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:
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.
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.
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
(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
(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.