Ascertainment of pre-incorporation and post-incorporation profits by preparing Profit and Loss Account and Balance Sheet

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’.

For example, X Ltd. was incorporated on 1st April 2006, took over a running business, Y Ltd., from 1st January 2006 and it closed its accounts on 31st December 2006. Now, the company X Ltd. is entitled not only to the profit/loss made by Y Ltd. from 1st April to 31st December 2006 but also to the profit/loss made by Y Ltd. from 1st January 2006 to 31st March 2006.

Thus, any profit/loss made before the incorporation is known as “Profit (Loss) Prior to Incorporation” which is treated as a capital profit and the same cannot be distributed as business profit. Hence, it cannot be distributed by way of dividend.

The same is to be transferred to Capital Reserve or may be adjusted against Goodwill. “Loss prior to incorporation” is treated as a capital loss and, hence, the same is shown under the head “Miscellaneous Expenditure” in the assets side of the Balance Sheet.

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.

To Sum up:

(a) Gross Profit should be apportioned between Pre-incorporation and Post-incorporation periods on the basis of Sales Ratio. If Gross Profit is not given the same is to be found out by preparing a Trading Account.

(b) Time Ratio between Pre-incorporation and Post-incorporation period should be computed. Usually fixed expenses are allocated on the basis of Time Ratio, viz. Rent, Tax, Insurance, Depreciation, Interest, Salaries to Office Staff, etc.

(c) Sales Ratio must be found out between Pre-incorporation and Post-incorporation period and usually selling expenses or variable expenses are allocated on the basis of Sales Ratio, viz. Advertisement, Godown Rent, Storage, Discount Allowed, Carriage Outwards, Salesmen’ Salaries and Commission, etc.

(d) Expenses excluding for Post-incorporation periods are: viz. Directors’ Fees, Debenture Interest, Preliminary Expenses, Provision for Taxation, Proposed Dividend, etc.

(e) Expenses excluding for Pre-incorporation period, are: Interest on Partners’ Capital, Partners’ Salaries, etc.

(f) Expenses relating to both Pre- and Post-incorporation should be charged to both the period on Time basis, e.g. Audit fees, interest paid to vendors, etc.

Treatment of Profit or Loss Prior to Incorporation

Sometimes, a company is formed for purchasing certain running or going concern. A company comes into existence only after its registration i.e., its incorporation. A company can earn profits only after its incorporation, but not before its incorporation. In many cases, th6 date of acquisition of business may not coincide with the date of the incorporation.

For instance, a company incorporated on 1st May 2004 may purchase a business from 1st January 2004, the date on which the financial year starts. Generally the business of going concern is purchased on the basis of last Balance Sheet.

It will be more convenient to both the vendor and the vendee. In case if the business is purchased on a date other than the date of Balance Sheet, accounts of stocks, assets, liabilities etc. have to be taken and verified. The processes are tedious jobs. To avoid such a tedious job, the business may be acquired from the date the firm prepared its last final accounts.

A private company can commence business soon after its incorporation, while a public company can commence business only after obtaining the certificate of commencement of business. That is, any profit made, in case of private company, before incorporation and in case of public company any profit made before the commencement of business, should be taken as a capital profit. However, it should be noted carefully that it is the date of incorporation and not the date of commencement of business which is taken into consideration for calculating profit or loss prior to incorporation.

For instance, a company incorporated on 1.4.2004 agrees to take over a running business from 1.1.2004. It closes its accounts on 31st December. The company is entitled to not only the profit or loss from 1.1.2004 to 31.3.2004 but also the profit or loss from 1.4.2004 to 31.12.2004. The profit earned prior to incorporation i.e., 1.1.2004 to 31.3.2004 is known as PRE-INCORPORATION PROFIT, which cannot be taken as revenue profit, but is CAPITAL PROFIT.

Such profit is to be transferred to CAPITAL RESERVE or may be used in writing down capital loss. When, there arises a loss in the pre-incorporation period, the loss should be debited to GOODWILL ACCOUNT. The profit earned during post period i.e., in the above example, from 1.4.2004 to 31.12.2004, is revenue profit and is available for dividend.

Allocation of ‘Profit/Loss into Pre-and Post-Incorporation Period:

As the profits earned prior to incorporation are not available for dividend, it is necessary to separate it from divisible profits. This is possible, when the profit and loss account is prepared separately for the pre-incorporation period and post-incorporation period. And this is possible only by closing of the books and stock taking for the two periods. These involve tedious work. Therefore, the profit or loss is estimated by apportioning on some reasonable basis – time, turnover, equitable or actual.

In practice, the same sets of books of accounts are 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 (Pre-incorporation period) and

(ii) From the date of incorporation to the closing of the accounting year (Post-incorporation period).

Method of Accounting:

Steps to find out the profit or loss before and after incorporation are as follows:

1. Prepare one trading account for the whole period. Do not consider the date of incorporation. Thus, one figure of gross profit for the entire period is arrived at.
2. The gross profit is apportioned between the two periods, prior to incorporation and post- incorporation, on the basis of sales in the two periods.
3. The various expenses, which are shown in the profit and Loss Account, should be divided between pre and post incorporation periods on some logical and appropriate basis.

Sales Ratio:

In simple problems, where the sales is evenly spread over the whole period, the sales are apportioned between pre and post-incorporation periods in the proportion of their time periods. But in many cases, the sales are fluctuating from time to time. Therefore, the Sales Ratio is found out by considering pre and post-incorporation periods on the basis of their respective turnover. (Turnover-cum-time basis.)

Treatment of Pre Incorporation Results:

Profit or loss from the date of purchase of business till the date of incorporation belongs to the company. Such profit should not be regarded as trading profit. The profit made before incorporation is not available for distribution as dividends to the shareholders of the purchasing company because it is treated as capital profit.

The treatment of pre-incorporation results is given below:

(A) Profit Prior to Incorporation:

1. The profit is in the nature of capital profit.
2. Capital profit should not be used for payment of dividend.
3. It can be used for writing down goodwill or capital losses.
4. The unutilised portion of the profit can be transferred to Capital reserve.

(B) Loss Prior to Incorporation:

1. It can be treated as goodwill and added to goodwill account.
2. It can also be treated as deferred revenue expenditure and written off against profits, over a number of years.
3. It may be debited to a separate account – Loss Prior to Incorporation Account.