7.3.

Profit Prior to Incorporation

Sometimes a company purchases a running business from a date prior to its incorporation. If
the company has earned any profit from the date of purchase to the date of incorporation such
profit is called as profit prior to incorporation.

As for example, a company incorporated on 1st April, 2004 may purchase a business from 1st
January, 2004, the date on which the accounting year of the vendor starts. Generally the business
is purchased from vendor on the last date of the balance sheet so that assets and liabilities are
taken over on the basis of the figures given in the Balance Sheet.

Such profit cannot be said to have been earned by the company as it is not available for
distribution as dividend to the shareholders. Such profit is treated as capital profit and is
transferred to Capital Reserve Account.

If there is any loss prior to incorporation such loss is in the nature of capital loss and is debited
to Goodwill Account. It should be noted that, the date of incorporation and not the date of
commencement of should be taken into consideration for calculating profit or loss prior to
incorporation.

Ascertainment of Profit or Loss Prior to Incorporation

Profit or loss prior to incorporation can be ascertained only when fresh stocktaking and balancing
of accounts is done on this date. But it will involve a great deal of inconvenience. In order to
avoid this inconvenience, the following steps may be taken:

(1) Prepare the trading account for the whole period i.e., from the date of purchase of business
to the last date of accounts closing in order to calculate the gross profit. Date of incorporation
will not affect the calculation of gross profit:
(2) Calculate time ratio and sales ratio. Time ratio is calculated by taking into consideration
the time falling from the last date of balance sheet to the date of incorporation and the
period between the date of incorporation to .the last date of presenting [mal accounts. For
example, if the business is purchased on 1st April 2006 and certificate of incorporation is
granted on 1st July 2006 and final accounts are being prepared on 31st March 2007, then
the time ratio is 3 months : 9 months or 1:3. Sales ratio is calculated taking into consideration
the sales of pre-incorporation period to that of sales of post-incorporation period. For
example, if sales of pre-incorporation period are Rs. 5,00,000 and that of post-incorporation
Rs. 20,00,000, then the sales ratio is 1 : 4.
(3) Prepare the profit and loss account for the pre-incorporation and post Incorporation periods
separately.
This is done on the following basis:
a. Gross profit should be apportioned between the two periods on the basis of their respective
sales ratio.

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b. Such expenses which are directly related on sales such as commission on sales, discount
allowed, bad debts, advertising, etc. should be apportioned on the basis of sales ratio of
the two periods.
c. Fixed expenses such as salaries, rent, audit fees, insurance, depreciation, etc. should be
allocated on the basis of time ratio as these expenses are incurred on the basis of time.
d. Expenses which are incurred after the incorporation of the company such as directors’
fees, preliminary expenses, interest on debentures etc. should be charged wholly to the
period after incorporation. Similarly expenses viz. salary of partners is debited to the Pre-
incorporation period.

Illustration

BK Ltd. was incorporated on 1st August, 2006 and received its certificate of commencement of
business on 1st Dec, 2005. The company bought the business of M/S BK & Co. with effect from
1st April, 2006. From the following figures relating to the year ending March 31, 2007, find out
the profits available for dividends:

(a) Sales for the year were Rs. 6,00,000 out of which sales up to 1st August were Rs.2,50,000.
(b) Gross Profit for the year was Rs. 1,80,000.
(c) The expenses debited to the Profit and Loss Account were:

Rs Rs
Rent 9000 Advertising 18000
Salaries 15000 Stationery and Printing 3600
Directors' fees 4800 Commission on sales 6000
Interest on debentures 5000 Bad debts(500 relate to 1500
debts created prior to
incorporation
Audit fees 1500 Interest to vendor on 3000
purchase consideration (up
incorporation date Rs
2000)
Discount on sales 3600
Depreciation 24000
General expenses 4800

Solution
Workings:-
1> Time Ratio: Pre –incorporation period 4 Months
Post –incorporation period 8 Months

536 Financial Accounting

So the ratio is 1:2
2> Sales Ratio.
Sales up to incorporation period Rs 2,50,000
Sales in post incorporation period Rs 3,50,000
So the ratio is 5:7

PROFIT AND LOSS ACCOUNT For the year ending March 31 2007

Basis Prior to After Basis Prior to After

of alto- Incor- Incor- of allo- Incor- Incor-
cation poration poration cation poration poration
Rs. Rs. Rs. Rs.
To Rent Time 3,000 6,000 By Gross
Profit Sales 75,000 1,05,000
-Salaries Time 5,000 10,000
- Directors' **
fees 4,800
-Interest on **
debentures 5,000
-Audit fees Time 500 1,000
-Discount
on sales Sales 1,500 2,100
-Depreciation Time 8,000 16,000
-General
expenses Time 1,600 3,200
-Advertising Sales 7,500 10,500
-Stationery
& Printing Time 1,200 2,400
-Commissi-
on sales Sales 2,500 3,500
-Bad Debts Actual 500 1,000
-Interest to Actual 2,000 1,000
Vendor
-Capital
Profit 41,700 -
-Net Profit 38,500
75,000 1,05,000 75,000 1,05,000

** Related to Post incorporation period only.

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Calculation of Sales Ratio

The calculation of sales ratio may be simple in those cases where the turnover is spread during
the whole financial period. But where the turnover fluctuates from month to month according
to the nature of product (as woolen garments where the sales are more in the month of Octo-
ber, November, December, and January as compared to other months), the calculation of sales
ratio becomes difficult Moreover, the sales of month of October may be different from the
month of December or January. Under such’ circumstances the sales ratio is determined taking
into consideration the relationship of monthly sales with that of total sales.

The following illustration may clarify the point more clearly.

Ludhiana woolen Mills Company Ltd., incorporated on 1st April, 2006, took over running
business from 1st January, 2006. The company prepares its first final accounts on 31st Decem-
ber 2006. From the following information, you are required to calculate the sales ratio of pre-
incorporation and post-incorporation periods.

(a) Sales for January, 1995 to December, 1995 Rs. 4,80,000,

(b) The sales for the month of January twice of the average sales; for the month of February
equal to average sales, sales for four months May to August-1/4th of the average of each
month; and sales for October and November three times the average sales.

Solution

Calculation of Average Sales per month

Rs 4,80,000/12 =Rs. 40,000
Sales for the months of

January 2 x Rs. 40,000 80,000

February 1 x Rs. 40,000 40,000
May 1/4 x Rs. 40,000 10,000

June 1/4 x Rs. 40,000 10,000

July 1/4 x Rs. 40,000 10,000

August 1/4 x Rs. 40,000 10,000

October 3 x Rs. 40,000 1,20,000

November 3 x Rs. 40,000 1,20,000
Total Sales for 8 4,00,000
Months

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Sales for the remaining 4 months = Rs, 4,80,000 - Rs. 4,00,000
= Rs. 80,000
Average sales for remaining months: = Rs 80,000/4 = Rs 20,000
Sales for Pre-incorporation Period:
` Rs
January 80,000
February 40,000
March 20,000
1,40,000

Sales for the Post incorporation period = Rs 4,80,000 – 1,40,000

= Rs 3,40,000
So the Sales Ratio between Pre and Post = 7:17

EXERCISE

1. State whether the following statements are true or false:

a> Loss prior to incorporation is a capital loss and is debited to Goodwill Account.
b> Expenses viz. preliminary expenses, interest on debentures and directors’ fees which
are incurred after incorporation of the company should be charged wholly to post
acquisition period.
c> Gross profit should be apportioned between prior to and after incorporation period
on the basis of time ratio of the two periods.
Answer :
(1) True; (b) False; (c) True

PROBLEMS

1. A company incorporated on 1st August, 2006 acquires a business as from 1st April, 2006.
The first accounts are drawn up upto 31 st December, 2006. The gross profit for this period
of 9 months was Rs. 56,000,000, the general expenses Rs. 14,220,000 the directors’ fees Rs.
12,000,000 per annum, formation expenses Rs. 1,500,000.
Rent upto 30th September was Rs. 1,200,000 per annum, after which it was increased to
Rs. 3,000,000 per annum. Salary of the manager who upon incorporation of the company
became a director was Rs. 6,000,000 per annum (since incorporation included in directors’
fees mentioned above).

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Show Profit and Loss Account assuming that the net sales were Rs. 820,000,000 the
monthly average of which for the first four months of 2003 being one half of that of the
remaining period. The profit was earned uniformly on sales.
Ans. [Profit prior to incorporation Rs. 7,280,000; after incorporation Rs. 24,650,000.
2. Kaipy Private Ltd. was incorporated on 1st July, 2005 with an authorized capital of Rs.
500,000,000 in equity shares of Rs. 10 each to take over a going concern as from 1st April
2005. The agreement for taking over provided that all profits made from 1st April, 2005
should belong to the company. The purchase consideration of Rs. 200,000,000 together,
with interest @ 8.75 % p.a. was satisfied on 1st October, 2005 by the allotment to the vendors
17,500,000 equity shares fully paid and the balance in cash.

The Trial Balance of the company on 31st March, 2006 was as follows:

Dr (Rs’000) Cr (Rs’000)
Share Capital 2.25.000
Freehold land-at cost 25,000
Building-at cost 65,000
Furniture at cost 7,500
Salaries 12,000
Purchases (including stock taken over) 4,85,000
Sales (including sales prior to incorporation Rs.75,000) 4,50,000
Sundry Debtors 45,000
Sundry Creditors 30,000
Rent Received 6,000
Rent and Taxes 3,000
Repairs 1,500
Directors' Fees 1,200
Miscellaneous Expenses 7,200
Interest to Vendors 8,750
Cash in hand 1,800
Cash at Bank 48,050
7,11,000 7,11,000

You are required to prepare the Profit and Loss Account of the company for the year ended
31st March, 2006, and a Balance Sheet as on that date after taking into account the following
adjustments:

(a) Stock on 31.3.93, Rs. 140,000,000.

(b) Bad Debts, Rs. 500,000 (including Rs. 200,000 out of book debts taken over from the vendors)
to be written off.
(c) Provision for Doubtful Debts to be made at Rs. 2,500,000.
(d) Depreciate Buildings by 5 per cent and Furniture by 10 per cent.

540 Financial Accounting

3. Rajasthan Udyog Limited, incorporated on Aug 1, 2005, received the certificate to
commence business on August 31, 2005. It had acquired a running business from M/s
PTA & Co. with effect from April 1, 2005. The purchase consideration was Rs. 5,000
Lakh of which Rs. 1,000 Lakh was to be paid in cash and Rs. 4,000 Lakh in the form of
fully paid shares. The company also issued shares for Rs. 4,000 Lakh for cash. Machinery
costing Rs. 2,500 lakh was then installed. Assets acquired from the vendors were:
Machinery Rs. 3,000 Lakh Stock Rs. 600 Lakh, Patents Rs. 400 Lakh.

During the year 1995, the total sales were Rs. 18,000 Lakh ; the sales per month in the first half-
year were one-half of what they were in the later half year. The net profit of the company after
charging the following expenses was Rs. 1,000. Depreciation Rs. 540 Lakh. Audit fees Rs. 75
Lakh, Directors’ fees Rs. 250 lakh, Preliminary expenses Rs. 60 lakh, Office expenses Rs. 390
lakh. Selling expenses Rs. 360 Lakh, Interest to vendors upto August 31, 1995 Rs. 25 Lakh.

Ascertain the pre-incorporation and post incorporation amount of profit, and prepare the
Balance Sheet of the company as on 31st March, 2006. Closing stock was valued at Rs. 700
Lakh.

Ans.[profit prior to incorporation Rs.165 Lakh; Post incorporation profit Rs. 835 Lakh; Balance
Sheet Total Rs. 9, 000 Lakh].

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