What is the treatment of preliminary expenses in cash flow statement?

Preliminary expenses are those expenses that are incurred before the company’s business commences. These expenses are written off annually which does not involve any flow of cash. Therefore, in the cash flow statement, preliminary expenses are added back to net profit before tax and extraordinary items under the head operating activities (indirect method).

A cash flow statement is a financial statement that summarises the cash and cash equivalents entering and leaving the company. They can be classified into operating activities, investing activities and financing activities.

Reason for Treatment

Operating activities refer to those sources or usage of cash that relates to business activities.
As per the indirect method, the cash flow statement for operating activities begins with net profit before tax and extraordinary items. Since the company records non-cash expenditures also, they should add these back to net profit to find out the true cash flows. This is why preliminary expenses are added to net profit in the indirect method.

As per the direct method, all cash receipts are added and all cash expenses are subtracted to get cash flow from operating activities. Since preliminary expenses are a non-cash activity, they do not require any treatment in the direct method.

Preliminary expenses do not fall under the head investing activities as investing activities involve the acquisition or disposal of long term assets or investments. They do not fit in financing activities either as financing activities relate to change in capital or borrowings of the company.

Example

If the balance in preliminary expenses for the year 2019 was Rs.5,000 and its balance in 2020 reduced to 3,000, then its treatment in the cash flow statement would be: