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 −
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.
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 −
Freight inward & outward
Salary and wages
Selling and distribution expenditure
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
Annual lease rent
Loss on sale of fixed assets
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.
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.
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.
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.
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.
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.
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.
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.