Profits Prior to Incorporation and Accounting Treatment
by Profit of a business for the period prior to the date company into existence is referred to as Pre-Incorporation profit. Hence prior period item are those item which is done before incorporation of the company. Profit prior to incorporation is the profit earned or loss suffered during the period before incorporation. It is a capital profit and not legally available for distribution as dividend because a company cannot earn a profit before it comes into existence.
Profit earned after incorporation is revenue profit, which is available for dividend. Profit of prior period and post period however divided separately because the prior period profit and loss hence always credited and charged from capital reserve A/c. Post period profit and loss thus credited and charged from Profit & Loss A/c.
When a running business is taken over from a date prior to its incorporation/commencement, the profit earned up to the date of incorporation/commencement (incorporation, in case of private company; and commencement, in case of public company) is known as ‘Pre-incorporation profit’.
The same is to be treated as capital profit since these are profits which have been earned before the company came into existence. In short, the profit earned after the date of purchase of business is called ‘Post-incorporation or Post-acquisition profit’ and the profit earned before the date of purchase of business is termed as ‘Pre-incorporation profit’.
Method of Computation of Profits/Loss Prior to Incorporation:
In order to ascertain the profit prior to incorporation a Profit and Loss Account is to be prepared at the date of incorporation. But in practice, the same set of books of accounts is maintained throughout the accounting year.
A Profit and Loss Account is prepared at the end of the year and thereafter the profits (or losses) between the two periods are allocated:
(i) From the date of purchase to the date of incorporation or pre-incorporation period;
(ii) From the date of incorporation to the closing of the accounting year or post-incorporation period.
Method of Accounting of Profit/Loss Prior to Incorporation:
Steps may be suggested for ascertaining profit or loss prior to incorporation:
Step I:
A Trading Account should be prepared at first for the whole period, i.e., between the date of purchase and the date of final accounts, in order to calculate the amount of gross profit.
Step II:
Calculate the following two ratios:
(i) Sales Ratio:
Amount of sales should be calculated for the pre-incorporation and post-incorporation periods.
(ii) Time Ratio:
It is calculated after considering the time period, i.e., one is required to calculate the period falling between the date of purchase and the date of incorporation and the period between the date of incorporation and the date of presenting final accounts.
Step III:
A statement should be prepared for calculating the amount of net profit before and after incorporation separately on the following principle:
(i) Gross Profit should be allocated for the two periods on the basis of sales ratio which will present the gross profit for the two separate periods, viz. pre-incorporation and post- incorporation.
(ii) Fixed Expenses or expenses incurred on the basis of time, viz., Rent, Salary, Depreciation, Interest, etc. should be allocated for the two periods on the basis of time ratio.
(iii) Variable Expenses or expenses connected with sales should be allocated for the two periods on the basis of sales ratio.
(iv) Certain expenses, viz., partners’ salary, directors’ salary, preliminary expenses, interest on debentures, etc. are not apportioned since they relate to a particular period. For example, partners’ salary is to be charged against pre-acquisition profit whereas directors’ remuneration, debenture interest, etc. are to be charged against post-acquisition profit.
List of Expenses: Allocated on the basis of Sales/Turnover:
(a) Gross Profit
(b) Selling Expenses
(c) Advertisement
(d) Carriage Outwards
(e) Godown Rent
(f) Discount Allowed
(g) Salesmen’s Salaries
(h) Commission to Salesmen
(i) Promotion Expenses for Sales
(j) Distributions Expenses (Variable Portions)
(k) Free Samples given
(l) Expenses incurred for After-Sale Service, etc.
(m) Delivery Van Expenses.
List of Expenses: Allocated on the basis of Time:
(a) Office and Administration Expenses
(b) Salaries to Office Staff
(c) Rent, Rates and Taxes
(d) Depreciation on Fixed Assets
(e) Printing and Stationery
(f) Insurance
(g) Audit Fees
(h) Miscellaneous Expenses
(i) Distribution Expenses (Fixed Portion)
(j) Travelling Expenses (General)
(k) Interest of Debenture
(l) General Expenses
(m) Expenses Fixed in Nature.
Application/Accounting Treatment of Profit/Loss Prior to Incorporation:
(a) Pre-incorporation Profit:
Since “Profit prior to Incorporation” is a Capital Profit the same should be written off against:
(i) Preliminary Expenses Account
(ii) Formation Expenses Account
(iii) Liquidation Expenses Account
(iv) Write down the value of Fixed Assets, if any
(v) Goodwill Account
(vi) Balance, if any, transferred to Capital Reserve.
(b) Pre-incorporation Loss:
Since “Pre-incorporation Loss” is a Capital Loss the same is adjusted against
(i) Any Capital Profit
(ii) Debited to Goodwill Account
(iii) Writing-off Fictitious Assets
(iv) Capital Reserve.
Basis of allocation of items between ‘pre’ and ‘post’ incorporation period
Time basis
Some type of expense and income which thus divided between pre- and post-period item on basis of time ratio.
For example: Depreciation, salary & wages, Rent and trade expenses etc.
Turnover basis
Some type of expense and income thus divided between pre- and post-period item on the basis of turnover.
Debtors & Creditors Suspense Accounts
- A company taking over a running business may also agree to collect its debts as an agent for the vendor and may further undertake to pay the creditors on behalf of the vendors in such a case, the debtors and creditors of a vendors will include in the accounts for the company by debit or credit separate total accounts in the general ledger to distinguish them from the debtors and creditors of the business and contra entries will make in corresponding suspense account. Also details of debtors and creditors balance will thus kept in separate ledger.
- The vendor hence treated as a creditors for the cash received by the purchasing company in respect of the debts due to the vendor, just as if he has himself collected cash from his debtors and remitted the proceeds to the purchasing company.
- The vendor thus considers a debtor in respect of cash paid to his creditors by the purchasing company. The balance of cash collected, less paid, will represent the amount due to or by the vendor, arising from debtors and creditors balances which have taken over, subject to any collection expenses.
- Balance in suspense account will be equal to the amount of debtor and creditors taken over remaining unadjusted at anytime.