Which one of the following is a revenue expenditure ?

Correct — C, (c) Amount spent for replacement of worn-out portion of a machine. This is the only one of the four that keeps an existing asset in its existing condition rather than acquiring an asset, extending its life or enlarging its earning capacity — which is the test that separates revenue expenditure from capital expenditure.

The distinction runs on a single question: does the spending BRING IN or ENHANCE an enduring benefit, or does it merely MAINTAIN one that is already there? Capital expenditure acquires a fixed asset, brings it into working condition, or adds to its capacity or useful life, and it is carried in the balance sheet. Revenue expenditure is incurred in the ordinary conduct of business, its benefit is consumed within the accounting period, and it is charged to the profit and loss account.

Replacing a worn-out part of a machine is the classic revenue item. The machine already exists; the part has been consumed by use; replacing it restores the machine to the condition it was in and does not give the business anything it did not have before. That is repair and maintenance, and the cost belongs in the profit and loss account of the year in which it is incurred.

The boundary is a fine one and worth stating precisely, because two of the distractors sit on the other side of it by a small margin. If a replacement upgrades the machine — a new engine of higher capacity, an overhaul that materially improves output or fuel efficiency, a part that extends the asset's useful life beyond its original estimate — the expenditure is capital, because the business is better off than it was. If the replacement merely restores, it is revenue. The word 'worn-out' in this option is doing exactly that work: it tells you the part had been used up in the course of ordinary operations and is being put back as it was.

One caution about a related item, since the paper's sibling papers test it. Money spent on a SECOND-HAND machine before it is put to use is capital even though the work looks like repair, because the asset is not yet in working condition and the expenditure is part of bringing it there. The same money spent on the same machine a year later, on an ordinary breakdown, is revenue.

Why the others are wrong

• (a)Overhaul expenses of a second hand machinery purchased — This is capital expenditure, and the giveaway is that the machinery has just been PURCHASED. Expenditure incurred to bring a newly acquired asset into working condition is part of its cost, whatever the work happens to be called — freight, insurance in transit, installation, erection, trial runs, and the overhaul or reconditioning of a second-hand machine before it is put to use. A second-hand machine is bought in the state it is in and at a price that reflects that state; the overhaul is what converts it into an asset the business can actually use, and the benefit of that work endures over the asset's whole life with the buyer. It is therefore added to the machinery account and depreciated, not charged to profit and loss. The same overhaul carried out three years later on the same machine, to put right ordinary wear, would be revenue.
• (b)Legal fees to acquire a property — This is capital expenditure. Legal fees paid to acquire a property are a cost of acquisition — like brokerage, stamp duty, registration charges and the cost of investigating title — and they are capitalised as part of the cost of the property. The principle is that the cost of an asset includes not only the purchase price but every expense necessary to acquire it and put it into a condition and location in which it can be used. The benefit of the legal work is not consumed in the year it is done; it endures for as long as the property is held, because it is what secures the title. Contrast the legal fees a business pays to defend an ordinary trade debt or a routine commercial dispute, which are revenue.
• (d)Expenses in connection with obtaining a license for running the cinema hall — This is capital expenditure. A licence to run a cinema hall is what makes the business possible at all, and money spent to obtain it purchases an enduring right rather than a service consumed within the year. It is treated as an intangible asset or as part of the cost of setting up the undertaking, and it is written off over the period for which the benefit lasts rather than charged to a single year's profit and loss account. The distinction to keep is between obtaining the licence and renewing it: the initial cost of acquiring the right is capital, while a periodic renewal fee that merely keeps an existing right alive for another year is revenue. Note the paper spells 'license' with an s as the noun, which is the American form; the point is unaffected.

Every payment a business makes has to be classified as capital, revenue or deferred revenue, and the classification decides whether it appears in the balance sheet or in the profit and loss account. CAPITAL EXPENDITURE is spending that acquires a fixed asset, brings it into working condition, or increases the earning capacity or useful life of an existing one; it is capitalised and, where the asset is depreciable, written off over its life. Its usual examples are the purchase price of an asset, freight and insurance in transit, installation and erection charges, legal and brokerage costs of acquiring property, expenditure on a second-hand asset before it is put to use, the cost of obtaining a licence or a patent, and additions or extensions to a building. REVENUE EXPENDITURE is spending in the ordinary conduct of business whose benefit is exhausted within the accounting period; its usual examples are wages and salaries, rent, ordinary repairs and maintenance, replacement of worn-out parts, renewal fees, insurance premiums, and interest on borrowings after an asset is put to use. DEFERRED REVENUE EXPENDITURE is revenue in nature but large enough and of sufficiently lasting benefit that it is spread over more than one period — heavy advertising for a new product launch is the standard example. Three rules of thumb settle most cases. The purpose test: does the money acquire or improve an asset, or maintain one? The timing test: is the benefit consumed this year or over several? The condition test: was the asset ready for use when the money was spent — because expenditure before that point is almost always capital.

Key facts

• Capital expenditure acquires a fixed asset, brings it into working condition, or increases its earning capacity or useful life; it appears in the balance sheet.
• Revenue expenditure is incurred in the ordinary conduct of business, its benefit is consumed within the period, and it is charged to the profit and loss account.
• Replacing a worn-out part that restores a machine to its former condition is revenue expenditure; replacing a part that increases capacity or extends life is capital.
• Expenditure on a second-hand asset incurred before it is put to use — overhaul, reconditioning, repairs — is capital, because it brings the asset into working condition.
• Legal fees, brokerage, stamp duty and registration charges incurred to acquire a property are capitalised as part of its cost.
• The cost of obtaining a licence or a right to carry on business is capital; a periodic renewal fee for an existing licence is revenue.
• Deferred revenue expenditure is revenue in nature but written off over more than one period, heavy launch advertising being the standard example.
• Interest on money borrowed to acquire an asset is capitalised until the asset is put to use and is revenue thereafter.

Common traps

• Treating any expenditure that looks like repair as revenue. Repairs to a newly bought second-hand asset before it is put to use are capital.
• Missing the distinction between obtaining a licence and renewing it.
• Assuming legal fees are always revenue. Legal fees to acquire property are part of the cost of the property.
• Reading 'replacement' as automatically capital. Replacing a worn-out part to restore an asset is revenue; replacing it with something better is capital.

• practice — not a real PYQ

  Money spent on repairing a second-hand machine before it is put to use is :

  • (a)Revenue expenditure, because it is a repair
  • (b)Capital expenditure, because it brings the asset into working condition
  • (c)Deferred revenue expenditure written off over three years
  • (d)A revenue receipt

  Answer(b) Capital expenditure, because it brings the asset into working condition

• practice — not a real PYQ

  The annual fee paid to renew an existing licence to run a business is :

  • (a)Capital expenditure
  • (b)Revenue expenditure
  • (c)Deferred revenue expenditure
  • (d)A capital receipt

  Answer(b) Revenue expenditure