The purpose of maintaining a detailed and systematic record of business transactions is two-fold i.e., to ascertain the net result of the trading activity for an accounting year, and to ascertain the financial position of the business as at the end of the accounting year.

Hence, we prepare an income statement called Profit and Loss Account for ascertaining the net result, and a position statement called Balance Sheet for determining the financial position. The Profit and Loss Account and Balance Sheet together are called Final Accounts.

You also know that before preparing the final accounts, we prepare another statement called Trial Balance in order to check the arithmetical accuracy of the books of account. The Trial Balance also forms the basis for the preparation of the Final Accounts. All items appearing in the Trial Balance are transferred either to the Profit and Loss Account or to the Balance Sheet.

As per rules, items of revenue nature are shown in the Profit and Loss Account and items of capital nature in the Balance Sheet. In other words, whether an item will appear in Profit and Loss Account or in the Balance Sheet depends upon the revenue and capital nature of the item.

If any item is wrongly classified i.e., if any item of revenue nature is treated as a capital item or vice versa, the ascertainment of profit will be incorrect. For example, the revenues earned during an accounting year are Rs.1,00,000 and the costs shown are Rs.80,000. The profit will work out as Rs.20,000. On rechecking you found that a revenue item of Rs.5,000 (an expenditure on repairs of machinery) had been treated as a capital item (added to cost of machinery) and hence not included. It means the actual costs are Rs.85,000 and not 80,000. So the correct profit is Rs.15,000. In other words, the profit worked out earlier was overstated. Thus, it can also be stated that if any capital expenditure is wrongly classified as revenue expenditure, it would result in an understatement of profits. Let us also illustrate this. Assume that a purchase of furniture worth Rs.10,000 was wrongly passed through the Purchases Book treating it as purchases of goods on credit. This would result in the boosting of costs by Rs.10,000 leading to an understatement of profits by Rs.10,000 and also to an understatement of assets. As such the final accounts will not reflect the try and fair view of the affairs of the business.

Thus you learn that wrong classification of items would lead to the wrong ascertainment of profit and also the financial position. Hence, it is necessary to determine correctly whether, an item is of a capital or of a revenue nature. This distinction is also important from taxation point of view because capital profits are taxed differently from revenue profits.