Weighted Ratio Profit Prior to Incorporation

When a company is formed by taking over a running business, its financial year often spans both pre-incorporation and post-incorporation periods. The profit earned before the date of incorporation is termed “Profit Prior to Incorporation”. This profit is considered capital profit and not available for dividend distribution. To calculate this profit accurately, time ratio and sales ratio are used. However, when expenses and income do not align proportionally with time or sales, the Weighted Ratio is applied for equitable apportionment.

Profit Prior to Incorporation

Profit prior to incorporation is the profit earned by a business before the company is legally formed. For example, if a business is acquired on January 1st but the company is incorporated on April 1st, then the profit from January 1 to March 31 is profit prior to incorporation.

This profit must be calculated separately because:

• It is capital profit.

• It is not available for dividend.

• It is usually transferred to Capital Reserve.

Apportionment of Profit and Expenses:

To determine the correct amount of profit prior to incorporation, the total profit of the period (from acquisition to the end of the financial year) must be split between:

• Pre-incorporation period: From acquisition date to incorporation date.

• Post-incorporation period: From incorporation date to the end of the accounting period.

For accurate apportionment of income and expenses, three types of ratios are used:

1. Time Ratio

2. Sales Ratio

3. Weighted Ratio

What is Weighted Ratio?

Weighted Ratio is a more refined method of apportioning expenses, particularly when both time and sales affect the distribution. It assigns weights to both the time and sales factors and then applies these weights to allocate items like salaries, rent, and other semi-variable expenses.

Weighted Ratio = Time × Sales

It is used in situations where neither the time ratio nor sales ratio alone gives a fair distribution.

When to Use Weighted Ratio:

Weighted ratio is used for:

• Expenses affected by both time and activity level (sales).

• Semi-variable or mixed expenses like salaries (increased post-incorporation due to more staff), advertisement, and office expenses.

Steps for Calculating Profit Prior to Incorporation Using Weighted Ratio

1. Determine the total period (acquisition to end of financial year) and divide it into:

   • Pre-incorporation period

   • Post-incorporation period

2. Calculate Time Ratio = Duration of each period in months.

3. Calculate Sales Ratio = Sales in each period.

4. Calculate Weighted Ratio = Time × Sales (for each period).

5. Prepare a Statement of Profit and Loss:

   • Allocate incomes and expenses using:

     • Time ratio: for fixed expenses (e.g., rent, depreciation).

     • Sales ratio: for variable expenses (e.g., selling commission).

     • Weighted ratio: for semi-variable expenses (e.g., salaries, office expenses).

6. Calculate Profit Prior to Incorporation: Subtract the pre-incorporation expenses from the pre-incorporation revenue.

7. Transfer the amount to Capital Reserve.

Items Treated Using Weighted Ratio