1. What are Pre-operative Expenses/preliminary Expenses?

A business may incur many expenditures before it starts.  These costs can be called as Start-up costs which consists of preliminary expenses incurred in establishing a legal entity such as legal and secretarial costs, expenditure to open a new facility or business (pre-opening costs) or expenditures for commencing new operations or launching new products or processes (pre-operating costs)

Few examples of such expenses are:

• Legal and secretarial costs in establishing the legal entity
• preparation of project report
• preparation of feasibility report
• Expenditure incurred on trial runs
• General administrative Expenses like Salaries, rents, etc till the commencement of business.

2. What does Accounting Standards Say?

Relevant portions of the Accounting Standards:

Para 7 of per Accounting Standard (AS) 10, “Property, Plant and Equipment”  & Indian Accounting Standard (Ind AS) 16 say:

“7. The cost of an item of property, plant and equipment should be recognised as an asset if, and only if: 

(a) it is probable that future economic benefits associated with the item will flow to the enterprise; and 

(b) the cost of the item can be measured reliably.”

Para 17 of AS 10 and Ind AS 16 say:

“17. The cost of an item of property, plant and equipment comprises: 

(a) its purchase price, including import duties and non–refundable purchase taxes, after deducting trade discounts and rebates. 

(b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. 

(c) the initial estimate of the costs of dismantling, removing the item and restoring the site on which it is located, referred to as ‘decommissioning, restoration and similar liabilities’, the obligation for which an enterprise incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.”

Para 18 of AS 10 says:

“18. Examples of directly attributable costs are: 

(a) costs of employee benefits (as defined in AS 15, Employee Benefits) arising directly from the construction or acquisition of the item of property, plant and equipment; 

(b) costs of site preparation; 

(c) initial delivery and handling costs; 

(d) installation and assembly costs; 

(e) costs of testing whether the asset is functioning properly, after deducting the net proceeds from selling any items produced while bringing the asset to that location and condition (such as samples produced when testing equipment); and 

(f) professional fees.” 

Para 20 of Ind AS 16 says:

“20. Examples of costs that are not costs of an item of property, plant and equipment are: 

(a) costs of opening a new facility or business, such as, inauguration costs; 

(b) costs of introducing a new product or service (including costs of advertising and promotional activities); 

(c) costs of conducting business in a new location or with a new class of customer (including costs of staff training); and 

(d) administration and other general overhead costs.

Para 56 of Accounting Standard (AS) 26, “Intangible Assets” says:

“56. In some cases, expenditure is incurred to provide future economic benefits to an enterprise, but no intangible asset or other asset is acquired or created that can be recognised. In these cases, the expenditure is recognised as an expense when it is incurred.

For example, expenditure on research is always recognised as an expense when it is incurred (see paragraph 41). Examples of other expenditure that is recognised as an expense when it is incurred include:

(a) expenditure on start-up activities (start-up costs), unless this expenditure is included in the cost of an item of fixed asset under AS 10. Start-up costs may consist of preliminary expenses incurred in establishing a legal entity such as legal and secretarial costs, expenditure to open a new facility or business (pre-opening costs) or expenditures for commencing new operations or launching new products or processes (pre-operating costs);

(b) expenditure on training activities;

(c) expenditure on advertising and promotional activities; and

(d) expenditure on relocating or re-organising part or all of an enterprise.”

3. Conclusion

As per the accounting standards, it can be noted that the basic principle to be applied while capitalising an item of cost to a property, plant and equipment (PPE) or an intangible asset is that it is directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. Directly attributable costs are those costs without the incurrence of which the asset cannot be brought to the location and condition necessary for it to be capable of operating in the manner intended by management. 

• Hence, pre-operative expenses that are directly attributable costs can be capitalised as part of PPE or an intangible asset in accordance with the Accounting Standards.

• Regarding other pre-operative expenses like Administration and other general overhead costs, the general rule that expenses of such nature should be expensed as no intangible asset or other asset is acquired or created that can be recognised.

For eg., the expenditure on employee benefits, rent expenses, travelling expenses and house-keeping expenses etc., which cannot be directly attributable to the cost of a PPE have to be should be expensed off in the profit and loss account in the year in which these are incurred and should not be carried forward to be amortised over a period.

Regarding the Income Tax Implications of the pre-operative/preliminary expenses, refer the article 

Disclaimer: The views expressed herein are strictly personal. This document is intended solely for informational purposes and does not constitute professional advice or recommendations. The entire content of this document has been formulated based on relevant provisions and information available at the time of preparation. Although diligent efforts have been made to furnish authentic information, it is advised to seek a better understanding and obtain professional advice after a thorough examination of the specific situation. The author disclaims any liability for any loss or damage of any kind arising from the information in this article and any actions taken in reliance thereon.