Methods of Computing Profit and Loss Prior to Incorporation

When a Company is formed, it is common for business operations to begin before the legal process of incorporation is completed. The period before the incorporation of a company is known as the pre-incorporation period, and any profits or losses made during this time are considered pre-incorporation profits or losses. These profits or losses cannot be treated in the same manner as those generated after incorporation. Therefore, companies need to carefully account for them, and several methods are used to determine the pre-incorporation profit or loss.

Importance of Calculating Pre-Incorporation Profit and Loss:

Pre-incorporation profits and losses have a distinct nature. Profits during this period are generally considered as capital profits because they are earned before the company comes into legal existence. These profits may not be distributed as dividends but can be used to create reserves or be adjusted against preliminary expenses. On the other hand, losses during this period are often seen as part of the company’s initial setup costs and might be treated as capitalized expenses.

Correctly determining the profit and loss during this period ensures transparency and compliance with accounting standards, which is crucial for the preparation of accurate financial statements and tax reporting.

Methods of Computing Pre-Incorporation Profit and Loss:

There are three primary methods used to compute profit and loss prior to incorporation:

1. The Time Ratio Method
2. The Sales Ratio Method
3. A Combined Approach

Each method serves a specific purpose and is used based on the nature of business transactions and available data.

Time Ratio Method

Time Ratio Method is one of the simplest and most commonly used methods for computing pre-incorporation profit and loss. This method is based on the principle that the profits or losses during the pre-incorporation period are proportionate to the time elapsed during that period compared to the total period.

• How It Works:

The time ratio is calculated by dividing the number of months in the pre-incorporation period by the total number of months in the accounting period.

For example, if the company was incorporated on July 1st and the financial year ends on December 31st:

• Pre-Incorporation Period: January 1st to June 30th (6 months)
• Post-Incorporation Period: July 1st to December 31st (6 months)
• Total Accounting Period: January 1st to December 31st (12 months)

Time Ratio = 6 months (pre-incorporation) : 6 months (post-incorporation) = 1:1

Application of Time Ratio:

This ratio is applied to expenses and income that are time-related. Examples include rent, salaries, insurance, and utilities. These expenses are assumed to be evenly spread across both the pre-incorporation and post-incorporation periods, making the time ratio a fair way to allocate them.

Advantages:

• Simple to apply and understand.
• Suitable when expenses are incurred uniformly over time.

Disadvantages:

• Not suitable for businesses with fluctuating income or seasonal sales.
• Does not consider varying business activity levels during the pre- and post-incorporation periods.

Sales Ratio Method

Sales Ratio Method is used when income and expenses are more directly related to sales than to time. This method assumes that profits or losses are proportional to the level of sales during the pre-incorporation and post-incorporation periods.

• How It Works:

The sales ratio is calculated by dividing the sales revenue during the pre-incorporation period by the total sales revenue for the entire accounting period.

For example, if a company’s total sales for the year were ₹1,200,000, with ₹400,000 earned during the pre-incorporation period and ₹800,000 earned post-incorporation, the sales ratio would be: Sales Ratio = ₹400,000 (pre-incorporation) : ₹800,000 (post-incorporation) = 1:2

• Application of Sales Ratio:

This ratio is applied to expenses and income directly related to sales, such as commissions, discounts, advertisement costs, and cost of goods sold. The sales ratio is considered more accurate for businesses where revenue generation is not uniform throughout the period.

Advantages:

• More accurate when revenue fluctuates or when there is significant variation in sales activity across different periods.
• Suitable for industries with seasonal sales or variable market conditions.

Disadvantages:

• Requires detailed sales data, which might not be available or reliable for the pre-incorporation period.
• Does not consider time-related expenses.

Combined Approach

In practice, a combination of the Time Ratio and Sales Ratio methods is often used to allocate different types of expenses and income. This approach recognizes that some costs are time-based (fixed expenses like rent and salaries), while others are related to sales volume (variable expenses like cost of goods sold or sales commissions).

How It Works:

1. Fixed Costs Allocation: Fixed costs, such as rent, insurance, and utilities, are allocated based on the time ratio.
2. Variable Costs Allocation: Variable costs, like sales commissions, discounts, and cost of goods sold, are allocated based on the sales ratio.

For example:

• If the rent for the year is ₹600,000, and the time ratio is 1:1 (as in the previous example), the pre-incorporation period would be allocated ₹300,000.
• If sales commissions total ₹150,000 for the year, and the sales ratio is 1:2, the pre-incorporation period would be allocated ₹50,000.

Advantages:

• Provides a more accurate allocation of expenses by considering the nature of costs.
• Flexible and adaptable to different business models and industries.

Disadvantages:

• More complex to calculate, requiring accurate data and careful judgment.
• May require significant bookkeeping effort, especially if sales data is not well-documented for the pre-incorporation period.

Steps Involved in Computing Pre-Incorporation Profit and Loss:

1. Identify the Pre-Incorporation and Post-Incorporation Periods:

Determine the exact dates of incorporation and establish the time periods for calculation.

2. Classify Expenses and Income:

Categorize all revenue and expenses into fixed (time-related) and variable (sales-related) components.

3. Determine Time and Sales Ratios:

Calculate the time and sales ratios based on the periods and revenue figures.

4. Allocate Expenses and Income:

Apply the relevant ratios to allocate income and expenses to the pre-incorporation and post-incorporation periods.

5. Compute Profit or Loss:

Subtract the pre-incorporation expenses from the pre-incorporation income to determine the profit or loss for the period.

6. Accounting Treatment:

Record the pre-incorporation profit as a capital profit, often transferred to a capital reserve. If there is a loss, it is treated as a deferred revenue expenditure or capitalized as part of the company’s preliminary expenses.