Preliminary expenses are the examples of

Correct — C, (c) deferred revenue expenditure. Preliminary expenses are the expenses of bringing a company into existence: drafting and printing the memorandum and articles of association, the registration fee and stamp duty paid to the Registrar of Companies, the legal and professional charges of incorporation, the cost of the company's common seal, and the promoters' costs of the preliminary work in forming the company.

Run them through the classification tests and the answer follows. Is it capital expenditure? Capital expenditure acquires an asset, or adds to the earning capacity of one that exists. Nothing here does. There is no machine, no building, no patent — nothing that could be sold, and nothing that would appear as property if the company were wound up the next morning. So the expenditure is revenue in nature.

Is it then simply an expense of the year in which it was incurred? On the strict logic of the matching concept, no. The benefit these expenses bought is the company's own existence, which is not consumed in the first year but continues for as long as the company does. Charging the whole amount against the revenue of the first year would burden a period that has barely traded, and would understate that year's profit while overstating every later year's.

That combination — revenue in nature, but with a benefit extending beyond the accounting period in which it was incurred — is exactly the definition of the third category, deferred revenue expenditure. So the amount is spread over a number of years, a proportion is charged to the statement of profit and loss each year, and the balance not yet written off used to be carried on the assets side of the balance sheet under the head 'Miscellaneous expenditure (to the extent not written off or adjusted)'. Preliminary expenses are the standard textbook illustration of the category, and the sister items are heavy launch advertising for a new product, the cost of shifting a factory, and research expenditure that has produced no identifiable asset.

One current qualification the card should give you plainly, because it is the point on which a well-prepared candidate hesitates. AS 26, Intangible Assets, provides in paragraph 56 that where expenditure is incurred to provide future economic benefits but no asset that can be recognised is acquired or created, the expenditure is to be recognised as an expense when it is incurred — and it names start-up costs, of which preliminary expenses are the leading example, as its illustration. So in the books of a company today the amount is written off in the year of incurrence rather than deferred, and the 'Miscellaneous expenditure' head has gone from the balance-sheet format. What has not changed is the classification the question asks about: in the capital-revenue-deferred taxonomy, preliminary expenses are the example of deferred revenue expenditure, and the income-tax law still treats them as an amount to be spread, allowing amortisation under section 35D of the Income-tax Act over five successive years, subject to a ceiling on the qualifying amount.

Why the others are wrong

• (a)capital expenditure — Capital expenditure is incurred to acquire a fixed asset, to bring one into working condition, or to increase the earning capacity of one already held — the purchase price of a machine, the freight and installation on it, the cost of an extension to a building, the legal fees of buying land. Its test is that something of enduring value comes into the enterprise and appears on the assets side as property. Preliminary expenses acquire nothing of the kind. It is true that the unwritten-off portion was traditionally shown on the assets side, and that is what makes this option superficially attractive; but appearing on the assets side as a balance still to be written off is not the same as being an asset, and a fictitious asset of that kind was always understood as a deferred charge rather than as property.
• (b)capital gain — This is a category error rather than a fine distinction. A capital gain is income — the surplus arising on the transfer of a capital asset over its cost of acquisition — and it belongs on the receipts side of the accounts and in a wholly different part of the income-tax law. Preliminary expenses are money going out, not money coming in. No amount of confusion about how they should be written off could make an outgoing into a gain, so a candidate who has read the option can eliminate it without knowing anything about preliminary expenses at all. Its function in the set is to occupy a slot.
• (d)revenue expenditure/expense — Preliminary expenses are revenue in nature, so this option is not wrong about their character — it is wrong about their classification, because a more specific category exists and the question asks which category they exemplify. Ordinary revenue expenditure is consumed within the accounting period in which it is incurred: rent for the year, wages, power, repairs. Preliminary expenses were incurred once and bought a benefit that lasts as long as the company, which is precisely why the traditional taxonomy separates them out as deferred revenue expenditure rather than leaving them in the general revenue class. This paper's own next question makes the distinction explicit by reserving 'revenue expenditure/expense' for depreciation, an expense that genuinely belongs to the year in which it is charged. Note also why a well-prepared candidate is drawn here: under AS 26 the amount is now written off in the year it is incurred, so in practice it is accounted for like ordinary revenue expenditure. That is the treatment, not the classification, and the stem asks for the classification.

Expenditure is classified in three ways for the purposes of the final accounts. Capital expenditure acquires or improves an asset, or increases earning capacity, and appears in the balance sheet; it is written off over the asset's life through depreciation. Revenue expenditure is consumed in earning the revenue of the period and is charged in full to the statement of profit and loss. Deferred revenue expenditure is revenue in nature — it acquires no asset — but its benefit runs beyond the year in which it is incurred, so the traditional treatment spreads it over the years expected to benefit, charging a portion each year and carrying the unwritten-off balance under 'Miscellaneous expenditure (to the extent not written off or adjusted)'. The classical examples are preliminary expenses, heavy advertising on the launch of a new product, the cost of shifting a factory, and research expenditure that produces no identifiable asset. The category has been narrowed sharply in modern practice: AS 26 paragraph 56 requires expenditure that provides future economic benefit but creates no recognisable asset to be expensed as incurred, naming start-up costs as the example, and the 'Miscellaneous expenditure' head disappeared when the balance-sheet format was revised and carried into Schedule III of the Companies Act, 2013. Tax law took a different road: section 35D of the Income-tax Act permits an Indian company to amortise qualifying preliminary expenses over five successive years — ten before the amendment of 1998 — subject to a ceiling on the qualifying amount, which produces a timing difference between the accounts and the tax computation.

Key facts

• Preliminary expenses are the costs of forming a company — memorandum and articles, registration fee and stamp duty, legal and professional charges of incorporation, the common seal, and the promoters' preliminary work.
• They acquire no asset, so they are revenue and not capital in nature.
• Their benefit extends beyond the year of incurrence, which is why the traditional taxonomy classes them as deferred revenue expenditure.
• The unwritten-off balance was shown on the assets side under 'Miscellaneous expenditure (to the extent not written off or adjusted)'.
• Other classical examples of deferred revenue expenditure: heavy launch advertising, the cost of shifting a factory, and research expenditure yielding no identifiable asset.
• AS 26 paragraph 56 requires expenditure that yields future benefit but creates no recognisable asset to be expensed when incurred, and names start-up costs as the example.
• The 'Miscellaneous expenditure' head is not part of the balance-sheet format under Schedule III of the Companies Act, 2013.
• Section 35D of the Income-tax Act allows qualifying preliminary expenses to be amortised over five successive years, subject to a ceiling on the qualifying amount.
• Before the 1998 amendment, that amortisation period under section 35D was ten years.
• The difference between the accounting write-off and the tax amortisation creates a timing difference.

Common traps

• Classifying preliminary expenses as capital expenditure because the unwritten-off balance once appeared on the assets side.
• Stopping at 'revenue in nature' when a more specific category is on offer and the question asks which category the item exemplifies.
• Confusing an expenditure classification with a receipt concept — capital gain is income.
• Assuming that because AS 26 requires an immediate write-off, the deferred revenue category has ceased to exist as a classification.
• Mixing the accounting treatment with the income-tax treatment; section 35D spreads the amount even where the accounts do not.

• practice — not a real PYQ

  Which one of the following would be included in the preliminary expenses of a company?

  • (a)Salaries paid to employees during the first year of trading
  • (b)Registration fee and stamp duty paid to the Registrar of Companies on incorporation
  • (c)The cost of a machine purchased before the commencement of business
  • (d)Interest on a term loan taken after the commencement of business

  Answer(b) Registration fee and stamp duty paid to the Registrar of Companies on incorporation

• practice — not a real PYQ

  Under section 35D of the Income-tax Act, qualifying preliminary expenses of an Indian company may at present be amortised over

  • (a)three successive years
  • (b)five successive years
  • (c)ten successive years
  • (d)fifteen successive years

  Answer(b) five successive years