Profit or loss prior to incorporation refers to the profit or loss earned by a business during the period before it is legally registered as a company. This period starts from the date of purchase of the business and ends on the date of incorporation. Since the company does not legally exist during this time, such profit or loss is not considered an operating result of the company. Profit prior to incorporation is treated as capital profit and transferred to Capital Reserve. Loss prior to incorporation is treated as capital loss and written off against capital profits or goodwill. This concept is important in corporate accounting to separate capital and revenue items clearly.
Allocation of Profit in the Pre-Incorporation Period:
Allocation of profit in the pre incorporation period refers to the process of dividing total profit of a business between the period before incorporation and after incorporation. When a business is purchased from an earlier date and the company is incorporated later, profits of the whole period are first calculated. These profits are then allocated on time basis or sales basis. Expenses like rent, salaries, and depreciation are usually divided on time basis. Gross profit is generally divided on sales ratio because it depends on turnover. Certain expenses such as directors remuneration, debenture interest, and preliminary expenses are charged only to post incorporation period. Profit prior to incorporation is treated as capital profit and transferred to Capital Reserve. Loss prior to incorporation is treated as capital loss and written off. Profit after incorporation is revenue profit and transferred to Profit and Loss account. Proper allocation is necessary to show true financial position and comply with accounting principles.
Steps to Determine Pre-Incorporation Profits of a Company:
1. Determine Pre and Post Incorporation Period
First, identify the period before incorporation and the period after incorporation. The pre incorporation period starts from date of purchase of business and ends on date of incorporation. Remaining period is post incorporation period.
2. Calculate Total Profit
Prepare Trading and Profit and Loss Account for the entire period to find total profit or loss of the business.
3. Ascertain Sales Ratio and Time Ratio
Calculate sales ratio for apportioning gross profit and time ratio for dividing common expenses like rent and salaries.
4. Apportion Income and Expenses
Divide gross profit on sales basis and common expenses on time basis. Certain expenses like directors remuneration are charged only to post incorporation period.
5. Find Pre Incorporation Profit
After allocation, profit related to pre incorporation period is calculated and transferred to Capital Reserve.
Allocation of Loss in the Pre-Incorporation Period:
Allocation of loss in the pre incorporation period means distribution of total loss of the business between the period before incorporation and after incorporation. When a company purchases a running business from an earlier date and is incorporated later, losses of the entire period are first determined. These losses are then divided between pre incorporation and post incorporation periods. Gross loss is generally apportioned on sales basis as it depends on turnover. Common expenses like rent, wages, and depreciation are divided on time basis. Certain expenses such as directors remuneration and preliminary expenses are charged only to post incorporation period. Loss prior to incorporation is treated as capital loss and adjusted against capital reserve or goodwill. Loss after incorporation is treated as revenue loss and transferred to Profit and Loss account.
Accounting Treatment of Profit or Loss prior to Incorporation:
- Treatment of Profit Prior to Incorporation
Profit prior to incorporation is treated as capital profit. It is not transferred to Profit and Loss Account.
Journal Entry
| Particulars | Debit ₹ | Credit ₹ |
|---|---|---|
| Profit and Loss A/c Dr | Amount | – |
| To Capital Reserve A/c | – | Amount |
- Treatment of Loss Prior to Incorporation
Loss prior to incorporation is treated as capital loss. It is written off against capital profits or goodwill.
Journal Entry
| Particulars | Debit ₹ | Credit ₹ |
|---|---|---|
| Capital Reserve or Goodwill A/c Dr | Amount | – |
| To Profit and Loss A/c | – | Amount |