Profit prior to Incorporation

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Acquisition of Business and Profit Prior to Incorporation

When a running business is taken over by a company from a date prior to its incorporation or commencement, the profit earned up to the date of incorporation or commencement is known as 'Pre-incorporation Profit'. For a private company, this date is the incorporation date, while for a public company, it is the commencement date.

Pre-incorporation Profit

  • Definition: Profit earned before the company's incorporation or commencement.
  • Nature: Treated as capital profit and cannot be distributed as dividends.
  • Example: If X Ltd. was incorporated on April 1, 2006, and took over Y Ltd. from January 1, 2006, the profit from January 1 to March 31, 2006, is pre-incorporation profit.

Treatment of Pre-incorporation Profit

  • Capital Profit: Transferred to Capital Reserve or adjusted against Goodwill.
  • Capital Loss: Shown under 'Miscellaneous Expenditure' in the assets side of the Balance Sheet.

Computation of Profits/Loss Prior to Incorporation

To ascertain pre-incorporation profit, a Profit and Loss Account is prepared at the incorporation date. However, in practice, the same set of books is maintained throughout the accounting year. The profits (or losses) between the two periods (pre- and post-incorporation) are allocated:

  • Pre-incorporation Period: From the date of purchase to the date of incorporation.
  • Post-incorporation Period: From the date of incorporation to the end of the accounting year.

Steps for Ascertaining Profit/Loss Prior to Incorporation

  • Prepare Trading Account: For the entire period to calculate gross profit.
  • Calculate Ratios:
    • Sales Ratio: Based on sales for pre- and post-incorporation periods.
    • Time Ratio: Based on time periods between purchase and incorporation and from incorporation to the end of the year.
  • Prepare Statement:
    • Gross Profit Allocation: Based on sales ratio for pre- and post-incorporation periods.
    • Fixed Expenses Allocation: Based on time ratio (e.g., Rent, Salary, Depreciation).
    • Variable Expenses Allocation: Based on sales ratio (e.g., Selling Expenses, Advertisement).

List of Expenses Allocation

  • Sales/Turnover Based Allocation:
    • Gross Profit
    • Selling Expenses
    • Advertisement
    • Carriage Outwards
    • Godown Rent
    • Discount Allowed
    • Salesmen’s Salaries
    • Commission to Salesmen
    • Promotion Expenses
    • Distribution Expenses (Variable Portion)
    • Free Samples
    • After-Sale Service Expenses
    • Delivery Van Expenses
  • Time-Based Allocation:
    • Office and Administration Expenses
    • Office Staff Salaries
    • Rent, Rates, and Taxes
    • Depreciation on Fixed Assets
    • Printing and Stationery
    • Insurance
    • Audit Fees
    • Miscellaneous Expenses
    • Distribution Expenses (Fixed Portion)
    • General Travelling Expenses
    • Debenture Interest
    • General Expenses

Application/Accounting Treatment of Profit/Loss Prior to Incorporation

  • Pre-incorporation Profit:
    • Written off against Preliminary Expenses, Formation Expenses, Liquidation Expenses, Fixed Assets, or Goodwill.
    • Balance transferred to Capital Reserve.
  • Pre-incorporation Loss:
    • Adjusted against any Capital Profit.
    • Debited to Goodwill Account.
    • Used to write-off Fictitious Assets.
    • Adjusted against Capital Reserve.

In conclusion, handling profits and losses prior to incorporation requires careful segregation and appropriate allocation based on specific accounting principles. This ensures accurate financial reporting and adherence to statutory requirements.