PREVIOUS YEAR SOLVED PAPERS - July 2018
11. Which one of the following statements is not true?
- Option : C
- Explanation : Capital Expenditures Vs. Revenue Expenditures: The terms, capital expenditure and revenue expenditure, are used in the context of accounting for property, plant, and equipment. A capital expenditure is one which is expected to benefit two or more accounting periods. A revenue expenditure is one whose benefits are not expected to extend beyond the current period. Thus a revenue expenditure benefits only the current period or no period at all.
Capital expenditures are recorded by increasing an asset account (or by decreasing the balance of the Accumulated Depreciation account). If an asset is of limited life, its cost is depreciated (expensed) over the periods which will be benefited (to comply with the matching principle). Because a revenue expenditure does not yield benefits beyond the current period, it is recorded as an expense in the period it is made.
The distinction between capital and revenue expenditures is of significance because it involves the timing of the recognition of expense and, consequently, the determination of periodic net income. This distinction also affects the costs reflected in asset accounts which will be recovered from future periods revenues.
Examples of capital expenditures include the acquisition of land, building and/or equipment. Examples of revenue expenditures include outlays for maintenance and repair services.
- Option : C
- Explanation : Operating ratios indicate the percentage of sales that is absorbed to the cost of goods sold and other operating expenses. It is the test of operational efficiency with which the business activities are being carried out. If the ratio is lower, the position is favourable since there is higher operating profit and the management has succeeded in minimising the operating costs. The higher operating ratio is less favourable because it would leave only a smaller margin of operating profit to meet the obligation towards interest, income tax, and dividend. There is no rule of thumb for this ratio, because it varies from firm to firm depending upon the nature of business. While analysing this ratio, it is suggested that the changes in operating ratios over a period of time should be well analysed. The changes in operating expenses can be either within the control of management or beyond the control of management. If the change in operating expense is within the control of management, appropriate steps can be taken to control the same in forthcoming period, based on the results and further probe.
- Option : A
- Explanation : The Meaning of Profit and Pure Profit
The meaning and source of ‘profit’ have always been a centre of controversy. “The word ‘profit’ has different meanings to businessmen, accountants, tax collectors, workers and economists...”. For example, ‘profit to a layman means all incomes that go to the capitalist class’. To an accountant, profit means the excess of revenue over all paid-out costs including both manufacturing and overhead expenses. For all accounting purposes, businessmen use accountants’ definition of profit.
For all practical purposes, profit or business income means profit in accountancy sense plus non-allowable expenses. Economist’s concept of profit is of ‘Pure Profit’ called ‘economic profit’ or ‘just profit’. Pure profit is a return over and above the opportunity cost, i.e., the income which a businessman might expect from the second best alternative use of his resources. These two concepts of profit are discussed below in detail.
Accounting Profit vs. Economic Profit
The two important concepts of profit that figure in business decisions are ‘economic profit’ and ‘accounting profit’. It will be useful to understand the difference between the two concepts of profit. As already mentioned, in accounting sense, profit is surplus of revenue over and above all paid-out costs, including both manufacturing and overhead expenses. Accounting profit may be calculated as follows:
Accounting profit = TR – (W + R + I + M + OC)
where,
W = Wages and salaries
R = Rent
I = Interest
M = Cost of materials
OC = Other paid out costs like electricity, transportation, etc.
Obviously, while calculating accounting profit, only explicit or book costs, i.e., the cost recorded in the books of accounts, are considered.
The concept of ‘economic profit’ differs from that of ‘accounting profit’. Economic profit takes into account also the implicit or imputed costs. The implicit cost is opportunity cost. Opportunity cost is defined as the payment that would be ‘necessary to draw forth the factors of production from their most remunerative alternative employment’. Alternatively, opportunity cost is the income foregone which a businessman could expect from the second best alternative use of his resources. For example, if an entrepreneur uses his capital in his own business, he foregoes interest which he might earn by purchasing debentures of other companies or by depositing his money with joint stock companies for a period. Furthermore, if an entrepreneur uses his labour in his own business, he foregoes his income (salary) which he might earn by working as a manager in another firm. Similarly, by using productive assets (land and building) in his own business, he sacrifices his market rent. These foregone incomes—interest, salary and rent—are called opportunity costs or transfer costs. Accounting profit does not take into account the opportunity cost whereas all these costs are taken into account while working out the economic profit.
In addition, it should also be noted that in working out economic or pure profit a provision is also made for (a) insurable risks, (b) depreciation, and (c) necessary minimum payment to shareholders to prevent them from withdrawing their capital. Pure profit may thus be defined as ‘a residual left after all contractual costs have been met, including the transfer costs of management, insurable risks, depreciation and payments to shareholders sufficient to maintain investment at its current level’.
Thus,
Economic profit = Total Revenue – (Explicit Cost + Implicit Cost)
In real life situation, if economic profit is greater than zero, one thing is certain that people will their money in business. However, in case economic profit is zero or insignificantly different from zero, people prefer to invest their money in business because it has a better future prospect in spite of risk involved.
