profit prior to incorporation

Sometime a company purchased a running business from data prior to its incorporation. For example:- A company incorporated on 1st April,2008 purchased an already running business from 1st January, 2008 the date on which accounting year of vendor starts. Generally, the business is purchased on the last date of balance sheet, so that assets and liabilities are taken over on the basis of figures of balance sheet. Thus, when a company earns profit from date of purchase to the date of its incorporation, it is called ‘profit prior to incorporation’.

EXAMPLE: Green limited is incorporated on 1st April 2008 to take over the running business of M/S black and white as from 1st January,2008. In this case the profit earned by Green limited from 1st Jan to 1st April i.e from date of purchase to date of incorporation is called PROFIT PRIOR TO INCORPORATION.

NATURE OF PROFIT PRIOR TO INCORPORATION

The profit earned by the company prior to its incorporation is of capital nature. Such profits are not treated as the profits of the company because they are not available for distribution as dividend to shareholders. Such profits are treated as CAPITAL PROFITS and are transferred to CAPITAL RESERVE ACCOUNT. If there is any loss then such loss is of capital nature and is debited to GOODWILL ACCOUNT.

NOTE: It should be noted that it is the “Date of incorporation” not the date of commencement, which is taken into consideration for the calculation of profit or loss prior to incorporation.

ASCERTAINMENT OF PROFIT OR LOSS PRIOR TO INCORPORATION

In order to ascertain the amount of profit or loss prior to incorporation, the following steps should be taken. STEP 1 In order to ascertain the amount of gross profit, the trading account for the whole period i.e. the date of purchase to the date of balance sheet is prepared.

STEP 2: Three Ratio calculated : Sale ratio Time ratio Vendor ratio SALES RATIO: Sales ratio is calculated on the basis of sales made between date of purchase to date of incorporation and date of incorporation to the date of balance sheet.

EXAMPLE Sales from date of purchase to date of incorporation is Rs 50000 Sales from date of incorporation to date of balance sheet is Rs. 80000 Then sales ratio = sale in incorporation period : ratio to post incorporation = 50000:80000 i.e = 5:8

TIME RATIO: It is calculated by taking into consideration the time from the date of purchase of business to the date of incorporation and from date from incorporation to the date of balance sheet. EXAMPLE: Date of incorporation on 1st April,01 to take over the already existing business from 1January,01. Z ltd prepares its final accounts on 31st December,01.

Time ratio: time(pre incorporation period) :(post incorporation period) 1.1.01 to 1.4.01: 1.4.01 to 31.12.01 3 months : 9 months Ratio is 3:9 or 1:3 VENDOR RATIO: It is calculated on the basis of date of purchase, date of incorporation and date of settlement of claims.

EXAMPLE: A co. incorporated on 1st Jan,01 purchased a business running from 1.10.00 claim are settled on 1st April, 01 Vendor ratio= date of purchase to date of incorporation : date of incorporation of date of settlement of claims. 3 months : 3 months 1 : 1

STEP 3 Profit and loss account is prepared as follow separately for two periods gross profit should be allocated on the basis of sales ratio. expenses that are connected with sales should be allocated on the basis of sales ratio. expenses incurred on the basis of time should be allocated on the basis of time ratio.

EXPENSES CONNECTED WITH SALES ARE : discount on sales , commission on sales , discount allowed , bad debts , advertising , selling expenses, carriage outwards etc. EXPENSES CONNECTED WITH TIME ARE : audit fees , salaries , rent and taxes , depreciation , insurance , general expenses , printing and stationary , administration expenses etc.

Expenses which are either completely comes under pre or post period Expenses which are either completely comes under pre or post period. They are not allocated on the basis of any ratio. Whole amount goes to the respective period i.e. pre or post . Expenses wholly related to pre – period are salaries of partners , interest on capital etc. Expenses wholly related to post - period are director’s fees, debenture interest, goodwill written off, provisions, preliminary expenses etc.

TREATMENT OF LOSS PRIOR TO INCORPORATION Loss prior to incorporation being of capital nature shall be debited to separate account called ‘loss prior to incorporation account’ and shown under miscellaneous expenditure on the asset side of the balance sheet to the extent not written off. Loss prior to incorporation can be dealt in any of the following manner:

write off against the profits of the company. Treated as goodwill and debited to goodwill account Such loss can be treated as deferred revenue expenditure and written out of profits of the company over a period of years.

ILLUSTRATION

Date of incorporation is 1st may,2001 Purchase consideration is Rs Date of incorporation is 1st may,2001 Purchase consideration is Rs. 5000000 of which Rs 1000000 was to be paid in cash n 4000000 in the form of fully paid shares. Co. also issued shares for Rs. 4000000 for cash. Machinery costing Rs 2500000 was installed. Assets acquired from vendors were :- machinery Rs. 300000, stock Rs. 600000, patent Rs. 400000.

Sales during the year, 18000000 Sales per month in the first half being one half of what they have in later half year. Net profit after charging following expenses was 1000000. Depreciation Rs 540000, audit fees Rs. 60000, preliminary expenses Rs 10000, office expenses Rs 240000, selling expenses Rs 198000, interest to vendors up to 31st may,2001 Rs 50000. Closing stock Rs. 700000. Prepare balance sheet of the company as an 31st December 2001.

CALCULATION OF RATIOS TIME RATIO: (D. O. P to D. O. I ): (D. O. I to D CALCULATION OF RATIOS TIME RATIO: (D.O.P to D. O. I ): (D.O.I to D. O.Balance sheet) 1.1.01- 1.5.01 : 1.5.01- 31.12.01 4 month : 8 month Time ratio 1 : 2 SALES RATIO: 100X2 + 200X6 200 + 1200 = 1400 Sales ratio 400 : 1400 = 2 : 7

Vendor ratio:- D. O. P to D. O. I : D. O. I to D. O Vendor ratio:- D. O. P to D.O.I : D.O.I to D. O.Settlement of claim 4 months : 1 months Vendors ratio= 4 : 1 SOLUTION OF ABOVE QUERY…..

CALCULATION OF GROSS PROFIT Net profit = gross profit- indirect expenses OR Gross profit= net profit+ indirect expenses CALCULATION OF GROSS PROFIT

PARTICULARS AMOUNT TOTAL Net profit 1000000 ADD: Depreciation 540000 audit fees 26000 director’s fee 60000 Preliminary expenses 240000 Office expenses selling expenses 198000 Interest to vendor 50000 Gross profit 2124000

Adarsh udhyog Ltd profit and loss for the year ending 31st march 2001

PRE I POST I Total To deprecia 180000 360000 By sales 472000 1652000 To audit f 8667 17333 To dire;s f - 60000 To prelim exp(post) 10000 To Off exp 80000 160000 To selling e 44000 154000 To interest to vendor (4 : 1) 40000 To capital reserve 119333(bal. Fig) To net profit 880667(bal. Fig) Total

BALANCESHEET AS ON 31ST DECEMBER, 2001

LIABILITIES AMOUNT ASSETS TOTAL 9000000 SHARE CAPITAL(4000000+4000000) 8000000 GOODWILL(5000000-3000000-600000-400000) 1000000 CAPITAL RESERVE 119333 PATENTS 400000 PROFIT AND LOSS ACCOUNT 880667 MACHINERY 5500000-540000(DEPR) 496000 CLOSING STOCK 600000 OTHER ASSETS 1940000 TOTAL 9000000

NOTE The profit prior to incorporation can be utilized in writing of goodwill or capital loss. The balance, if any should be transferred to capital reserve account.