Introduction, Meaning Calculation of Sales Ratio Profit Prior to Incorporation

In the lifecycle of a company, the phase before its legal incorporation is known as the pre-incorporation period. During this phase, promoters often initiate business activities like purchasing assets, hiring staff, and even making sales. However, a company legally comes into existence only after receiving a Certificate of Incorporation from the Registrar of Companies. This creates a distinction between pre-incorporation and post-incorporation periods for accounting purposes.

When a business is taken over by a newly incorporated company, profits earned during the pre-incorporation period are not considered the income of the company. This is because the company did not legally exist at that time. Therefore, such profits are called Profit Prior to Incorporation and are treated as capital profits. Conversely, profits earned after incorporation are revenue profits.

Meaning of Profit Prior to Incorporation:

Profit Prior to Incorporation refers to the profits or losses earned by a business during the period before the company was legally formed. Since the company is not a legal entity during this time, any profit earned cannot be distributed as dividends. Instead, it is transferred to a Capital Reserve.

The business may have been operated by promoters or taken over from an existing sole proprietor or partnership. The financial results for the full accounting period (before and after incorporation) are often given together, so it becomes necessary to apportion the profits between the pre-incorporation and post-incorporation periods.

Necessity of Calculating Profit Prior to Incorporation:

1. Correct Profit Reporting: Ensures the company’s financials reflect only profits made during its legal existence.

2. Dividend Distribution: Dividends can only be paid from revenue profits.

3. Legal Compliance: Prevents distribution of capital profits as dividends, which is prohibited under the Companies Act.

4. Tax Purposes: Helps determine taxable profits accurately.

Steps to Calculate Profit Prior to Incorporation:

1. Ascertain Total Profit or Loss: Determine the profit for the entire period (before and after incorporation).

2. Divide the Period: Identify the number of months before and after incorporation.

3. Calculate the Sales Ratio: Used for apportioning items related to sales (e.g., gross profit).

4. Calculate the Time Ratio: Used for apportioning time-based expenses (e.g., rent, salaries).

5. Allocate Expenses and Incomes:

   • Allocate incomes and expenses between pre- and post-incorporation using appropriate ratios.

6. Prepare a Statement: Show profit or loss for each period separately.

Calculation of Sales Ratio:

Sales Ratio is used to apportion sales-based items (e.g., gross profit, commission on sales). It is the ratio of sales made during the pre-incorporation and post-incorporation periods.

Formula:

Sales Ratio = Sales in Pre-Incorporation Period / Sales in Post-Incorporation Period​

Steps to Calculate:

1. Find Total Sales: Determine the total sales during the accounting period.

2. Break Sales Period-Wise: Separate sales into pre- and post-incorporation periods.

3. Calculate the Ratio: Divide sales of the respective periods to get the sales ratio.

Example:

If total sales from Jan 1 to Dec 31 are ₹12,00,000 and the company was incorporated on May 1:

• Sales from Jan to April = ₹4,00,000 (Pre)

• Sales from May to Dec = ₹8,00,000 (Post)

Then,

Sales Ratio = 4,00,000 : 8,00,000 = 1 : 2

Items Apportioned on Time Ratio vs Sales Ratio:

• Preliminary expenses: Post-incorporation

• Director’s fees: Post-incorporation

• Interest on purchase consideration: Pre-incorporation

Treatment of Profit Prior to Incorporation:

1. Capital Reserve: Profit prior to incorporation is transferred to Capital Reserve on the balance sheet.

2. Cannot be Distributed as Dividend: As it is capital in nature.

3. Can be Used for:

   • Writing off goodwill or preliminary expenses

   • Issuing bonus shares

   • Meeting capital losses

Format of Profit Prior to Incorporation Statement: