REPAIRS, RENEWALS, DEPRECIATION AND FLUCTUATION 1. Difficulty of distinguishing between capital and revenue charges.—Whether a certain item of.expendi ture should be charged to capital or to revenue ac count is a perplexing question for both accountants and business managers. It is also a question for which it is easy to prescribe general rules but difficult to provide for their practical application. The impor tance of this distinction may best be shown by two hypothetical cases.
2. Intentional confusion, of capital and revenue items.—In the first case, a corporation has an issue of income bonds bearing interest. Now if the board of directors should charge improvements ma terially increase the earning capacity of the corpora tion against earnings, instead of to capital account, there may be nothing left for the holders of the in come bonds. As this interest is payable only when there are earnings, one can readily see the difference which such a charge makes.
The peculiar feature of income bonds, as shown in the Text on "Corporation Finance," is that the inter est is not a fixed charge as in the case of mortgage bonds, but only a lien against the income of the cor poration. Moreover, the holder of income bonds re ceives interest only where there are earnings left after all fixed charges have been defrayed.
3. Surplus produced by wrong classification.—In the second case the situation is reversed. A corpora tion has made repairs and improvements which do not increase the earning capacity of the company but which are actual replacements of assets which were wasted during operation. The board of directors are in a quandary. On account of business depression they fear they will be unable to declare the usual yearly dividend. But if they withhold the dividend, serious fluctuations in the stock of the company may be noted in the market quotations. To guard against such a contingency, the directors order the repairs and improvements charged to capital and treat them as acquisitions of property and hence assets, leaving to the corporation a surplus which may be used for the payment of dividends.
It is not intended here to discuss the propriety or impropriety of the action of the directors in either ease, but merely to cite these illustrations that the reader may understand the importance of proper classification of capital and revenue items.
4. Definition of terins.—"Capital receipts" repre sent sums contributed to a business with the intention of using them to carry on the enterprise.
"Capital expenditures" is a term given to expendi tures incurred for the purpose of acquiring, extending or completing the equipment of an enterprise in order to place it on a revenue earning basis, or to increase its earning capacity.
"Revenue receipts" are the receipts of business op erations, i.e., earnings. The cash revenue receipts will generally be less than the actual earnings, as prac tically no line of business is conducted on a strictly cash basis and, therefore, the credit to revenue ac count, and not the receipts in cash, will show the true earnings for the period.
"Revenue expenditures" are those expenditures which are incurred in the operation of the business. Indeed, any expenditure of a business that does not improve the fixed assets, increase the earnings, enlarge the field of operations, reduce the cost of doing busi ness, or any expenditure the life of which does not extend beyond one year, should be charged to revenue.
"Additions" are amounts which are expended for additional buildings or equipment or facilities; in brief, those expenditures made for structures or equip ment which do not take the place of anything previ ously existing.
"Betterments" may be distinguished from addi tions in that they include the improvement or en largement of buildings, machinery or equipment al ready in existence.
"Replacements" is the term used to designate the removal of a capital asset which has become exhausted or inadequate in service and the substitution of an other of the same or greater capacity. Where the new unit has a capacity substantially greater than that for which it was substituted, it is proper to charge the cost of replacement to capital account. The unit dis placed should be credited to capital account.