Why the distinction between capital and revenue is considered to be vital importance or Difference between capital and revenue expenditure

IMPORTANCE OF DISTINCTION BETWEEN CAPITAL AND REVENUE :-

While calculating the taxable income one must know the difference the revenue and capital. If he does not know then he cannot calculate the real taxable income due to the following reasons :

1.      Income tax is imposed on revenue receipts.

2.      Income tax is not levied on capital receipts.

3.      When we want to determine the profits of a business or profession it is the revenue expenditure, which is deducted from the trading receipts.

4.      Deduction from capital receipts is not allowed. Keeping in view the above reasons one person must be capable to distinguish between revenue and capital expenditure and the he should determine the profits of the business. Sometimes it becomes very difficult to know that the particular receipt is a capital receipt or revenue receipt. However some tests are applied for this purpose which may guide to know the facts.

Following are the important tests which may be applied to know the difference.

1.      Purchase Of Fixed Asset or Floating Asset Purchase :-

When money is paid to purchase in asset, we have to decide that it is a fixed asset or floating asset. If the money is paid on the purchase of fixed asset, it is an expenditure of capital revenue.

Example 1 : Miss. Sophie purchases the building and machinery for sugar factory. It is an expenditure of capital nature, because building and machinery is a fixed asset. On the other hand money is spent on floating nature it will be called revenue expenditure.

Example 2 : Miss. Sophie purchases the sugar-cane raw material for her factory. It is revenue expenditure and it will be deducted from the sale of business.

2.      Expenditure On Opening Business :-

While establishing the new business all the expenses are called capital expenditure.

Example :

1.      Purchase of land

2.      Construction of building

3.      purchase of machinery

4.      Fee paid the manager

5.      Govt. fee paid to the obtain the license etc.

Note : When the fee is paid for the renewal of license it will be treated as revenue expenditure.

Any how the initial expenditures are included in the capital expenditure.

3.      Business Extension :-

If a businessman spends money to expand the volume of business, such expenditure will be called capital expenditure.

Example : National bank limited opens new branches to extend the volume of business, it will be considered as the capital expenditure. On the other hand National bank spends the money on the repair of buildings, it will be a revenue expenditure.

4.      Period Of Benefit :-

When we want to determine the nature of expenditure we also calculate the period of benefit.

a) If expenditure gives a continuous benefit to the business. It will be called capital expenditure.

b) On the other hand if the period of benefit is less then one year it will be treated as revenue expenditure.

Example : Sun-silk Shampoo company introduces the sun-silk paste and fixes the advertising boards. Such expenditure will benefit the company through out the life of the product. On the other hand if once it is advertised on the T.V. Such expenditure will be included in the day to day expenditure.

5.      Earning Capacity Principle :-

If the earning capacity increases due to increase in expenditure, it will be called capital expenditure. On the other hand it increase in expenditure only maintains the earning capacity, it will be called revenue expenditure.

Example : Royal textile company replaces the part of machine and spends twenty thousand. It is a revenue expenditure because it only maintains the earning capacity.

Example : Royal textile company installs two new weaving machines. The production of the company becomes double. Now such such expenditure will be called capital expenditure because it has increased the earning capacity of this company.

Example Of Capital Expenditure :

1.      Cost of issuing shares and debentures.

2.      Cost of experiments.

3.      Purchase of machinery and building etc.

Example Of Revenue Expenditure :

1.      Payment made for rented machinery.

2.      Pension paid.

3.      Repair of machinery.

4.      Distribution of samples.

5.      Expenses on display exhibition.