Introduction to Capital and Revenue Transactions
The concept of Capital and Revenue is very important in order to determine the accounting process correctly for a particular period of time. At the end of the accounting year, it is very necessary to bifurcate the transactions between capital and revenue for the recognition of the assets of the business.
Accounting is the process of identifying, recording, classifying, summarizing, interpreting, and communicating financial information relating to an organization to the interested users for judgment and decision-making. In this segment, some basic terms are discussed that can be helpful in understanding advanced accounting.
The transactions which have long-term effects on the business are known as capital transactions. Basically, by this, we understand that the effect of these transactions can be extended to a period of more than one year.
What are Business Transactions?
Transaction refers to a financial agreement or an economic event that various parties enter into and the details of the transaction are recorded in the books of accounts. Basically, it is an agreement between two parties that involves the transfer or exchange of goods or services. It is termed as ‘Business Transaction’ or ‘Financial Transaction’.
Example: Purchase of goods, receipt of money from the debtors, payment to a creditor, purchase or sale of fixed assets, payment of interest, payment of dividend, etc.
Characteristics of a Business Transaction
It is associated with money or money that is worth goods or services.
It occurs when the transfer or exchange of goods and services takes place.
It brings about a shift in the financial position of an organization (i.e., the assets and the liabilities of the organization).
It makes an impact on the accounting equation of a business firm.
It has two sides --- Receiving which is called Debit and Giving which is called Credit of the benefit.
The total assets of a business must be equal to the total liabilities and capital of the firm after each transaction.
The nature of each transaction must be verified very accurately since it determines the financial status of a business unit.
Classification of Business Transaction
A transaction can be of four types: Cash transaction and Credit transaction, External Transaction and Internal Transaction
Cash Transaction:
When the amount is received or paid immediately on entering into an agreement then it is a cash transaction.
Credit Transaction:
When an agreement is done between two parties wherein one party promises to pay at a later date then it is a credit transaction.
External Transaction:
When a transaction takes place between the business entity and the second party then it is called an external transaction.
Example: XYZ firm sold goods to Mr A.
Internal Transaction:
In this transaction, any second party is not involved.
Example: Depreciation charged on machinery
What are Revenue and Capital Transactions?
Revenue Transaction
When a transaction arises due to day-to-day business activities and the transaction affects only one accounting period or a transaction whose benefits are received within one year then it is called a revenue transaction.
Revenue transactions can be of the following two types.
Revenue expenditure
Revenue receipts
Revenue Expenditure:
It is the expenses incurred for the normal activities of the business and whose benefit is consumed within the accounting period. There is a direct relationship between the revenue and the accounting period.
Example: Rent of the establishment, electricity, salaries, cost of goods sold, etc.
Revenue Receipts:
The amount that is received or receivable for normal business activities like the sale of goods or rendering services or interests of business investments. This is shown in the Profit & Loss Account in the case of profit enterprises and in the Income and Expenditure account in the case of Non-profit organizations.
Example: Sale of goods, rendering services, interest on fixed deposits or capital investments, etc.
Capital Transaction
When a transaction has a considerable effect of more than one accounting period or a transaction whose benefit is received more than one year is called a Capital transaction.
A capital transaction can be of the following two types.
Capital expenditure
Capital receipts
Capital Expenditure:
It is the expense that is incurred while procuring assets or maintaining the existing assets which will increase the production capacity resulting in an increase in earning capacity. Capital expenditure is incurred to purchase tangible or intangible assets. This expenditure is shown in the Balance Sheet of the entity.
Example: Purchase of machinery to manufacture goods, computers to operate a business, money paid for goodwill, etc.
Capital Receipts:
It is the amount received or receivable by selling assets and they are not revenue in nature. They are also shown in the balance sheet of the entity.
Example: Amount received or receivable from the sale of machinery, building, furniture, investment, loan, etc.
Difference between Capital and Revenue Transaction
Capital transactions consume long term benefits from the transactions whereas revenue transactions consume short term benefits from the transactions.
The capital transaction has an irregular recurrence of transactions whereas revenue transaction has a regular recurrence of transactions.
Rules to Determine Capital Expenditure
Any type of expenditure that increases the earning capacity of that business is also considered as capital expenditure. Any expenditure which incurs on the improvement in the present condition of fixed assets to bring it back in a good working condition is considered as capital expenditure.
Those expenditures which are made for the purchase of fixed assets with the purpose of resale will not be considered as capital expenditure.
Rules to Determine Revenue Expenditure
Expenditures that are incurred on the goods and services and consumable items.
Expenditure that is incurred in maintaining the fixed assets like repairing and renewing is the revenue expenditure.
Expenditures incurred on the day to day activities of the business entities are a revenue
Expenditure. The benefits from revenue expenditures last for a period of one year only.
Important Accounting Terms
Capital
Capital is the amount invested by the proprietor in the business in the case of proprietorship or by partners in the case of the partnership business. It may be in the form of cash or in the form of assets.
Capital Profit
When a profit is earned by selling an asset of a business at a higher cost than the original cost then it is termed as capital profit. The profit earned from the sale of assets is credited to the profit & loss account as an unusual item of income. If the profit is earned on the sale of shares, then the profit earned from capital is credited to the Capital Reserve.
Capital Loss
The loss that is incurred on the sale of business assets or while raising more funds for the business, is called a capital loss. It is shown as fictitious assets in the balance sheet.
Revenue
Revenue is the cash inflow or receivables arising in the course of business activities of an enterprise from the sale of goods or from rendering services or interests earned from the usage of business resources by others, dividends on business investments, etc.
Note: Revenue is different from income.
Revenue Profit
When a profit is earned in the ordinary course of business operations then it is termed as revenue profit. The profit earned from revenue appears in the Profit & Loss Account. Revenue profit and revenue income are the same.
Example: Profit made from the sale of goods, income received from letting out business property, dividends received on investments, etc.
Revenue Loss
The loss that is incurred from the day-to-day operations of a business like the sale of goods, theft, bad debts, etc., is termed as revenue loss. It appears in the profit & loss account of the year in which it arises.
Deferred Revenue Expenditure
Some revenue expenses are the expenses, the benefit of which may be accrued in more than one financial year is termed deferred revenue expenditure. Every accounting year, a part of this expenditure is written off even though it is revenue in nature. It appears in the balance sheet till it is written off completely.
Example: Advertising expenses for branding, professional fees, discounts on shares and debentures, etc.
FAQs on Capital vs. Revenue Transactions
1. What is the fundamental difference between capital and revenue transactions in accounting?
The fundamental difference lies in the timeframe of the benefit received. A capital transaction is an expenditure or receipt whose benefit extends over multiple accounting periods, typically more than one year. It usually involves acquiring or selling fixed assets. In contrast, a revenue transaction relates to the daily operations of a business, and its benefit is consumed within a single accounting period. For more foundational concepts, you can refer to the Introduction to Accounting Class 11 Notes.
2. How do you distinguish between capital expenditure and revenue expenditure?
The distinction between capital and revenue expenditure is based on their purpose and benefit period:
Capital Expenditure: This is an amount spent on acquiring or improving long-term assets, such as machinery, buildings, or furniture. Its purpose is to increase the earning capacity of the business. The benefit lasts for several years, and it is shown on the asset side of the Balance Sheet.
Revenue Expenditure: This is an expense incurred for the day-to-day running of the business, like paying salaries, rent, or purchasing raw materials. Its purpose is to maintain the existing earning capacity. The benefit is exhausted within the current accounting year, and it is shown in the Trading and Profit & Loss Account.
3. Can you provide some common examples of capital and revenue items?
Certainly. Here are some common examples to illustrate the difference:
Examples of Capital Items: Purchase of land and building, installation of new machinery, money raised from issuing shares, and long-term loans taken from a bank.
Examples of Revenue Items: Sale of goods, salaries paid to employees, rent for the office premises, commission received, and discount allowed to customers.
4. What is the difference between a capital receipt and a revenue receipt?
Capital and revenue receipts differ based on their nature and frequency:
A capital receipt is an amount received from sources that are not part of the main business operations. These are generally non-recurring and either create a liability (e.g., a bank loan) or reduce an asset (e.g., sale of machinery). They are shown on the liabilities side of the Balance Sheet.
A revenue receipt is income generated from the normal, everyday activities of the business, such as the sale of goods or services. These receipts are recurring in nature and are shown on the credit side of the Trading and Profit & Loss Account. To learn more, see our detailed explanation of Capital Receipt and Revenue Receipt.
5. Why is it so important for a business to correctly classify transactions as capital or revenue?
Correct classification is crucial for several reasons. Firstly, it ensures the ascertainment of true profit or loss for an accounting period. Treating a capital expense as a revenue expense would understate profits. Secondly, it ensures a true and fair view of the financial position in the Balance Sheet. Incorrectly classifying items would misrepresent the value of assets and liabilities. Finally, it is essential for legal compliance, as accounting standards and company law mandate this distinction. This aligns with the fundamental theory base of accounting.
6. What happens if a business mistakenly treats a capital expenditure as a revenue expenditure?
This is an error of principle with significant consequences. If a capital expenditure (e.g., purchase of a new computer) is wrongly debited to an expense account (e.g., Office Expenses), it leads to:
Understatement of Profits: The Profit & Loss Account will show a higher expense, thus reducing the net profit for the year.
Understatement of Assets: The Balance Sheet will not reflect the newly acquired asset, leading to an incorrect representation of the company's financial position.
No Depreciation Charge: Since the asset is not recorded, no depreciation can be charged on it in subsequent years.
Such mistakes require rectification entries to correct the accounts. You can learn more about how to fix such issues in Trial Balance and Rectification of Errors.
7. How do capital and revenue transactions affect a company's financial statements differently?
The impact is fundamentally different and segregated between the two main financial statements:
Capital Transactions primarily affect the Balance Sheet. For instance, a capital expenditure (like buying a factory) increases assets, while a capital receipt (like taking a loan) increases liabilities. They are about the long-term financial structure.
Revenue Transactions primarily affect the Trading and Profit & Loss Account. Revenue receipts (like sales) increase the income, and revenue expenditures (like wages) increase the expenses, directly determining the net profit or loss for the period.
8. Is heavy expenditure on an advertising campaign a capital or revenue expense?
This is a classic example of a special case. Typically, advertising is a revenue expenditure because its benefit is expected to be short-term. However, if a company incurs a very large, one-time advertising expense to launch a new product with the expectation of generating benefits over several years, it may be treated as a Deferred Revenue Expenditure. In this case, the amount is written off over a few years in the Profit & Loss Account, rather than being fully expensed in the year it was incurred.
9. What is the distinction between a capital loss and a revenue loss?
The distinction is based on the source of the loss. A capital loss arises from the sale of a long-term or fixed asset for less than its book value. For example, selling company machinery for ₹80,000 when its book value was ₹1,00,000 results in a capital loss of ₹20,000. In contrast, a revenue loss is incurred during the normal course of business operations, such as loss of stock due to fire, theft of cash, or goods becoming obsolete.
