BASES OF ACCOUNTING

 6.3 BASES OF ACCOUNTING

The accounts are prepared by the business either on cash basis or on accrual basis. In the Cash System accounting entries are made on the basis of dash received or cash paid. In other words, no entry is made when an income is' eqed or an expenditure is incurred. It will be recorded in books only when thq amount involved is actually received or paid. Thus, the incomes earned but not yet received (accrued income) or the expenses incurred but not yet paid (outstanding expenses) are completely ignored while preparing the final accounts. For example, rent for the month of December, 1987 paid in January 1988 will be taken to the Profit and Loss Accounlt of 1988 even though the expenditure relates to 1987. This leads to hc~rrect ascertainment of profit or loss of the business. Bxt it is not true of the accounts maintained on accrual basis, Under the Accrual System (aiso called Mercantile System of Accounting) the financial effect of transactions is recorded in th,: books as and when they occur and not when the amount involved is received or paid by the business. This system attempts to relate the revenues and expenses to the accounting period during which they are actually earned or incurred. Thus, rent for the month of December, 1987 paid in January, 1988 will betaken into the Profit and Loss Account of 1987 and not of 1988. This is more logical because the benefit of expenditure is enjoyed in the year 1987 and not in 1988.

The main difference between accrual basis of accounting and cash basis of accounting is the timing of recognition of revenues, gains, expenses and losses. The objective of accrual accounting is to account for the effect of transaclions and events to the extent their financial effect are recognisable and measurable in the periods in whcih they occur. The adjustments made in the final accounts in respect of outstanding cxpenses, prepaid expenses, income received h advance, inc~rne earned but not yet received, etc. are in fact based on accrual accounting. You will learn about t~nese adjustments in Unit 8.

Sometimes the businessman adopts a combination of both the above systems. In that case it is called Mixed or Hybrid System. For exabple, he may consider inconles on cash basis and expenses on accrual basis. This is consideerd  most conservation , In practice most enterprise adopt the accrual basis of accounting.

6.4 DISTFNCTHON BETWEEN 'CAPITAL AND REVENUE

You know that a firm prepares Profit and Loss Account for ascertaining the net resuit of business operations and the Balance Shcct for determining the financiai position of the business. These are prepared with the help of Trial Balancs which shcrws the final position of all ledger accounts'. All items appearing in the Trial Balance ale transferred either to the Profit and'lsss Account or to the Balance Sheet. As per rules, the items of revenue nature are taken to the Profit and Loss Account and the items of capital nature are shown in the Balance Sheet. In other words whether an item appearing in the Trial Balance is to be taken to the Profit and Loss Account or the Balance Sheet depends upon the capital and revenue natu e of the item. If any item is wrongly classified i.e., if an item of revenue nature is t f eated as a capital item or vice versa, the Profit and toss Account will nqt reveal the correct amount of profit and the Balance Sheet will not reflect the true and fair view of the affalrs of the business. It is therefore necessary to determine correctly whether an itcmn is of capital nature or of a revenue nature and record it in the books accordingly. There are certain rules governing the allocatidn of expenditures and receipts between capital and revenue which should be clearly understood..

6.4.1 Capital and Revenue Expenditures 

You incur expenditure on various items every day. You buy food items, stationery, cosmetics; utensils, furniture, etc. Some of them are consumablles and sdmc are durables. The benefit of expendituraon consutnables like stationery, cosmetics, etc. is derived over a short period. But in case of durables like furniture, utensils, etc., the benefit spreads over a number of years. Same is true of business also. In business you incur expenditure on two types of items: (i) routine items like stationery, and (ii) fixed assets like machinery, building, furniture, etc., whose benefit is available over a number of years. In accounting terminology the first category of expenditure is called revenue expenditure and the second one is called capital expenditure.

Let us now study,the exact nature of capital and revenue expenditures.

Capital Expenditure: As stated above, when the benefit of an expenditure is not exhausted in the year in which it is incurred but is available over a number of years it is considered as capital expenditure. The following expenditures are usually treated as capital expenditures. 

1 Any expenditure which results in the acquisition of fixed assets such as land, buil&ngs, plant and machinery, furniture and fixtures, office equipment, copyright, etc. You should note that such capital expenditure includes not only the purchase price of the fixed asset but also the expenses incurred in connection with their acquisition. Thus, the brokerage or comlission paid in connection with the acquisition of an asset, the freight and cartage paid for transportation of machinery, the expenses incurred on its installation, the legal fees and registration charges incurred in connection with purchase of land and buildings are also treated as capital expenditure.

2 Any expenditure incurred on a fixed asset which results in (a) its expansion, (b) substantial increase in its life, or (c) improvement in its revenue earning capacity. Improvement in the revenue earning capacity can be in the form of (i) increased production capacity, (ii) reduced cost of production, or (iii) increased sales of the firm. Thus, cost of making additions to buildings and the amount spent on renovation of the old machinery are also regarded as capital expenditures. If you buy a second hand machinery and incur heavy expenditure on reconditioning it, such expenditure is also to be treated as capital expenditure. Similarly, expenditure ' on structural improvements or alterationk to existing fixed assets whereby their revenue earning capacity is increased, is also treated as capital expenditure.

3 Expenditure incurred, during the early years, on development of mines and land for plantations till they become operational.

4 Cost of experiments which ultimately result in the acquisition of a patent. The cost of experiments which are not successful is not to be treated as capital expenditure. It is treated as a deferred revenue expenditure which is written off within two to three years.

5 Legal charges incurred in connection with acquiring or defending suits for protecting fixed assets, rights, etc. 

Revenue Expenditure: When the benefit of an expenditure is not likely to be available for more than one year, it is treated as revenue expenditure. So all expenses which are incurred during the regular course of business are regarded as revenue expenditures. The examples of such expenses are:

1 Expenses incurred in day-to-day conduct of the business such as wages, salaries, rent, postage, stationery, insurance, electricity, etc. 

2 Expenditure incurred for buying goods for resale or raw materials for manufacturing. 

3 Expenditure incurred for maintaining the fixed assets such as repairs and renewals of building, machinery, eta. 

4 Depreciation on fixed assets. This can also be termed as revenue loss. 

5 Interest on loans borrowed for running the business. You should note that any I interest on loan paid during the initial period before production commences, is not treated as revenue expenditure. It is treated as capital expenditure. 

6 Legal charges incurred during the regular course of business such as lqal expenses incurred on collection from debtors, legal charges incurred on defending a suit for damages, etc.

6.4.2 Deferred Revenue Expenditure

'Sometimes, certain expenditure which is normally treated as revenue may be unusually heavy and its benefit is likely to be available for more than one year. In such a situation, it is considered appropriate to spread the cost of the expenditure over a number of accounting years. Hence, it is capitalised and only a portion of the total amount spent is charged to the Profit and Loss Account of the current year. The balance is shown as an asset which will be w&en off during the subsequent amounting years. Such expenditure is called a Defer'red Revenue Expenditure because its charge to Profit and Loss Account has been deferred to future years. Somc examples of such expenditure are:

1 Expenditure incurred on advertising campaign to introdqce a new product in the market. 

2 Expenditure incurred on formation of a new company (preliminary expenses) 

3 Brokerage charges, underwriting commission paid and other expenses incurred in connection with the issue of shares and debentures. 

4 Cost of shifting the plant and machinery to a new site which may invalve dismantling, removing and re-erection of the plant and machinery.

Let us take the case of expenditure on advertising campaign. It is not a routine advertisement and the amount involved is unusually heavy. Its benefit will not completely exhaust in one accounting year but vrill continue over two to three years. Hence, it is not proper to charge such expenditure to the Profit and Loss Account of one year. It is better to distribute it carefully over three years. So, in the first year we may charge one-third of the amount spent to the Profit and Loss Account and show the balance in the Balance Sheet as an asset. In the second year again we may charge a similar amount to the Profit and Loss Account and show the balance as an asset. In the third year, we may charge this balance to the Profit and Loss Account. Every expenditure which is regarded as deferred revenue is treated in this way in the final accounts.

Look at Illustration 1 and note how each expenditure has been treated and why. 

      x) It is a capital expenditure as it is incurred on making the                 newly bought second hand machinery operational.

6.4.3 Capital and Revenue Receipts

Receipts refer to amounts received by a business i.e,, cash inflows. Receipts may be classified as Capital Receipts and Revenue Receipts. It is necessary to note this distinction clearly because only the revenue receipts are taken to the Profit and Loss Account and not the capital receipts.

Capital Receipts: Capital receipts are the amounts received in the form of (a) additional capital introduced in tlie business, (b) loans received, and (c) sale proceeds of £ked assets. You are aware that a loan taken by the business is repayable sooner or later. Similarly, additional capital received represents an increase in the proprietor's claim over the business assets. Thus these two items represent increase in liabilities of the business and obviously are not incomes or revenues. These are capital receipts and should be treated as such. The sale proceeds of a fixed asset are also treated as a capital receipt because the amount receivedis not revenue earned in the normal course of business. The capital receipts increase the liabilities or reduce the assets. They do not affect the profit or loss.

Revemare Receipts: Revenue receipts are the amounts received in the normal and regular course of business. They take the form of (a) sale proceeds of goods, and (b) incomes such as interest earned, commission earned, rent received, etc. These receipts are on account of goods sold or some services rendered by the business and as such they are not repayable. All revenue receipts are treated as incomes and shown on the credit side of the Profit and Loss Account.