Profit or Loss prior to Incorporation refers to the profits or losses earned by a company before it was incorporated or became a legal entity. This may happen when a company is formed after the start of a business or when an existing business is taken over by a company.
In such cases, the profits or losses earned by the business before it was incorporated are usually transferred to the books of the newly formed company. This is done through a process known as the adjustment of profit or loss prior to incorporation. The adjustment is made in the books of the company to reflect the actual profits or losses earned by the business before it was incorporated.
The adjustment is necessary as the profits or losses earned by the business prior to incorporation do not belong to the company. They belong to the owners or partners who started the business. Hence, these profits or losses must be adjusted in the books of the company to ensure that the true financial position of the company is reflected.
The adjustment of profit or loss prior to incorporation is necessary because the profits or losses earned by the business before it was incorporated do not belong to the company. They belong to the owners or partners who started the business. As a result, it is necessary to adjust the financial statements of the company to reflect the actual profits or losses earned by the business prior to incorporation.
The adjustment of profit or loss prior to incorporation involves two steps: calculating the profit or loss prior to incorporation and making the necessary adjustments to the financial statements of the company.
Calculating the Profit or Loss Prior to Incorporation:
The profit or loss prior to incorporation is calculated by preparing a statement of profit or loss for the period between the start of the business and the date of incorporation. This statement should show the revenue earned, expenses incurred, and any profits or losses earned by the business during this period.
The statement of profit or loss prior to incorporation is prepared using the same accounting principles and methods that would be used to prepare the financial statements of the company. It should be prepared in accordance with the Generally Accepted Accounting Principles (GAAP) and should include all relevant income and expenses incurred by the business.
Making the Necessary Adjustments to the Financial Statements of the Company:
Once the profit or loss prior to incorporation has been calculated, the necessary adjustments must be made to the financial statements of the company. These adjustments will ensure that the financial statements of the company reflect the actual profits or losses earned by the business prior to incorporation.
The adjustments may include:
- Transferring the profits or losses earned by the business prior to incorporation to the capital accounts of the owners or partners who started the business.
- Adjusting the opening balance of retained earnings to reflect the profits or losses earned by the business prior to incorporation.
- Adjusting the opening balance of other reserves to reflect the profits or losses earned by the business prior to incorporation.
- Adjusting the opening balance of assets and liabilities to reflect any changes that occurred as a result of the profits or losses earned by the business prior to incorporation.
Accounting treatment of Profit or Loss prior to incorporation
The accounting treatment of profit or loss prior to incorporation involves the following steps:
- Calculate the amount of profit or loss: The first step is to determine the amount of profit or loss earned prior to incorporation. This can be done by preparing a statement of profit or loss for the period prior to incorporation.
- Open a capital reserve account: The profit or loss earned prior to incorporation cannot be distributed to the shareholders as dividends. Instead, it must be transferred to a capital reserve account. This account represents the amount of profit or loss that is available for distribution to the shareholders at a later date.
- Transfer the profit or loss to the capital reserve account: The profit or loss earned prior to incorporation is transferred to the capital reserve account by debiting the profit and loss account and crediting the capital reserve account.
- Show the capital reserve in the balance sheet: The capital reserve is shown in the balance sheet as a part of the shareholders’ equity. It is not shown as a part of the share capital or the retained earnings.
For example, let’s say a company was incorporated on 1st January 2023, and it earned a profit of Rs. 50,000 during the period 1st October 2022 to 31st December 2022. The accounting treatment of this profit prior to incorporation would be as follows:
Calculation of profit or loss:
Particulars Amount (Rs.)
Revenue 1,00,000
Less: Expenses (50,000)
Profit for the period 50,000
Opening of a capital reserve account:
Particulars Amount (Rs.)
Capital reserve account 50,000
To profit and loss account 50,000
Transfer of the profit to the capital reserve account:
Particulars Amount (Rs.)
Profit and loss account 50,000
To capital reserve account 50,000
Presentation in the balance sheet:
Particulars Amount (Rs.)
Shareholders’ equity:
Share capital xxx
Retained earnings xxx
Capital reserve 50,000
Total shareholders’ equity xxx
Note that the capital reserve is shown as a part of the shareholders’ equity, but not as a part of the share capital or the retained earnings.