Time Ratio Profit Prior to Incorporation

When a newly incorporated company takes over an existing business, it is common for the business to have been operational even before the company was legally formed. In such cases, the total profit or loss for the entire period needs to be split between the Pre-incorporation period and the Post-incorporation period.

The profit earned before incorporation is known as Profit Prior to Incorporation. It is considered a capital profit and cannot be distributed as dividends. For an accurate and fair division of profits and expenses between the two periods, two essential tools are used:

• Sales Ratio: Used for apportioning sales-related items.

• Time Ratio: Used for apportioning time-based expenses.

This note focuses on the Time Ratio and how it is used in calculating Profit Prior to Incorporation.

What is Profit Prior to Incorporation?

Profit Prior to Incorporation refers to the portion of the net profit (or loss) earned by a business before it becomes a legally incorporated company. It arises in cases where a business is already operational and later taken over by a company from a specific date.

For example, if a business operates from January 1 and is incorporated on April 1, profits from January to March would be termed as Profit Prior to Incorporation, and profits from April onwards would be Revenue Profits.

Nature and Treatment of Profit Prior to Incorporation:

Capital Nature:

• Treated as capital reserve, not as distributable profit.

• Shown on the liabilities side of the Balance Sheet under Reserves and Surplus.

• Can be used for:

  • Writing off preliminary expenses.

  • Writing off goodwill.

  • Issuing bonus shares.

  • Absorbing capital losses.

Revenue Profits:

• Arise after incorporation.

• Can be distributed as dividends to shareholders.

• Shown in the Profit & Loss Account.

Time Ratio – Meaning and Importance:

Time Ratio is the ratio between the lengths of the pre-incorporation and post-incorporation periods. It is used to apportion time-based expenses and incomes that accrue evenly over time.

• Formula of Time Ratio

Time Ratio = Number of months (or days) in pre-incorporation period: Number of months (or days) in post-incorporation period

Example:

Items Apportioned Using Time Ratio:

Time-based items that are not directly linked to sales are divided using Time Ratio.

Examples:

1. Determine Total Profit or Loss for the full accounting period.

2. Identify the Date of Incorporation and divide the period into:

   • Pre-incorporation period.

   • Post-incorporation period.

3. Calculate Time Ratio for time-based expenses.

4. Calculate Sales Ratio for sales-based incomes/expenses.

5. Classify Expenses and Incomes into:

   • Time-based (use time ratio).

   • Sales-based (use sales ratio).

   • Specific to pre- or post-incorporation.

6. Prepare a Profit Allocation Statement.

Format of Profit Prior to Incorporation Statement: