EPFO APFC 2023 General Studies · Question 81 of 120

Correct — A, (a) ₹ 5,000 spent to remove a worn-out part. This part needs to be replaced with a new engine. The ask is negative — the booklet prints that 'not' in bold italics — so three of the four options are capital expenditure and the work is to find the single revenue item. What separates the two families is never the size of the sum; it is what the sum does to the asset. An outlay is capital if it acquires a fixed asset, if it brings a newly acquired asset to the location and condition in which it can work, or if it enlarges an existing asset's earning capacity beyond the standard previously assessed of it — a longer life, a higher output, a lower running cost. An outlay is revenue if it merely keeps the asset performing at the standard already assumed of it, and is consumed within the accounting period in which it is incurred. Option (a) prices the money spent to take a worn-out part out of a machine. Taking out a component that has worn out restores the machine to the condition it was already assumed to be in; it buys back capacity that has been used up rather than adding capacity that was never there. That is the ordinary description of repairs and maintenance, and such a cost is written off to the profit and loss account of the year in which it is incurred rather than added to the book value of the machine. Read the option's second sentence carefully, because it is where the item is designed to mislead: it says the worn-out part is to be replaced with a new engine. The new engine, when it is bought, is a separate outlay to be judged on its own facts. What this option puts a figure of ₹ 5,000 against is the removal, and removal of a worn-out part is a repair-type cost. The other three options are textbook members of the capital family — the travel cost of going abroad to buy a machine, the freight and insurance of bringing the machine home, and the repairs that make a second-hand machine fit to be used at all. Each attaches to the acquisition of an asset; only option (a) attaches to the upkeep of one already in service.

• (b)Expenses on foreign tour for purchasing a new machine — This is capital expenditure. A cost incurred wholly for the purpose of acquiring a fixed asset forms part of the cost of that asset, whether or not it takes the shape of a payment to the seller. A foreign tour undertaken to select and purchase a new machine is directly attributable to the acquisition; it produces no benefit that is used up in the year on its own account, and it would not have been incurred but for the purchase. So it is capitalised along with the invoice price, the import duty, the freight, the insurance in transit, the erection and installation charges and the cost of trial runs. The general principle is that everything spent up to the point at which the asset is ready for its intended use goes into the asset account. The contrast worth carrying away is a foreign tour undertaken for ordinary business promotion or a routine sales visit, which buys no asset and is charged to revenue.
• (c)Freight and insurance of the machinery purchased — This is capital expenditure, and it is the cleanest example in the option set. Freight and insurance on machinery purchased are the classic directly attributable costs of bringing an asset to its present location and condition, and every text on the capital-revenue distinction uses them to illustrate the rule. The machine cannot be used where it was bought; the carriage that moves it and the insurance that protects it in transit are part of what the business has to spend before the asset can earn anything, so they are added to the machinery account and recovered through depreciation over the asset's life rather than charged against a single year's profit. Note the symmetry that examiners like to test: insurance in transit on a new machine is capital, while the annual insurance premium on the same machine once it is working is revenue. The same word describes two outlays on opposite sides of the line, and only the stage at which it is incurred tells them apart.
• (d)Amount spent on repairing a secondhand machine before put to use — This is capital expenditure. Repairs are the usual example of a revenue item, but repairs carried out on a second-hand asset before it is put to use are the recognised exception, and they are capitalised. The reason follows from the test rather than from the word 'repair': a second-hand machine bought in a state in which it cannot be used is not yet an asset ready for its intended use, and the outlay that makes it usable is part of what the business has paid to obtain a working machine. Once the machine has been commissioned, the same shape of expenditure becomes revenue, because it is then maintaining a standard the asset already had. The booklet prints this option as 'before put to use', without the word 'being' — the grammar is incomplete as printed and has been left exactly as the Commission set it. The sense is not in doubt and the timing word is the whole of the point: before commissioning, capital; after commissioning, revenue.

Every payment a business makes has to be classified as capital or revenue, because the two are reported in different places and the choice moves both the profit for the year and the balance sheet. Capital expenditure is spent to acquire a fixed asset, to bring a newly acquired asset to the location and condition in which it can operate, or to improve an existing asset beyond the performance standard originally assessed of it; the benefit lasts beyond the current period, so the amount is added to the asset account and released to the profit and loss account gradually as depreciation. Revenue expenditure is spent to earn the revenue of the current period or to maintain the earning capacity the asset already has; the benefit is consumed within the year, so the whole amount is charged against this year's profit. The tests that decide a doubtful case are the purpose of the outlay, the point in the asset's life at which it falls and whether it restores or enhances. Restoration is revenue and enhancement is capital, which is why replacing a worn-out part is a repair while adding a device that raises the machine's output is an improvement. Two neighbouring ideas complete the picture. Deferred revenue expenditure is a revenue outlay of unusual size whose benefit spills into later periods and which is written off over a few years. And the same capital-revenue division runs on the receipts side as well, where a receipt that arises from a fixed asset or from the capital structure of the business is a capital receipt and a receipt from trading operations is a revenue receipt.

This paper's accountancy block sets the capital-revenue distinction twice — here from the expenditure side and, at the other end of the block, from the receipts side, where the money an insurer pays for machinery completely destroyed by fire has to be recognised as a capital receipt. Setting the same rule from both ends is deliberate: a candidate who has learnt the phrase 'capital expenditure gives long-term benefit' can usually recite it and still fail to apply it, because applying it means asking a separate question of every option rather than recognising a definition. The habit the item rewards is mechanical and fast. Take each option and ask two things: is the business buying an asset or getting an asset it has just bought into working order, and is the outlay adding to what the asset can do or putting back what use has taken out of it. Buying, transporting, installing and making fit for first use are all capital; maintaining, restoring and replacing worn parts are revenue. The design of this option set is also worth noticing, because it recurs. Three options describe money spent around the acquisition of a machine and one describes money spent on a machine already in service, so the odd one out can be found from the timing alone, without valuing anything. Misclassification is not a harmless error: charging a capital item to revenue understates both this year's profit and the assets, and capitalising a revenue item overstates both, which is why the distinction is examined as often as it is.

• Capital expenditure acquires a fixed asset, brings a newly acquired asset to the location and condition in which it can be used, or improves an existing asset beyond the performance standard originally assessed of it; the amount goes into the asset account and reaches the profit and loss account only through depreciation over the asset's useful life.
• Revenue expenditure is incurred to earn the current period's revenue or to maintain the earning capacity an asset already has, and is charged in full against the profit of the year in which it is incurred; ordinary repairs, maintenance, renewals of worn-out parts, rent, wages and annual insurance premiums are the standard members of this family.
• The deciding test in a doubtful case is restoration against enhancement. Putting back capacity that use has consumed is revenue; adding capacity, life or efficiency the asset was never assessed to have is capital. Removing and replacing a worn-out part restores, which is why the cost of doing so is charged to revenue.
• Costs incurred up to the point at which an asset is ready for its intended use are added to its cost — invoice price, import duty, freight and insurance in transit, erection and installation, trial runs, and repairs needed to make a second-hand asset usable. After commissioning, the same kinds of outlay become revenue.
• Misclassification moves two statements at once. Treating capital expenditure as revenue understates the profit of the year and understates the assets in the balance sheet; treating revenue expenditure as capital overstates both. This is why the distinction is treated as a matter of principle rather than of book-keeping convenience.
• The same division applies to receipts. Money received on the sale or destruction of a fixed asset, or raised from the capital structure of the business, is a capital receipt; money received from trading operations is a revenue receipt. This paper tests that side of the rule separately in the same block.

• Reading past the bold-italic 'not'. Three of these four options are capital expenditure, so a candidate who marks the first plainly capital item he sees will be wrong on three of the four possible picks.
• Treating the size of the sum as the test. ₹ 5,000 is small and the machine is large, but a small outlay that improves an asset is still capital and a large outlay that merely restores one is still revenue.
• Being pulled by the words 'new engine' in option (a). The engine, when it is bought, is a separate outlay; what this option prices is the removal of the worn-out part, and removal of a worn-out part is a repair-type cost.
• Assuming that anything called a repair is revenue. Repairs to a second-hand asset carried out before it is put to use are capital, because they are part of what makes the asset usable at all; the same repair after commissioning is revenue.
• Forgetting that a cost can change sides with timing. Insurance on a machine in transit is capital and the annual insurance premium on the same machine in service is revenue.

The accountancy block of this paper puts the capital-revenue distinction in one of three shapes. The commonest is this one: four short descriptions of outlays, of which three sit on one side of the line and one on the other, with the ask phrased negatively so that the reading of the stem is half the difficulty. The second shape moves to the receipts side and asks how to treat an insurance claim, a sale of scrap or a premium on the issue of shares. The third asks for the consequence rather than the classification — what happens to the profit and to the assets if a capital item is charged to revenue. All three are answered by the same two questions, asked of each option in turn: is the business acquiring an asset or getting a newly acquired one into working order, and does the outlay add to what the asset can do or put back what use has taken out of it. Expect at least one option in every such set to be a repair whose classification turns entirely on whether it falls before or after the asset was put to use.

No directly related past PYQ was found.

• practice — not a real PYQ

  An amount spent on overhauling a second-hand machine to make it fit for use, incurred before the machine is put into operation, should be treated as

  • (a)revenue expenditure charged in full to the profit and loss account of the year
  • (b)capital expenditure added to the cost of the machine
  • (c)deferred revenue expenditure written off over five years
  • (d)a capital receipt of the business

  Answer(b) capital expenditure added to the cost of the machine — a second-hand asset bought in a condition in which it cannot be used is not yet ready for its intended use, so the outlay that makes it usable is part of the cost of obtaining a working asset and goes into the machinery account. The same overhaul carried out after the machine has been commissioned would be revenue, because it would then be maintaining a standard the asset already had.

• practice — not a real PYQ

  Which one of the following is a revenue expenditure for a manufacturing firm?

  • (a)Import duty paid on a machine imported for the factory
  • (b)Wages paid to workmen for erecting a newly purchased machine
  • (c)The annual whitewashing of the factory building
  • (d)Legal fees paid on the purchase of a factory building

  Answer(c) the annual whitewashing of the factory building — it is recurring upkeep that maintains the building at the standard already assumed of it and is consumed within the year. Import duty, erection wages and the legal fees on a purchase are all incurred to acquire an asset or to bring it to the condition in which it can be used, so all three are added to the cost of the asset concerned.