Earning profit is the ultimate goal of all business and commercial activities. Simply put, profit is the excess of income over expenditure or value over cost. Business entities may generally earn profits from various sources – profits from sale of goods, profits from rental premises, profits from sale of assets etc. One of the main bifurcations of profit earned is based on their source of generation.
This article looks at meaning of and differences between the two sources/classification of profits – capital and revenue profits.
Definitions and meanings
Capital profits:
Capital profit is the net income that results from the transfer of any capital asset or from the issue of share capital. As these profits do not accrue due to normal day to day business operations, they are generally less frequent and non-recurring in nature. Capital profits are primarily linked with two types of transactions – transactions that involve sale of capital assets and transactions that involve issue of shares.
(1). Transfer/sale of capital assets:
Entities typically own several capital assets, these can be tangible such as land and buildings, plant and machinery and office equipment or intangible such as software, licenses and trademarks etc. When these assets are transferred, capital profits may be generated. The formula for this is:
Capital profits = (Sale consideration/Insurance compensation received) less (written down book value of the asset)
Example journal entry of capital profit coming from sale of a asset:
Surplus machinery having book value of $50,000 sold for $60,000.
Bank a/c…..60,000 [Dr]
Machinery a/c…..50,000 [Cr]
Capital reserve a/c…..10,000 [Cr]
(Being machinery sold and profit on sale recorded)
(2). Issue of share capital:
When an entity issues its share capital, it may do so at a premium; which qualifies as a capital profit. Capital profit in this case can be computed as follows:
Capital profits = (Issue value of share capital) less (face value of share capital)
Example journal entry of capital profit coming from issuance of shares at premium:
10,000 shares of face vale of $10 each issued at a premium of $2 per share.
Bank a/c…..120,000 [Dr]
Share capital a/c…..100,000 [Cr]
Securities premium a/c…..20,000 [Cr]
(Being shares issued at a premium)
Capital profits are reported as special reserves under ‘reserves and surplus’ on the liability side of the balance sheet.
Revenue profits:
Revenue profit is the net income that results from the business operations of an entity. Revenue profits include profits from the sale of goods and/or services, net income earned from leasing out activities, commission business etc.
Essentially, the profit earned by all day-to-day operating activities of the business classifies as revenue profits. Revenue profits thus result from regular business transactions, making them highly frequent and recurring in nature.
The formula for calculating revenue profit is:
Revenue profit = (Operating incomes) less (Operating expenses)
Revenue profits are generally determined at the close of an accounting period. All operating incomes are credited to and all operating expenses are debited to the profit and loss account. This account is balanced periodically and net determined result is revenue profit. This amount is then transferred to the general reserves or profit and loss account on the liabilities side of the balance sheet.
Difference between capital and revenue profits:
The eight key points of difference between capital and revenue profits have been detailed below:
1. Meaning
- Capital profits are the profits generated through sale or disposal of capital assets or on issue of share capital.
- Revenue profits are the profits generated from the operating activities such as manufacture and sale of products, provision of services etc.
2. Source
- The source of generation of capital profits are an entity’s non-operating activities.
- The source of generation of revenue profits are the regular operating activities of the business.
3. Recurring nature
- Capital profits accrue from transactions that are not very frequent. Capital profits are thus non-recurring in nature.
- Revenue profits accrue from day-to-day business transactions and are thus recurring in nature.
4. Frequency of accounting entries
- Capital profits are individually calculated for each capital-based transaction and accounted for through a separate accounting entry.
- Revenue profits, on the other hand, are not determined for each sale transaction. They are, in fact, generally determined on a periodic basis. No separate entry is passed for the accrual of revenue profits. It is the balancing figure of the profit and loss account.
5. Accounting reporting
- Capital profits are not credited to the profit and loss account but are reported as capital reserve or securities premium under the head ‘reserves and surplus’ on the liabilities side of the balance sheet.
- Revenue profits are reflected as the excess of operating incomes over operating expenses in the profit and loss account. This balance is eventually transferred to general reserve or retained earnings.
6. Impact on overall profitability
- Capital profits do not impact the profitability of the business.
- Revenue profits form the core of the reflected profitability of a business.
7. Utilization of profits
- Jurisdictional law generally imposes restrictions on the use of capital profits generated. Capital profits cannot be distributed to shareholders as dividend. For example, securities premium is generally permitted to be applied only for specific purposes.
- There are generally no restrictions on the use of revenue profits. In fact, revenue profits are the profits that are distributed to shareholders, reinvested in projects or retained in business for future needs.
8. Examples
- Capital profits include profit on sale of tangible and intangible fixed assets and share premium generated on sale of entity’s shares etc.
- Revenue profits include profit from the sale of manufactured or traded goods and from the provision of services etc.
Conclusion – capital vs revenue profit:
Correct determination of capital profits and revenue profits is particularly important from an accounting and reporting stand point. It is important for stakeholders to understand the profitability the business generates from its operations in relation to those generated from non-operating one-off transactions. Earning both type of profits however assume importance for a business. Capital reserves created out of capital profits are important to create provisions for future asset replacements whereas revenue profits are important for smooth functioning of day-to-day operations of the business.
