based on £2,820 instead of £2,825 as the difference in the value of the 100,000 old bricks (£175-£170) will be

1£4,630-£236.

'As per question.

In order to obtain the desired results, transfers will be made to capital from the accounts presented in the original question, eg wages-dehit Kiln Account and credit wages with £800, thus reducing the figure of

£2,320 to £1,520.

ACCOUNTANCY

The depletion cost of clay, if known, will be charged up like the other expenses and its due proportion charged to capital.

It is assumed that the spoiled bricks realize nothing.

SUMMARY OF CLASSIFICATION OF EXPENDITURE

The position relating to expenditure may be summarized as follows.

EXPENDITURE

(a) Private

(i) Capital

(b) Business

Revenue

Charge against profits

(v) Appe priation of profits

(ii) Wholly

current charge.

(iv) Wholly deferred

(iii) Partly

current and

partly deferred

The debits will be as follows: (a) Proprietor's Capital Account. (b) (i) Asset.

(ii) Profit and Loss Account.

(iii).

(Profit and Loss Account for current proportion. Deferred Revenue item for carry-forward portion. (iv) Deferred Revenue item for the whole amount. (v) Profit and Loss Appropriation Account.

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