What are the principal considerations in determining whether any item of expenditure by a manufacturing and trading company should be allocated to capital or revenue?

What are the principal considerations in determining whether any item of expenditure by a manufacturing and trading company should be allocated to capital or revenue? State the importance of allocation between Capital and Revenue.

Ans.

CAPITAL EXPENDITURE

It is that expenditure which is incurred in purchasing new property which will help the production of goods and hence increase the earning capacity of the business. This type of expenditure in “incurred in acquiring assets for the purpose of earning income or increasing the earning capacity of the business.” If heavy expenditure is incurred on repairs which ultimately increase the efficiency of the plant or machinery, such an expenditure is of capital nature. Similarly expenses incurred in erecting plant and machinery should be capitalised as such expenses increase the value of machinery.

Sometimes a wrong idea is formed that if a heavy expenditure is incurred, it is of the nature of capital expenditure and when a small expenditure is incurred, it is revenue expenditure. It may or may not be so. It depends upon the circumstances of each particular case.

The auditor should, therefore, see the basis on which expenditure has been allocated and should not be guided by the amount of expenditure alone.

REVENUE EXPENDITURE

It is an expenditure which is periodically incurred to maintain the revenue-earning capacity of the business, e.g.,

1. Expenditure incurred to maintain the value of any existing asset. e.g., ordinary repairs, whitewashing of the building, etc.

2. Expenditure incurred in the ordinary conduct and administration of the business, i.e., rent, salaries, wages, etc.

3. Expenditure incurred in connection with the administration and distribution of the goods manufactured or sold, e.g., commission, travelling expenses, advertising and so on.

It is not easy to classify a particular expense as revenue expenditure. e.g., wages during the ordinary course of manufacturing business will be of a revenue nature, while on the other hand wages paid for erecting and fitting a new machinery will be of a capital nature, carriage paid for buying a new machinery, interest paid during the construction of work, legal charges incurred for purchasing a building, etc. will all be considered as expenses of capital nature and will be debited to the particular asset account while on the other hand carriage expenses, interest on money borrowed or debentures, etc., will be considered as revenue expenditure and will be debited to the revenue account.

IMPORTANCE OF ALLOCATION BETWEEN CAPITAL AND REVENUE

The correct allocation of expenditure between capital and revenue is of great importance as it will affect the profit and loss account and the balance-sheet of a concern.

Improper allocation of expenditure between capital and revenue will have far-reaching results on the accounts of a concern. The auditor should very carefully see that proper allocation is made. He should get a certificate regarding the allocation of expenditure from a responsible official and mention that fact in his report especially when the expenditure involved is very heavy. he should state in his report that he has relied upon the certificate from a responsible official about the allocation of expenditure between capital and revenue, but he should not be negligent and cannot absolve himself om liability behind the clock of the certificate.