What happens if Capital Expenditure is treated as Revenue Expenditure?
The Effects of Incorrect Treatment of Capital And Revenue Expenditure On The Financial Statements / Final Accounts
It is very interesting question when someone
asks that what happens if Capital Expenditure is treated as Revenue Expenditure.
If you don’t know about these terms then kindly read the article about Difference Between Capital And Revenue Items.
Obviously, it is a mistake and its effect is that the Users of Financial Statements can not get the complete and true and fair view of the financial statements of the company businesses. International Accounting Standards - IAS -1 requires fair Presentation of Financial Statements of company businesses.
Let us come to the question. Okay!
When we treated Capital Expenditure as
revenue expenditure, then the Income Statement is understated in the
current year but the net income shown in the Income Statement in the next accounting year will be overstated as we do not
charge any Depreciation On Non- Current Assets.
For Example
If we paid wages for Rs.500 for
the installation of the machine, then it should be capitalized but if we
consider it as a revenue expenditure, then Rs.500 is deducted from the Income Statement in the current year, but in the next year, there is no
capital expenditure so no depreciation is charged on machine and therefore Net Income for the next accounting period will be overstated.
On the other hand, if we are treating a revenue expenditure as a capital expenditure, then the Asset Side of Balance Sheet is overstated during the current accounting period and Net Income in Income Statement will also be overstated at the end of accounting period, but in the next accounting period, both Net Income and Total Net Assets will be overstated if the depreciation expense charged on Fixed Assets is less that actual amount of Revenue Expenditure, otherwise overstated.
For Example, Wages Rs. 300 paid on goods purchased is an example of Revenue Expenditure but if we consider it as a Capital Expenditure, then it is added to the cost of Relevant Asset (Lets' say Machinery which has cost Rs. 10000 depreciated at the rate of 10% Per Year on Straight Line Method) on Balance Sheet and hence Asset Side will be overstated due to the addition of Rs. 300 and Net Profit will also increased as only Rs. 30 Depreciation Expense is deducted, while it should be 270 more as it is actually a revenue Expenditure. In the next accounting period, both Net Income and Total Net Assets will still be overstated as depreciation charged on Machinery which is an expense charged to Income Statement which reduces the Income Statement by Rs. 30 and also Accumulated Deprecation on Machinery is also deducted from the Machinery on Asset Side By Rs. 1030, while in the previous accounting period Rs. 300 is added to the cost of Machinery, so Balance sheet's Total Net Assets still increases.
If we paid wages for Rs.500 for the installation of the machine, then it should be capitalized but if we consider it as a revenue expenditure, then Rs.500 is deducted from the Income Statement in the current year, but in the next year, there is no capital expenditure so no depreciation is charged on machine and therefore Net Income for the next accounting period will be overstated.
For Example, Wages Rs. 300 paid on goods purchased is an example of Revenue Expenditure but if we consider it as a Capital Expenditure, then it is added to the cost of Relevant Asset (Lets' say Machinery which has cost Rs. 10000 depreciated at the rate of 10% Per Year on Straight Line Method) on Balance Sheet and hence Asset Side will be overstated due to the addition of Rs. 300 and Net Profit will also increased as only Rs. 30 Depreciation Expense is deducted, while it should be 270 more as it is actually a revenue Expenditure. In the next accounting period, both Net Income and Total Net Assets will still be overstated as depreciation charged on Machinery which is an expense charged to Income Statement which reduces the Income Statement by Rs. 30 and also Accumulated Deprecation on Machinery is also deducted from the Machinery on Asset Side By Rs. 1030, while in the previous accounting period Rs. 300 is added to the cost of Machinery, so Balance sheet's Total Net Assets still increases.
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