Cost Value the Usual Basis
The values which are, for the most part, shown in the commercial balance sheet are cost value or adjusted cost value. Occasionally, values which bear only an indirect relation to cost must be taken into account. The determination of cost value is sometimes a comparatively simple matter, as where the source is a purchase invoice, but more often it involves numerous other costs in addition to those shown by the purchase invoice, both definite and indefinite, i.e., estimates. It is in connection with the determination of cost that the proper segregation of the so-called capital and revenue charges is of vital importance. An effort will be made to formulate the distinction between them so as to give a working rule for their determination under most circumstances.
Definition of Capital and Revenue Expenditures
Capital expenditures may be defined as expenditures of funds or other assets on capital account. In accounting language, they may be said to be those expenditures which result in charges to some asset account. They may sometimes ultimately result in a charge to a liability account by the conversion of the asset to the decrease of the liability. Expenditures of capital may be made on account of expenses. This can occur only when revenues are insufficient to meet all expenses. Such expenditures of capital bring about an impairment of capital. As the term is generally used, however, capital expenditures have the meaning first given.
Revenue expenditures may be defined similarly as expenditures of funds or other assets on revenue account. That is, such expenditures must be booked as charges to expense accounts. They represent the expenses incurred in the earning of the revenue, and measure its cost. Just as the original capital fund, through its expenditure, must provide the plant and equipment with which to work, so the other expenditures necessary to prepare and market the product must provide the revenue out of which to meet these expenditures and secure a margin of profit; else there is encroachment upon the original capital funds.
A few other terms need definition by way of differentiation from these. The term “capital receipts” is used to differentiate receipts of funds from the sale of capital stock or the sale of capital or fixed assets, from funds or other assets received from revenue or profits sources. Thus, upon the sale of any asset which was originally purchased out of capital, the receipts therefor must first be applied to take the place of the capital expended for the asset, and any balance not used for the first purpose is then a receipt of revenue.
The term “capital expense” is sometimes used to indicate the group of expenses incurred in providing the capital needs of the business. They are the financial management expenses as the term is used in Volume I. Opposed to capital expenses are the capital income or revenue items. These are the receipts or income from portions of the capital employed otherwise than in the purchase and sale of commodities; or the income which represents savings effected through the handling of the funds of the business as distinguished from income derived from the handling of stock-in-trade. They are deductions from the financial management expenses.
Capital and revenue expenditures are thus easily differentiated on paper. It is in the application of the definition to situations as they develop in practice that difficulty is encountered. Some of these situations will be examined with the purpose of determining the application to them of the distinction between revenue and capital expenditure.
Organization Expenses
Upon the organization of a new enterprise the distinction between capital and revenue expenditures can usually be made without much difficulty. All costs incurred to put the concern in a position to earn revenue are properly treated as capital expenditures. Sufficient capital must be provided to put the undertaking on an earning basis, as otherwise it fails. These costs will include many items which upon their second incurrence must be treated as expense charges because the revenue must provide for keeping the plant in a state of efficient repair. One group of capital expenditures, usually carried on the books under the title “Organization Expense,” is often treated as a revenue expenditure as soon as sufficient revenues have accumulated to care for them conveniently. This is discussed in detail in [Chapter XVIII] on intangible assets. It is sufficient to say here that upon their incurrence organization expenses constitute capital expenditures, for no other funds are available for the purpose.