Overview: Preliminary Expenses are those expenses that incur towards startup activities, consisting of expenses incurred in establishing a legal entity, including legal fees, secretarial fees, government fees, meeting expenses, etc. Many more expenses can be added to the list of preliminary expenses. As per Section 35 of the Income Tax Act 1961, the total preliminary expenses can’t exceed more than 5% of the capital employed. The blog gives you deeper insights into pre-incorporation expenses accounting treatment as per the Companies Act 2013.
Preliminary expenses are the expenses incurred prior to the incorporation of a Company or LLP. These are normally the expenses that founders/promoters of the company incur on account of government and professional fees paid to the consultant while incorporating the company. The project reports are prepared to assess the viability of the business as such and the expenses incurred towards the brand building of the company while the incorporation process is underway.
The preliminary expenses are in the nature of expenses that provide future economic benefits to the enterprise. But no physical or tangible assets are created or acquired according to standard 10 , which deals with preliminary expenses. According to that, the expenses incurred towards startup activities, which may consist of expenses incurred in establishing a legal entity, such as legal fees, secretarial fees, government fees, travelling and meeting expenses, while the entity is under creation. The broader understanding is to include the following expenses under preliminary expenses.
- Meeting expenses of the promoter.
- Preliminary consultation charges for the formation of a company.
- Actual Govt. fee and stamp duty paid in the course of incorporation of a legal entity.
- Secretarial costs incurred for dealing with the Registrar of Companies (ROC).
- Expenses to open a new facility or business (pre-opening cost).
- Training expenses incurred prior to the incorporation of the company.
- Expenses incurred towards human resources prior to incorporation.
- Expenses incurred towards any pre-incorporation agreement.
- Project report and feasibility study related expenses, etc.
It is clear from all the expenses that the pre-operational expenses are grouped under preliminary expenses. The Companies Act and the Income Tax Act treat the preliminary expenses differently.
Companies Act Treatment
In view of the fact that the preliminary expenses do not result in any physical or tangible assets, they take away any possibility of depreciation being recorded in the books. For the useful life of the assets. The Companies Act & Schedule VI provides for recognition of 1/5th of the total preliminary expenses each year for five consecutive years. To record this transaction, the following accounting entries are passed.
To record the preliminary expenses incurred prior to incorporation of the legal entity, the following entry should be passed on the first day of the incorporation: Debit the preliminary expenses A/c and Credit the Profit & Loss A/c for the amount determined as preliminary expenses. As stated above, the preliminary expenses can be written off in five years. To record that, the following entry should be passed: Debit the Preliminary expenses written off, and credit the preliminary expenses A/c with the amount which is equal to 1/5th of the total preliminary expense booked as per point no 1.
Income Tax Act Treatment
As explained above the preliminary expenses can be written off within five years however as per Section 35 of The Income Tax Act 1961, the total preliminary expenses cannot be more than 5 % of the capital employed, which can be amortised in five equal installments, this also means that a company cannot write off preliminary expense more than 1 % of the capital employed in one year.
At the time of computation of the taxable income, the assessee must add the preliminary expense written off in the balance sheet, which is prepared by following the provisions of The Companies Act 2013, and deduct the pre-incorporation expenses as 1/5th of the 5% of the capital employed.
Conclusion
Expenses that incur prior to incorporation of a business entity are generally referred to as preliminary expenses. Several expenses can be kept in the list of preliminary expenses that are required to make a legal entity operational. With the above blog, you would have gained a clearer and better understanding of preliminary expenses as per the Companies Act 2013, preliminary expenses and their accounting treatment in LLP/company.
FAQ’s
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