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Capital and revenue -- Aspects of business expenditure

N. R. Parasuraman looks at the two categories of expenditure a company can incur, and suggests ways to organise them effectively

A BUSINESS organisation necessarily incurs a number of expenses during the course of its operations. As we have seen already in earlier pieces, the profit or loss that the enterprise makes is determined by the difference between the income and the expend iture. The question is whether all the items resulting in an outflow of cash can be called ``expenditure'' for this purpose.

The various types of expenditure that a company can possibly incur can be classified into two broad categories. The first category consists of items incurred for carrying on the day-to-day operation of the organisation. These expenses have to be incurred ``to keep things going''. Salaries paid to employees, expenditure on rent incurred, interest payments, factory expenses, administrative expenses and sales commissions are examples of this category.

The other category relates to assets purchased by the company, which can be put to use for a number of years to come. They result in increased productivity or greater efficiency and are expected to contribute to improving the earning capacity of the comp any. New machineries purchased, renovation of buildings, purchase of furniture and fixtures, purchase of computer equipment and office vehicles are examples. The former category is called revenue expenditure and the latter capital expenditure.

In finalising the accounts of a given year, the company takes into account only the revenue items. From the income, revenue expenditure is deducted to arrive at the profit. Why are Capital items not considered? These items result in benefits not merely f or the current year, but also for future years. It would not be fair for the current year to ``suffer'' for the whole of the expenditure, when a fair portion of the benefits is going to be enjoyed by future years.

For instance, machinery that was purchased paying Rs 1,00,000 can be used for, say, five years. This means that each of the five years has to take a share of the total expenditure of Rs 1,00,000. It so happens that the expenditure was incurred in the cur rent year, but the benefits will accrue for the future years as well. The current year need just take a share of the expenditure proportionate to its use.

So, in other words, the machinery having five years of useful life should be written off over the five years, and if, a equal proportion is allocated to each of the years, the current year and four subsequent accounting periods will be charged with Rs 20 ,000 each. This is called amortisation and is dealt with in greater detail a little later.

What are the broad criteria to determine whether an item of expenditure is to be treated as a capital item or a revenue item? The company's size and operations play an important part in this. A huge corporation may prefer to treat an expenditure of Rs 10 ,000 incurred on a printer as revenue, even though it could be used for future years. A small company might capitalise an equipment costing Rs 5,000 and spread the expenditure to the useful life of the equipment. In both the cases, the companies concerne d will be aware that if they capitalise expenditure, the immediate effect will be to improve the current profitability.

Depreciation

As we saw above, in the case of ``capital'' expenditure, the degree of allocation of the overall expenditure among the useful years assumes significance. The amount charged to a year on this count is called ``depreciation'' and the process of writing off the value of a capital asset over a number of years is called ``amortisation''. The intuitive method would be to determine the useful life by an engineering estimation, and divide the cost of the machinery (less than any expected salvage value at the en d of the period), equally among the useful years.

Under this method, each year will get an equal share of the charge. By any chance, if the machinery does not last the full distance and is scrapped, say, in year three, the balance expenditure remaining to be written off will be charged to that year. In such an eventuality, year three will ``suffer'' more than years 1 and 2. This is an unexpected development and could not have been anticipated. Conversely, it may be discovered at the end of year 5 that the machinery is not worthless after all and could be used for a further period or two. In such cases, year 6 and all the subsequent periods that use the machine get the usage ``free'', since the entire value of the machine has been absorbed in the books in the earlier periods.

Among many other alternative methods of charging depreciation, the Reducing Balance Method or the Written Down Value method (WDV method) is also quite popular. The charge on account of depreciation will be heavier for the earlier years and will come prog ressively down as the useful life increases. This is the method of depreciation followed under the Income-Tax rules. The system has its logical base from the fundamental hypothesis that any capital expenditure is of maximum value in the initial years and has lesser and lesser value as the years go by. The charge is proportionate to this assumed value.

There is a further logic to the Written Down Value Method. The repair and maintenance expenditure of any asset is likely to be lower in the initial years and will be higher as the years progress. Under the WDV Method, depreciation is highest in the initi al years and comes down as the year's progress. The two charges together -- repairs and depreciation -- constitute the total ``expenditure'' to the company on the asset for any year. By following differing patterns, the total charge on this count will re main more or less the same for all the years under the Written Down Value Method.

Depreciation as a charge has also a conceptual background. Suppose a company purchases capital equipment expected to last five years, it must plan the replacement of the asset after five years, as otherwise, the machinery will become useless and the comp any will have nothing to substitute it with. The replacement should be planned by setting aside a portion of the profits into a fund, which will accumulate to a figure more or less sufficient for the purpose of replacing the equipment. This is what depre ciation achieves in effect.

Deferred revenue expenditure

Sometimes expenditure may be predominantly revenue in nature, but its benefits could be enjoyed by subsequent years. Expenses incurred by companies on Research & Development and/or Public issue of shares or debentures are cases in point. The amounts incu rred are fairly large and it is conceivable that a portion of the benefit of these expenses will be enjoyed by subsequent years. It is conventional to treat such items as capital expenditure and amortise them over a number of future periods. However, pru dent accounting demands that when it is realised that an expenditure will have no further benefit to give beyond the current year, it must be treated as revenue and written off.

Concept check

1. Under what category can we place amounts paid for acquisition of brands?

2. Do we need to depreciate items, which are appreciating in value?

3. If a capital equipment is purchased with an expected life of seven years, but after two years it is realised that the useful life overall will be only five years. How do we take this into account for purposes of depreciation?