ACCRUAL BASIS AND CASH BASIS OF
ACCOUNTING
1.
Accrual Basis of Accounting
Accrual basis of accounting is a
method of recording transactions by which revenue; costs, assets and
liabilities are reflected in the accounts for the period in which they accrue.
This basis includes consideration relating to deferrals, allocations,
depreciation and amortization. This
basis is also referred to as mercantile basis of accounting. Under the companies Act 1956, all companies
are required to maintain the books of accounts according to accrual basis of
accounting.
2.
Cash Basis of Accounting
Cash basis of accounting is a
method of recording transactions by which revenues, costs, assets and
liabilities are reflected in the accounts for the period in which actual
receipts or actual payments are made
Hybrid or Mixed Basis
Is the combination of both the
basis i.e. cash as well as Accrual basis.
Incomes are recorded on cash basis but expense are recorded on Accrual basis
This is not a system of
accounting on its own. It is a
combination of the cash basic accounting and accrual basis accounting. This system is based on the concept of
conservatism.
Under the hybrid system of
accounting, incomes are recognized as in cash basis accounting i.e. when they
are received in cash and expenses are recognized on accrual basis i.e. during
the accounting period in which they arise irrespective of when they are paid.
CAPITAL AND REVENUE TRANSACTIONS
The concepts of capital and
revenue are of fundamental importance to the correct determination of
accounting profit for a period and recognition of business assets at the end of
that period. The distinction affects the
measurement of profit in a number of accounting periods.
Capital has been defined by
economists as those assets which are used in the production of goods and
rendering of services for further production of assets. In accounting, on the other hand, the capital
of a business is increased by that portion of the periodic income which has not
been consumed by the owner.
The relationship between capital
and revenue is that of between a tree and its fruits. It is the tree which produces the fruits, and
it is the fruit that can be consumed. If
the tree is tendered with care, it will produce more fruits, conversely, if the
tree is destroyed, there will be no more fruits. Likewise, revenue comes out of capital and
capital is the source of revenue.
Capital is invested by a person in the business so that it may produce
revenue. Moreover, as a fruit may give
birth to another new tree, different revenues may also produce further new
capital.
Capital can be brought in by a
person into the business in different forms- cash or kind. When capital is brought in the form of cash,
it is spent away on various items of assets that make the business a running
concern. Capital of the firm is thus,
represented by its inventory of assets.
Capital of a business can be
increased in a twofold way:
1.
When the
owner brings in more capital to the business; and /or
2.
When the
owner does not consume the entire periodic income.
When the owner brings in further
capital to his business, the amount is credited to the capital account.
Likewise, the net income for a period is credited to the capital account, and
if his drawings are less than that income, the capital is increased by the
difference. Example, capital Rs.500,
profit Rs.300, drawings Rs.350/-. So the revised capital will be Rs.450
(500+300-350).
The difference between the two
terms ‘revenue’ and ‘receipt’ should be carefully distinguished. A receipt is the inflow of money into
business, whereas revenue is the aggregate exchange value received for goods
and services provided to the customers.
CAPITAL AND REVENUE EXPENDITURES
Capital expenditure is the
outflow of funds to acquire an asset that will benefit the business for more
than one accounting period. A capital
expenditure takes place when an asset or service is acquired or improvement of
fixed asset is affected. These assets are expected to provide benefits to the
business in more than one accounting period and are not intended for resale in
the ordinary course of business. In
short, it is an expenditure on assets which is not written off completely
against income in the accounting period in which it is acquired.
Revenue expenditure is the outflow of funds to
meet the running expenses of a business and it will of benefit for the current
period only. A revenue expenditure is
incurred to carry on the normal course of business or maintain the capital
assets in a good condition.
It may be pointed out here that
expenditure need not necessarily be a payment made to somebody in cash- it may
be made by the exchange of another asset, or by assuming a liability. Expenditure incurrence and expenditure
recognition are distinct phenomena. Expenditure refers to the receipt of goods
and services, where as expenditure recognition is a matter to be decided
whether the expenditure is of capital or revenue nature. For example, the buying of an asset is a
capital expenditure but charging depreciation against profit is revenue
expenditure, over the entire life of that asset. On the application of
periodicity, accrual and matching concepts, accountants identify all revenue
expenditures for a given period for ascertaining profit. An expenditure which cannot be identified to
a particular accounting period is considered of capital nature.
The Accounting treatment of
capital and revenue expenditure is as under:-
Revenue expenditures are charged
as on expense against profit in the year they are incurred or recognized. Capital expenditures are capitalized- added
to an asset account.
The following are the points of
distinction between capital expenditure and revenue expenditure:
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S.No.
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Capital Expenditure
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Revenue Expenditure
|
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1.
|
The economic benefits of Capital expenditure are enjoyed for more than
one accounting period.
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The economic benefits of Revenue expenditures are enjoyed within a
particular accounting period.
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2.
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Capital expenditures are of non-recurring in nature.
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Revenue expenditures are of recurring in nature.
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3.
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All capital expenditure eventually becomes Revenue expenditures like
depreciation.
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Revenue expenditures are not generally capital expenditures.
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4.
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Capital expenditures are not matched with capital receipts.
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All revenue expenditures are matched with revenue receipts.
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Rules for Determining Capital
Expenditure
Expenditure can be recognized as
capital if it is incurred for the following purposes:
An expenditure incurred for the
purpose of acquiring long term assets (useful life is at least more than one
accounting period) for use in business to earn profits and not meant for
resale, will be treated as a capital expenditure. For example, if a second hand motor car
dealer buys a piece of furniture with a view to use it in business; It will be
a capital expenditure. But if he buys
second hand motor cars, for re-sale, then it will be revenue expenditure
because he deals in second hand motor cars.
When expenditure is incurred to
improve the present condition of a machine or putting an old asset into working
condition, it is recognized as a capital expenditure. The expenditure is capitalized and added to
the cost of the asset. Likewise, any
expenditure incurred to put an asset into working condition is also a capital
expenditure.
For example, if one buys a
machine for Rs.5,00,000 and pays Rs.20,000 as transportation charges and
Rs.40000 as installation charges, the total cost of the machine comes upto
Rs.560000. Similarly, if a building is purchased
for Rs.100000 and Rs.5000 is spent on registration and stamp duty, the capital
expenditure on the building stands at Rs.105000
If expenditure is incurred, to
increase earning capacity of a business that will be considered as of capital
nature. For example, expenditure
incurred for shifting the factory for easy supply of raw material. Here, the cost of such shifting will be a
capital expenditure.
Preliminary expenditure incurred
before the commencement of business is considered capital expenditure. For example, legal charges paid for drafting
the memorandum and articles of association of a company or brokerage paid to
brokers, or commission paid to underwriters for raising capital.
Thus, one useful way of
recognizing expenditure as capital is to see that the business will own
something which qualifies as an asset at the end of the accounting period.
Some examples of Capital
expenditure:
1.
Purchase
of land, building, machinery or furniture;
2.
Cost of
leasehold land and building;
3.
Cost of
purchased goodwill;
4.
Preliminary
expenditures;
5.
Cost of
additions or extensions to existing assets;
6.
Cost of
overhauling second-hand machines;
7.
Expenditure
on putting an asset into working condition; and
8.
Cost
incurred for increasing the earning capacity of a business.
Rules for Determining Revenue Expenditure
Any expenditure which cannot be recognized as capital expenditure can be
termed as revenue expenditure. Revenue
expenditure temporarily influences only the profit earning capacity of the
business. Expenditure is recognized as
revenue when it is incurred for the following purposes;
Expenditure for day to day conduct of the business, the benefits of which
lasts less than one year. Examples are
wages of workmen, interest on borrowed capital, rent, selling expenses, and so
on.
Expenditure on consumable items, on goods and services for resale either
in their original or improved form.
Examples are purchases of raw materials, office stationery, and the
like. At the end of the year, there may
be some revenue items (stock, stationery etc.) still in hand. These are generally passed over to the next
year though they were acquired in the previous year.
Expenditures incurred for maintaining fixed assets in working order. For example repairs, renewals and
depreciation.
Some examples of Revenue Expenditure
1.
Salaries
and wages paid to the employees;
2.
Rent and
rates for the factory or office premises;
3.
Depreciation
on plant and machinery;
4.
Consumable
stores;
5.
Inventory
of raw materials, work-in-progress and finished goods;
6.
Insurance
premium;
7.
Taxed
and legal expense and
8.
Miscellaneous
expenses.
Replacement of Fixed Assets
The above rules of capital and revenue
expenditure do not hold good when an existing asset is replaced for
another. If any asset is replaced with a
similar kind of asset, the expenditure incurred is treated as revenue
expenditure. For example, if a set of
weighing machines in a shop becomes defective and is replaced with a similar
set, the cost of replacement should be treated as revenue expenditure and it
should be charged to the profit and loss account. However, if an asset is replaced with an
asset which is superior to the previous one, the expense is partly capital and
partly revenue. For example, if a manual
typewriter costing Rs.5,000 is replaced with an electronic typewriter costing
Rs.15000, then Rs.5000/- will be revenue expenditure and the excess value of
the new typewriter over the old one Rs.10,000 will be capital expenditure.
Deferred Revenue Expenditure
Deferred revenue expenditures
represent certain types of assets whose usefulness do not expire in the year of
their occurrence but generally expires in the near future. These type of
expenditures are carried forward and are written off in future accounting
periods. Sometimes, we make some revenue
expenditure but it eventually becomes a capital asset (generally of an
intangible nature). If one undertake substantial repairs to the existing
building, the depreciation of the premises may be avoided we may engage our own
employees to do that work and pay them at prevailing wage-rate, which is of a
revenue nature. If this expenditure is treated as revenue expenditure and the
current year’s profit is charged with these expenses, we are making the current
year to absorb the entire expenses, though the benefit of which will be enjoyed
for a number of accounting years. To overcome this difficulty, the entire
expenditure is capitalized and is added to the asset account. Another example is an insurance policy, a
business can pay insurance premium in advance, say, for a 3 year period. The right does not expire in the accounting
period in which it is paid but will expire within a fairly short period of time
(3 years). Only a portion of the total premium paid should be treated as revenue
expenditure (portion pertaining to the current period) and the balance should
be carried forward as an asset to be written off in subsequent years.
Capital and Revenue Receipts
A receipt of money maybe of a capital or revenue nature. A clear distinction, therefore, should be
made between capital receipts and revenue receipts.
A receipt of money is considered as capital receipt when a contribution
is made by the proprietor towards the capital of the business or a contribution
of capital to the business by someone outside the business. Capital receipts do not have any effect on
the profits earned or losses incurred during the course of a year.
Additional capital introduced by the proprietor; by partners, in case of
partnership firm, by issuing fresh shares, in case of a company; and, by
selling assets, previously not intended for resale.
A receipt of money is considered as revenue receipt when it is received
from customers for goods supplied or fees received for services rendered in the
ordinary course of business, which is a result of the firm’s activity in the
current period. Receipts of money in the
revenue nature increase the profits or decrease the losses of a business and
must be set against the revenue expenses in order to ascertain the profit for
the period.
The following are the points of difference between capital receipts and
revenue receipts:
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S.No.
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Revenue Receipt
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Capital Receipt
|
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1.
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It has short-term
effect. The benefit is enjoyed within
one accounting period
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It has long-term effect. The
benefit is enjoyed for many years in future
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2.
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It occurs repeatedly. It is recurring and regular.
|
It does not occur again and
again. It is nonrecurring and
irregular.
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3.
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It is shown in profit and
loss account on the credit side, as an income for the year.
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It is shown in the Balance
sheet on the liability side.
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4.
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It does not produce capital
receipt.
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Capital receipt, when
invested, produces revenue receipt e.g. when capital is invested by the
owner, business gets revenue receipt (i.e. sale proceeds of goods etc.)
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5.
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This does not increase or
decrease the value of asset or liability
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The capital receipt decreases
the value of asset or increases the value of liability e.g. sale of a fixed
asset, loan from bank etc.
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6.
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Sometimes, expenses of
capital nature are to be incurred for revenue receipt, e.g. purchase of
shares of a company is capital expenditure but dividend received on shares is
a revenue receipt.
|
Sometimes expenses of revenue
nature are to be incurred for such receipt e.g. on obtaining loan ( a capital
receipt) interest is paid until its repayment.
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Capital and Revenue Profits
While ascertaining the trading profit of a business for a particular
period, a proper distinction is to be made between capital and revenue
profits. If profit arises out of an
ordinary nature, being the outcome of the ordinary function and object of the
business. It is termed as ‘Revenue
Profit’. But, when a profit arises out of a casual and non-recurring
transaction, it is termed as capital profit.
Revenue profit arises out of the sale of the merchandise that the
business deals in
Capital profit arises from:-
a.
Profit
prior to incorporation;
b.
Premium
received on issue of shares;
c.
Profit
made on re-issue of forfeited shares;
d.
Redemption
of Debenture at a discount;
e.
Profit
made on sale or revaluation of a fixed asset.
Generally, capital profits arise out of the sale of assets other than
inventory at a price more than its book value or in connection with the raising
of capital or at the time of purchasing an existing business. For example, if an asset, whose book value is
Rs.5000 on the date of sale, is sold for Rs.6000 then Rs.1000 will be
considered as capital profit. Likewise,
issue of shares at a premium is also a capital profit. Revenue profits are distributed to the owners
of the business or transferred to General Reserve Account, being shown in the
balance sheet as retained earnings.
Capital profits are generally capitalized – transferred to a capital
reserve account which can only be utilized for setting off capital losses in
future. Capital profits of a small
amount (arising out of selling of one asset) is taken to the profit and loss
account and added with the revenue profit-applying the concept of materiality.
Capital and Revenue Losses
While ascertaining losses, revenue losses are differentiated from capital
losses, just as revenue profits are distinguished from capital profits. Revenue losses arise from the normal course
of business by selling the merchantable at a price less than its purchase price
or cost of goods sold or where there is a declining in the current value of
inventories. Capital losses may result
from the sale of assets, other than inventory for less than written down value
or the diminution or elimination of assets other than as the result of use or
sale (floor, fire, etc.) or in connection with raising capital of the business
(issue of shares at a discount) or on the settlement of liabilities for a
consideration more than its book value (debenture issued at par but redeemed at
a premium). Treatment of capital losses
is same as that of capital profits.
Capital losses arising out of sale of fixed assets generally appear in
the profit and loss account (being deducted from the net profit). But other capital losses are adjusted against
the capital profits. Where the capital losses are substantial, the treatment is
different. These losses are generally
shown on the balance sheet as fictitious assets and the common practice is to
spread that over a number of accounting years as a charge against revenue
profits till the amount is fully exhausted.
Illustration:1.
State whether the following are capital, revenue or deferred revenue
expenditure.
1.
Carriage
of Rs.7500 spent on machinery purchased and installed.
2.
Heavy
advertising cost of Rs.20000 spent on the launching of a company’s new product.
3.
Rs.200
paid for servicing the company vehicle, including Rs.50 paid for changing the
oil.
4.
Construction
of basement costing Rs.1,95,000 at the factory premises.
Solution:
1.
Carriage
of Rs.7500 paid for machinery purchased and installed should be treated as a
capital expenditure.
2.
Advertising
expenses for launching a new product of the company should be treated as
revenue expenditure.
3.
Rs.200
paid for servicing and oil change should be treated as revenue expenditure.
4.
Construction
cost of basement should be treated as a capital expenditure.
Illustration:2.
State whether the following are capital or revenue expenditure.
1.
Paid a
bill of Rs.10000 of Mr.Kumar, who was engaged as the erection engineer to set
up a new automatic machine costing Rs.20000 at the new factory site.
2.
Incurred
Rs.26000 expenditure on varied advertisement campaigns under taken yearly, on a
regular basis, during the peak festival season.
3.
In
accordance with the long-term plan of providing a well-equipped labour welfare
centre, spent Rs.90,000 being the budgeted allocation for the year.
Solution:
1.
Expenses
incurred for erecting a new machine should be treated as a capital expenditure.
2.
Advertisement
expenses during the peak festival season should be treated as revenue
expenditure.
3.
Expenses
incurred for labour welfare centre should be treated as a capital expenditure.
Illustration: 3.
Classify the following items as capital or revenue expenditure:
1.
An
extension of railway track in the factory area;
2.
Wages
paid to machine operators;
3.
Installation
costs of new production machine;
4.
Materials
for extension to foremen’s offices in the factory;
5.
Rent
paid for the factory;
6.
Payment
for computer time to operate a new stores control system.
7.
Wages
paid to own employees for building the foremen’s offices.
Give reasons for your classification.
Solution:
1.
Expenses
incurred for extension of railway tracks in the factory area should be treated
as a capital expenditure because it will yield benefit for more than one
accounting period.
2.
Wages
paid to machine operators should be treated as Revenue expenditure as it will
yield benefit for the current period only.
3.
Installation
costs of new production machine should be treated as a capital expenditure
because it will benefit the business for more than one accounting period.
4.
Materials
for extension to foremen’s offices in the factory should be treated as a
capital expenditure because it will benefit the business for more than one
accounting period.
5.
Rent
paid for the factory should be treated as revenue expenditure because it will
benefit only the current period.
6.
Payment
for computer time to operate a new stores control system should be treated as
revenue expenditure because it has been incurred to carry on the normal
business.
7.
Wages
paid for building foremen’s offices should be treated as a capital expenditure
because it will benefit the business for more than one accounting period.
Illustration: 4.
For each of the cases numbered below, indicate whether the
income/expenditure is capital or revenue.
1.
Payment
of wages to one’s own employees for building a new office extension.
2.
Regular
hiring of computer time for the preparation of the firm’s accounts.
3.
The
purchase of a new computer for use in the business.
4.
The use
of motor vehicle, hired for five years, but paid at every six months.
Solution:
1.
Payment
of wages for building a new office extension should be treated as a capital
expenditure.
2.
Computer
hire charges should be treated as revenue expenditure.
3.
Purchase
of computer for use in the business should be treated as a capital expenditure.
4.
Hire
charges of motor vehicle should be treated as a revenue expenditure.
Illustration: 5.
State with the reasons whether the following are capital or revenue
expenditure:
1.
Freight
and cartage on the new machine Rs.150 and erection charges Rs.500
2.
Fixtures
of the book value of Rs.2500 sold off at Rs.1600 and new fixtures of the value
of Rs.4000 were acquired. Cartage on
purchase Rs.100
3.
A sum of
Rs.400 was spent on painting the factory.
4.
Rs.8200
spent on repairs before using a second hand car purchased recently, to put it
in usable condition.
Solution:
1.
Freight
and cartage totaling Rs.650 should be treated as capital expenditure because it
will benefit the business for more than one accounting year.
2.
Loss on
sale of fixture Rs.(2500-1600)=Rs900 should be treated as a capital loss. The
cost of new fixtures and carriage thereon should be treated as a capital
expenditure because the fixture will be used for a long period. So
Rs.(4000+100) the cost of new fixture will be Rs.4100.
3.
Painting
of the factory should be treated as revenue expenditure because it has been
incurred to maintain the factory building.
4.
Repairing
cost of second hand car should be treated as a capital expenditure because it
will benefit the business for more than one accounting period.
Illustration: 6.
State the nature (capital or revenue) of the following expenditure which
were incurred by Vedanta & co. during the year 30 th june 2016.
1.
Rs.350
was spent on repairing a second hand machine which was purchased on 8th
may,2016 and Rs.200 was paid on carriage and freight in connection with its
acquisition.
2.
A sum of
Rs.30000 was paid as compensation to two employees who were retrenched.
3.
Rs.150
was paid in connection with carriage on goods purchased
4.
Rs.20000
customs duty is paid on import of a machinery for modernization of the factory
production during the current year and Rs.6000 is paid on import duty for
purchase of raw materials.
5.
Rs.18000
interest had accrued during the year on term loan obtained and utilized for the
construction of factory building and purchase of machineries; however, the
production has not commenced till the last date of the accounting year.
Solution:
1.
Repairing
and carriage totaling Rs.550 for second hand machine should be treated as a
capital expenditure.
2.
Compensation
paid to employees shall be treated as a revenue expenditure.
3.
Carriage
paid for goods purchased should be treated as revenue expenditure.
4.
Customs
duty paid on import of machinery to be treated as a capital expenditure.
However, import duty paid for raw materials should be treated as revenue expenditure.
5.
Interest
paid during pre-construction period to be treated as a capital expenditure.
Illustration: 7.
State with reasons whether the following items relating to Prashali sugar
Mills Ltd. Are capital or revenue:
1.
Rs.50000
received from issue of shares including Rs.10000 by way of premium.
2.
Purchased
agricultural land for the mill for Rs.60000 and Rs.500 was paid for land
revenue.
3.
Rs.5000
paid as contribution to PWD for improving roads of sugar producing area.
4.
Rs.40000
paid for excise duty on sugar manufactured.
5.
Rs.70000
spent for constructing railway siding.
Solution:
1.
Rs.40000
(50000-10000) received from issue of share will be treated as a capital
receipt. The premium of Rs.10000 should
be treated as a capital profit.
2.
Cost of
land Rs.60000 to be treated as capital expenditure and land revenue of Rs. 500
to be treated as Revenue expenditure.
3.
Contribution
paid to PWD should be treated as Revenue expenditure.
4.
Excise
duty of Rs.40000 should be treated as revenue expenditure.
5.
Rs.70000
spent for constructing railway siding to be treated as a capital expenditure.
Illustration: 8
State with reasons whether the
following are capital expenditure or revenue expenditure;
1.
Expenses
incurred in connection with obtaining a license for starting the factory were
Rs.10,000.
2.
Rs.1000
paid for removal of stock to a new site.
3.
Rings
and pistons of an engine were changed at a cost of Rs.5000 to get full efficiency.
4.
Rs.2000
spent as lawyer’s fee to defend a suit claiming that the firm’s factory site
belonged to the plaintiff. The suit was
not successful.
5.
Rs.10000
was spent on advertising the introduction of a new product in the market, the
benefit of which will be effective during four years.
6.
A
factory was constructed at a cost of Rs.100000. A sum of Rs.5000 had been
incurred for the construction of the temporary huts for storing building
materials.
Solution:
1.
Rs.10000
incurred in connection with obtaining a license for starting the factory is a
capital expenditure. It is incurred for
acquiring a right to carry on business for a long period.
2.
Rs.1000
incurred for removal of stock to a new site is treated as revenue expenditure
because it is not enhancing the value of the asset and it is also required for
starting the business on the new site.
3.
Rs.5000
incurred for changing rings and pistons of an engine is a revenue expenditure
because, the change of rings and piston will restore the efficiency of the engine
only and it will not add anything to the capacity of engine.
4.
Rs.2000
incurred for defending the title to the firm’s assets is revenue expenditure.
5.
Rs.10000
incurred on advertising is to be treated as revenue expenditure.
6.
Cost of
construction of factory shed of Rs.100000 is a capital expenditure, similarly
cost of construction of small huts for storing building material is also a
capital expenditure.
Illustration: 9.
State clearly how you would deal with the following in the books of a
company:
1.
The redecoration
expenses Rs.6000
2.
The installation
of a new coffee-making machine for Rs.10000
3.
The building
of an extension of the club dressing room for Rs.15,000
4.
The purchase
of snacks and food stuff Rs.2000
5.
The purchase
of V.C.R and T.V for the use in the club lounge for Rs.15000
Solution:
1.
The redecoration
expenses of Rs.6000 shall be treated as revenue expenditure.
2.
The installation
of a new coffee-making machine is a capital expenditure because it is the
acquisition of an asset.
3.
Rs.15000
spent for the extension of club dressing room is a capital expenditure because
it creates an asset of a permanent nature.
4.
The purchase
of snacks and food stuff of Rs.2000 is revenue expenditure.
5.
The purchase
of V.C.R and T.V. for Rs.15000 is a capital expenditure, because it is the
acquisition of assets.
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