While all business entities strive to earn profits, there may be certain circumstances in which they incur losses. Loss primarily occurs when the monetary cost or expense of a resource or transaction exceeds the monetary value of benefits derived from it. All losses must be appropriately measured and accounted for so that the correct financial position of a business can be reflected. The primary bifurcation of losses incurred by an entity is done on the basis of the nature of resource or transaction which leads to the loss in question i.e., capital and revenue.
This article looks at meaning of and differences between these two types of losses – capital losses and revenue losses.
Definitions and meanings
Capital loss is the loss incurred on capital asset or capital liabilities. These losses can accrue when a capital asset is transferred at a value less than its cost or on the issue of share capital at a discount. It is essentially a fall in the monetary value of an entity’s capital.
Capital loss does not occur on account of the routine day-to-day business operations and their incurrence can, therefore, be considered as non-recurring. It can take several forms including loss on sale or damage of capital assets and discounted issue of an entity’s share capital.
On capital assets:
- Entities use several capital assets in their operations which include both tangible or intangible assets. These assets generally have a certain useful life after which they become obsolete and may be disposed of at scrap value. This can lead to generation of capital loss.
- There may also be circumstances when capital assets get damaged due to fire, floods or as a result of an accident. This also leads to capital loss.
The formula for loss on capital assets:
Example journal entry for recording the sale of capital asset at a loss:
Obsolete plant and machinery of book value amounting to $20,000 is sold as scrap for $8,000. The journal entry for this transaction would be made as follows:
Bank a/c…..8,000 [Dr]
Loss on sale of machinery…..12,000 [Dr]
Machinery a/c…..20,000 [Cr]
(Being machinery disposed of and capital loss recorded)
Discounted issue of share capital:
When an entity needs to raise funds, it issues its share capital. An entity may need to do so at a discount if its shares are not in demand at their face value. Such discount qualifies as a capital loss and can be determined as follows:
Capital loss = [Face value of share capital] less [issue value of share capital]
Revenue loss is the excess of operating expenditure over operating revenue. Revenue results from the business operations of an entity. It includes loss due to sale of goods or provision of services below cost and excess of operating expenses over gross profit.
The net losses accruing from day-to-day operating activities of the business essentially qualify as revenue losses. As they occur due to regular business transactions, revenue losses are recurring in nature.
The formula for revenue loss can be presented as follows:
Revenue losses = (Operating expenses) less (Operating incomes)
An entity prepares a trading and profit and loss account to which all operating incomes are credited and all operating expenses are debited. This account is balanced periodically and if the total expenses exceed the total income, the net result is revenue loss. This amount is transferred to the balance sheet and reduced from the general reserves or retained earnings, reflected on the liabilities side.
Difference between capital and revenue losses:
The key points of difference between capital and revenue losses have been detailed below:
- Capital loss is a decrease in the value of an entity’s capital due to loss on sale of capital assets or issue of shares at a discount to their face value (i.e., below face value).
- Revenue loss is the loss resulting from the operating activities of a business when expenses exceed revenues.
2. Arise from
- Capital losses result from an entity’s non-operating activities.
- Revenue losses result from the regular operating activities of the business.
- Capital loss in case of a capital asset is the excess of its book value over its salvage value.
- Revenue loss is the excess of operating expenditure over operating revenue.
4. Indication of
- Capital losses do not necessarily indicate operational inefficiency of the entity.
- Revenue losses, on the other hand, indicate operational inefficiency as the entity is unable to generate enough revenue to cover all of its cost of operations.
- Capital losses are realized on transactions that are less frequent, making them non-recurring in nature.
- Revenue losses are incurred on account of inefficient day-to-day business transactions and are thus recurring in nature.
6. Periodicity of accounting
- Capital losses are separately calculated for each sale of capital asset or each tranche of share capital issue. Each calculated capital loss is accounted for by recording a separate accounting entry.
- Revenue losses on the other hand are not calculated for each individual transaction. They are typically calculated on a periodic basis. No separate entry is passed for the realization of revenue losses. It is the balancing figure of the profit and loss account which typically drawn at the end of accounting year.
7. Accounting reporting
- Capital losses are not debited to the profit and loss account. They are reduced from capital reserve under the head ‘reserves and surplus’ on the liabilities side of the balance sheet.
- Revenue losses is the excess of operating expenses over operating revenues, in the profit and loss account. This balance is ultimately reduced from general reserve or retained earnings in the balance sheet.
8. Tax treatment
- Capital losses can be set off against capital gains. The remaining capital loss, if any, is generally carried forward for a specific time period.
- Revenue losses generally cannot be set off against capital gains. They are carried forward to subsequent tax years.
- Capital losses include loss on sale or disposal of tangible and intangible fixed assets and discount on issue of shares or debentures etc.
- Revenue losses include loss from the sale of manufactured or traded goods and the provision of services etc.
Conclusion – capital vs revenue losses
Appropriate classification and reporting of losses into capital loss and revenue loss is essential for both management and external stakeholders. When management analyses the nature of losses incurred, they can take corrective measures to recover from losses. At the same time, external stakeholders can gauge the financial condition of the entity by assessing the nature and reason for losses incurred.