Introduction, Meaning Concept of Profit (or Loss) Prior to the Date of Incorporation

When a company is formed, there is often a gap between the date it starts business operations and the date it is legally incorporated. This period, from when the business begins its operations to the official date of incorporation, is referred to as the “pre-incorporation period”. Any profit or loss that arises during this time is called Profit or Loss Prior to Incorporation.

Such profits or losses are not earned or incurred by a legal company since the company did not exist legally during that period. As a result, the treatment of such profits or losses is different from normal business results. These pre-incorporation profits are considered capital profits and are not available for dividend distribution. Similarly, pre-incorporation losses are treated as capital losses.

This concept arises especially when a business is taken over as a going concern — for example, when promoters take over a partnership firm or an existing business before incorporating the company.

Profit Prior to Incorporation:

Profit prior to incorporation refers to the profit earned by a business between the date of acquisition of a business and the date on which the company is incorporated. Since the company was not a legal entity during this period, any income or expense during this time is not operational in nature for the company. These profits are usually earned from sales or services and are computed by apportioning income and expenses between the pre- and post-incorporation periods using appropriate ratios.

For example, if a company is incorporated on 1st June, but starts operations on 1st April, any income or expense from 1st April to 31st May is considered for pre-incorporation period, while income/expense after 1st June is for the post-incorporation period. The profit prior to incorporation is treated as a capital profit and transferred to Capital Reserve, not Profit and Loss Account.

Concept and Significance:

The concept of profit prior to incorporation is important for maintaining accurate financial reporting and legal compliance. As per company law, only profits earned after incorporation are available for distribution as dividends to shareholders. Hence, profits earned before incorporation cannot be used for that purpose. These profits are instead transferred to the Capital Reserve Account, which is a part of shareholders’ funds but cannot be used for dividend.

The apportionment between pre- and post-incorporation periods ensures that income and expenses are recorded correctly. This also helps in identifying which part of the revenue and expenses are legally attributable to the company. For example, salaries paid during the pre-incorporation period are often treated differently from those paid later, since the company wasn’t officially formed and hence, did not employ staff legally during that time.

Basis of Apportionment:

Income and expenses are divided between the pre- and post-incorporation periods using the following bases:

• Time Ratio = Period before incorporation : Period after incorporation

• Sales Ratio = Sales before incorporation : Sales after incorporation

This helps ensure that the Profit and Loss Account reflects only post-incorporation activities, and the pre-incorporation profit is appropriately adjusted in capital accounts.

Accounting Treatment:

• Profit Prior to Incorporation is transferred to Capital Reserve account.

• Loss Prior to Incorporation is treated as a capital loss and is debited to Goodwill Account or shown as a separate item under Miscellaneous Expenditure (to the extent not written off).

Journal Entries:

(a) When Profit Prior to Incorporation is ascertained:

Profit and Loss A/c (Pre-incorporation Dr.)

To Capital Reserve A/c

(b) When Loss Prior to Incorporation is incurred:

Goodwill A/c or Capital Reserve A/c Dr.

To Profit and Loss A/c (Pre-incorporation)

The treatment ensures profits or losses not earned during the legal existence of the company do not distort distributable earnings.

Example with Table:

A business was taken over on 1st April 2024, and the company was incorporated on 1st August 2024. The financial year ends on 31st March 2025. Sales and expenses are as follows:

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

Apportionment Table:

Gross Profit – (Rent + Salaries + Selling Exp. for pre-incorp)

= ₹1,33,333 – (₹20,000 + ₹40,000 + ₹26,667) = ₹46,666

→ This is transferred to Capital Reserve.