Auditing Capital and Revenue – tryspring

By | October 14, 2019

Auditing – Capital and Revenue

In this chapter, we will discuss the Auditing of Capital and
Revenue.

It is essential to distinguish revenue expenses and capital
expenditure to prepare correct financial statements. The absence
of these will lead to misleading results where no one can
conclude anything. As per this principle, revenue item should be
posted in Trading and Profit & Loss account and capital item
should be posted in the balance sheet of any firm.

There is no firm rule for making distinction between capital
expenditure and revenue expenses. Expenses may be of capital
nature and capital expenditure may be of revenue nature.
Allocation can be done only after knowing all the facts &
figures. However, we have the following rules that act as guiding
principles for making a distinction between capital expenditure
and revenue expenses −

Capital Expenditure

Consider the following points to decide the nature of capital
expenditure −

  • The expenditure, the benefit of which cannot be consumed or
    utilized in the same accounting period should be treated as
    capital expenditure.

  • Expenditure incurred to acquire fixed assets for the company.

  • Expenditure incurred to acquire fixed assets, erection and
    installation charges, transportation of assets charges,
    travelling expenses directly relates to purchase fixed assets
    are covered in capital expenditure.

  • Capital addition to any fixed assets which increases the life
    or efficiency of those assets; for example, additional
    expenses made on a building.

Revenue Expenditure

The benefit of which is consumed in the same accounting year in
which those are incurred comes under the category of revenue
expenditure. Following are a few examples of revenue expenditure

  • Purchases

  • Wages

  • Freight inward & outward

  • Salary and wages

  • Selling and distribution expenditure

  • Depreciation

  • Assets purchased for resale purpose

  • Repairs and renewal expenditure which are necessary to keep
    fixed assets in running and efficient conditions

  • Accidental losses like loss on account of fire, etc

  • Interest on borrowings

  • Royalty paid

  • Annual lease rent

  • Loss on sale of fixed assets

How to Allocate Revenue or Capital?

An item can be classified and allocated as revenue or capital on
the basis of principles discussed above. Allocation requires
proper care and attention otherwise there will be misleading
financial results. Complete situation and facts are important
before any allocation. Treating revenue expense as capital
expenditure will increase profit and treating capital expenditure
as revenue expense will reduce the profit.

Treatment for same nature of expenses can be different at two
different point of time; for example, inward freight, insurance,
wages and brokerage are of revenue nature in ordinary course of
business but the same are treated as capital expenditure when
they are incurred to purchase or development of any assets.

Following points can be considered to decide the nature of
expenses −

  • Whether expenses are incurred to purchase or development of
    an asset.

  • Is it for an addition or improvement to fixed asset?

  • Whether it increases the revenue earning capacity.

  • Whether expenditure is towards raising of the capital sum.

If answer is in the affirmative, then expenditure is of capital
nature otherwise of revenue nature.

Revenue Expenses Which are Treated as Capital Expenditure

Let us now discuss in brief the revenue expenses which are
treated as capital expenditure.

Following is a list of expenses which come under revenue
expenditure but should be treated as capital expenditure −

  • Raw material and consumables − If these are used in
    making any fixed assets.

  • Cartage and freight − If these are incurred to bring
    in fixed assets.

  • Repairs & renewals − If incurred to enhance life
    or efficiency of the assets.

  • Preliminary expenditure − This is the expenditure
    incurred during the formation of a business.

  • Interest on capital − If paid for construction work
    before the commencement of production or business.

  • Development Expenditure − In some businesses,
    long-term development and heavy amount of investment is
    required before starting production especially in Tea and
    Rubber plantation; such expenditure should be treated as
    capital expenditure.

  • Wages − If paid to build up assets or for erection and
    installation of Plant and Machinery.

Deferred Revenue Expenditure

Some non-recurring and special nature of expenditure for which
heavy amount is incurred and the benefits for the same spreads to
upcoming years, such expenditure is to be treated as capital
expenditure and will show as assets of the firm. Part of the
expenditure should be debited to Profit & Loss account every
year. For example, if heavy amount is paid for the advertisement
of a product, the benefit of which are expected four years down
the line, then it should be debited as 1/4 of the part in Profit
& Loss account as revenue expenses and balance 3/4 will be
shown as assets in Balance Sheet.

Auditor’s Duty regarding Deferred Revenue Expenditure

Let us now understand an Auditor’s duty regarding deferred
revenue expenditure. The duties are listed below −

  • The Auditor should investigate the whole transaction in
    totality to understand the treatment of the transaction.

  • The Auditor should check the complete details of transaction,
    like total expenditure incurred initially, year wise amount
    written off and the amount carried forward to next year.

  • Carried forward amount should be shown in Balance Sheet.

  • The Auditor should ensure that the amount of exceptional loss
    should not be mixed with the deferred revenue expenditure.

Capital and Revenue Profit

Premium received on issue of shares and profit on sale of fixed
assets is main example of capital profit and should not be
treated as revenue profit. Capital profit should be transferred
to capital reserve account which is used to set off capital
losses in future if any.

Capital and Revenue Receipts

Sale of fixed assets, capital employed or invested and loans are
example of capital receipts. On the other hand, sale of stock,
commission received and interest on investment received are
examples of revenue receipts. Revenue receipts will be credited
to profit and loss account and on the other hand capital receipts
will affect the Balance-sheet.

Auditor’s Duty regarding Capital and Revenue Receipts

  • Knowledge about the nature of business is very important for
    an Auditor to decide the nature of transaction; for example,
    purchase of motor vehicle is a revenue expenditure for a
    motor vehicle dealer whereas, it is a capital expenditure for
    any other businessman.

  • The Auditor should study and verify the complete transaction
    by obtaining relevant data and documents relating to
    transaction.

  • He may discuss any doubtful or controversial point with
    concerned official of a company before reaching to any
    conclusion.

  • The Auditor should observe the classification of transactions
    according to correct accounting principles.

Capital and Revenue Losses

Discount on issue of shares and losses on sale of fixed assets
are capital loss and only would be set off against capital
profits only. Revenue losses on normal business activity are part
of profit and loss account.

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