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UNIT – 3 : PROFITS OR LOSS PRIOR TO INCORPORATION

Learning Objectives

After stu dying this unit, you will be able to:

1. Account for pre-incorporation profit.

2. Learn various methods for computing pr ofit or loss prior to incorporation.

3.1 INTRODUCTION

Whe n a running business is taken over by the pr omoters of a company, from a date before the

company which is to manage and own is registered, the amount of profit or loss of such a business

for the period prior to the date the company came into existence is referred to as pre-incorporation

profits or losses. Such profits or losses, tho ug h belonging to the company or payable by it, are of

cap ital nature; it is necessary to disclose them separately as trading profits or losses. The general

practice  in this regard is that if there is a loss, it is either written  off by debit to the Profit and Loss

Account or to a special account described as oss Prior to Incorporation_ and show as an 殿sset_

in the Balance Sheet: in the alternative, it is debited to the Goodwill Account. On the other hand, if

a profit has  been earned by business prior to the same being taken over and the same is not fully

absorbed by any interest payab le for the period, it is credited to Cap ital Reserve Acco unt or to the

Goodwill Account, if any goodwill has been adjusted as an asset. The profit will not be available for

distributio n as a dividend among the members of the company.

3.2  METHODS OF COMPUTING PROFIT OR LOSS PRIOR TO INCORPORATION 

The determination of such pro fit or loss would be a simple matter if it is possible to close the books

and take th e stock hel d by th e business before the company came into existence. In such a case,

the trial balance will be abstracted from the books and the profit or loss computed: Thereafter, the

books will be either closed off or the balance allowed to continue undistributed; only the amount of

profit or loss so determined being adjusted in the manner described above. When this is not

possible, one or the other of the following methods will have to be followed for the purpose.

(1)   The simplest, though not always the most expedient method is to close off old books and

open new books with the assets and liabilities as they existed at the date of

incorporation. In this way, automatically the result to that date will be adjusted, the

difference between the values of assets and liabilities acquired and the purchase

consideration being accounted for either as goodwill or as reserve. The accounts,

therefore, would relate exclusively to the post-incorporation period and any adjustment

for the pre-incorporation period, whether an adjustment of profit or loss, would not be

required.

(2)   Since the decision to take over a business is usually reached long after the date from

which it is agreed to be taken over it is normally not possible to follow any of the method

 

3.102

 

 

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Company Accounts  

 

aforementioned. The only alternative left, in the circumstances, is to split up the profit of

the year of the transfer of the business to the company between ‘pre’ and ‘post’

incorporation periods. This is done either on the time basis or on the turnover basis or by

a method which combines the two.

The amount of gross profit of a business is not dependent on time. It is, therefore, more

appropriate to dstribute it on the b asis of turnover. Similarly, the expenses incurred in earning the

gross profit, not having any direct relationship thereto, should be distri buted on a basis considered

appropriate, having regard to the circumstances of each case. Common charges which are fixed

e.g., insurance, salaries, depreciation etc., are allocated on time basis, while those which are

fluctu ating  e.g., bad de bts, discount and carriage outwards are allocated according to turnover

unless, in the light of available information time at which these were incurred or in consideration of

the relatio nship that these bear to the profit of the two pe rio ds. For example, interest payable on

the credit balance of vendors is charged against the profit of the period before the business was

taken over on the consideration th at it is  in respect of that period before the business was taken

over  on the consideration that it  is in respe ct of that period that the profit accrued to the company,

tho ugh the purchase consider ation had not been discharged. But if the pu rchase  consideration is

not paid on taking over the business, the interest for the su bsequent per iod is charged to the post-

incorporation period. Again, preliminary expenses on the formation of the company though incurred

in point of time, before the company was incorpor ated are charged against the profit of the period

subsequent to incorporation.

 

Rs.

Suppose Sales in Pre-i ncorporation Period

6,000

Sales in Post-incorporation Period

19,000

 

25,000

The company deals in  one type of product. The unit cost  of sales was  reduced  by 10% in post

incorp oration period as compared to the pre-incorporation period in the year. In this case the cost

of sales  will  be divided between the two periods in the ratio of 6,000: 17,100 i.e., 19,000–1,900.

Illustration 1

Bidyut Limited was incor po rated on 1st July, 2005 to acquire from Bijli as and fro m 1st January, the

individual business carried on by him. The purchase price of the fixed assets and goodwill was

agreed to be the sum equal to 80% of the profits made each year on ascertainment of the sum

due.

The following Trial Bala nce as on 31st Dec., 2005 is presented to you to enable you to prepare a

Balance Sheet as at that date. Also prepare a statement of appropriation of profit writing off one-

third of the preliminary expenses.

 

Dr. Cr.

 

3.103

 

 

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  Advanced Accounting

 

 

Rs. Rs.

Share Capital - 1,500 equity shares of

Rs. 100 each, Rs. 80 paid up

   1,20,000

Sundry Debtors

82,000

Stock on 31st Dec., 2005

67,000

Cash at bank and on hand

24,000

Dir ectors’ fee

3,000

Prelimin ary expenses

24,000

Sundry Creditors

   32,000

Net  Profit  for  the  year  after  providing  for  all 

expenses under agreement entered into with Bijli 

     48,000

 

2,00,000 2,00,000

Solution

Balance Sheet of M/s Bidyut Ltd. as on 31st Dec., 2005

Liabilities

Rs.  Assets

Rs.

Share Capital

   Fixed Assets

Issued & Subscribed

   Goodwill & Fixed Assets  38,400*

Ca pital 1,500 Equity

   Investments

Nil

Shares of Rs. 100 each,   Curr ent Assets

Rs. 80 paid up  1,20,000  Stock

67,000

Reserves & Surplus

De btors

82,000

Ca pital Reserve  24,000  Bank

24,000

(Pre-incorporation profit)    Misc. Expenses &

Profit & Loss A/c  13,000  Losses not written off

Secure d Loans

Nil  Prelimin ary expenses  16,000

Unsecured Loans

Nil

Curr ent Liabilities & Provisions

Trade Cr editors

32,000

Du e to Bijli

38,400 

   

 

2,27,400 

2,27,400

*In Travancore Sugars and Chemicals Ltd. v. CIT (62 CIT 566), the Supreme Court has held that

such payment is a revenue expenditure and deductible from the profits of the company, for tax

purposes.

 

3.104

 

 

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Company Accounts  

 

Statement of Appropriation of Profit

 

  Pre-incorporation  Post-incorporation

 

Rs.  Rs.

Rs.

Net Pr ofit for the Year

   24,000  24,000

Less: Directors’ fee  3,000

Prelimi nary Exps.  8,000   11,000

 

   24,000 13,000

Amount Payable to Bijli:

  Profit for the year

     48,000

  80% due as cost of goodwill, assets, etc.    38,400

Illustation 2

Ind er and Vishnu, working in partnership registered a joint stock company under the name of

Fell ow Travellers Ltd. on May 31, 2005 to take over their existing business. It was agreed that they

wo uld take over the assets of the partnership for a sum of Rs. 3,00,000  as from January 1st, 2005

and that until the amount was discharged they would pay interest on the amount at the rate of 6%

per annum. The amount was paid on  June 30, 2005. To dischar ge the purchase consideration, the

company i ssued 20,000 equity shares of Rs. 10 each at a premium of Re. 1 each and allotted 7%

De bentures of the face value of Rs. 1,50,000 to the vendors at par.

The Profit and Loss Account of the ellow Travellers Ltd._ for the year ended 31st Decemb er,

2005 was as follows :

 

Rs. 

Rs.

Purchase, including stock  1,40,000  Sales:

Freig ht a nd carriage  5,000  1st January to 31st May 2005  60,000

Gross Profit c/d

60,000  1st June to 31st Dec., 2005  1,20,000

 

   Stock in hand  25,000

 

2,05,000 

2,05,000

Salaries and Wages  10,000  Gross pr ofit b/d  60,000

De benture Interest  5,250

De preciation

1,000

Interest on Purchase

Co nsideration (up to 30-6-2005)  9,000

Selling Commission  9,000

Dir ectors’ Fees

600

 

 

 

3.105

 

 

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  Advanced Accounting

 

Prelimin ary Expenses  900

Provi sion for taxes  6,000

Dividend on equity shares @ 5%  5,000

Balance c/d

13,250

 

60,000 

60,000

 

Prepare statement apportioning the balance b etween the ‘post’ and ‘pre-incorporation’ periods and

also show how these figures would appear i n the Balance Sheet of the company.

Solution:

Fellow Travellers Ltd.

Statement showing apportionment of profit between periods prior to and since

incorporation

  

     Pre-  Post-

  

   Ratio  incorporation incorporation

Gross pr ofit allocated on the basis of sale    1:2  20,000 40,000

Admi nistrative Expenses allocated

on time basis:

(i)  Salaries and wages  10,000

(ii) Depreciation

1,000  5:7  4,583  6,417

Selling Commission on the basis of sales    1:2  3,000  6,000

Interest on Purchase Consideration

(time b asis)

   5:1  7,500  1,500

Exp enses applicable wholly to the

post-incorporation period:

De benture Interest

5,250

Dir ector’s Fees

    600

Appropriations:

   5,850

Preliminary Exps., w/o

900

Provi sion for Tax

6,000

Dividend on equity share  5,000    11,900

Balance c/d to Balance Sheet        4,917    8,333

  

     20,000 40,000

 

Fellow Travellers Ltd.

 

3.106

 

 

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Company Accounts  

 

Extract From the Balance Sheet as on 31st Dec., 2005

Share Capital:

Rs.

  20,000 equity shares of Rs. 10 each ful ly p aid

2,00,000

Reserve and Surplus:

 

  Profit Pri or to Incorporation

4,917

Securities Premium Account

20,000

  Profit and Loss Account

8,333

7% Debentures

1,50,000

Provi sion for Taxes

   6,000

Total

3,89,250

Illustration 3

The partners of Maitri Agenci es decided to convert the partnership into a private limited company

called MA (P) Ltd. with effect from 1st January, 2005. The consideration was agreed at Rs.

1,17,00,000 based on the firm’s Balance Sheet as at 31st December, 2004. However, due to some

procedural difficulties, the company co uld be incorporated only on 1st April, 2005. Meanwhile the

business was continued on behalf of the company and the consideration was settled o n that day

with interest at 12% per annum. The same books of account were continued by the company which

closed its account for the first time on 31st March, 2006 and prepared the following summarized

profit and loss account.

 

   Rs.

Sales

   2,34,00,000

Cost of goods sold:

1,63,80,000

Salaries

11,70,000

Depreciation

1,80,000

Advertisement

7,02,000

Discou nts

11,70,000

Man aging Director’s remuneration

90,000

Miscell aneous office expenses

1,20,000

Office-cum-show room rent

7,20,000

Interest

   9,51,000 2,14,83,000

Profit

       19,17,000

The company’s only borrowing was a loan of Rs. 50,00,000 at 12% p.a. to pay the purchase

con sideration due to the firm and for wor king capital requirements.

 

3.107

 

 

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  Advanced Accounting

 

The company was able to double the average monthly sales of the firm, from 1st April, 2005 but

the salaries trebled from that date. It had to occupy additional space from 1st July, 2005 for which

rent was Rs. 30,000 per month.

Prepare a profit and loss account in a columnar form apportioni ng cost and revenue between pre-

incorporation and post-incorporation periods. Also, suggest how the pre-incorporation profits ar e to

be dealt with.

Solution

MA (P.) Ltd.

  Profit & Loss A/c for 15 months ended 31st March, 2005

 

Pre-inc. Post-inc.    Pre-inc. Post-inc.

 

Rs.  Rs.    Rs.  Rs.

To  Cost of goods sold  18,20,000  1,45,60,000  By  Sales  26,00,000  2,08,00,000

_ Salaries  90,000  10,80,000 _ Loss  19,000

_  De pre ciation  36,000  1,4 4,000

_  Advertisement  78,000  6,2 4,000

_  Discou nts  1,30,000  10,40,000

_  M.D.’s remu neration  —  90,000

_  Misc. Office Expenses  24,000  96,000

_  Re nt  90,000  6,3 0,000

_  Interest  3,51,000  6,00,000

_  Net Profit              —    19,36,000     ________ _________

 

26,19,000 2,08,00,000     26,19,000 2,08,00,000

Working Notes:

(1)  Calculation of ratio of sales:

Let the average sales per month in pre-incorporation period be x. Then the average sales

in post-inc. period are 2x. Thus total sales are (3 x) + (12 2x) or 27x. Ratio of sales

will be 3x : 24x or 1:8.

Time ratio is 3 months : 12 months or 1:4

(2)    Expenses apportioned on turnover ratio basis are cost of goods sold, advertisement, discounts.

(3)  Expenses apportioned o n time ratio basis are Depreciation, and misc. office expenses.

(4)  Ratio for apportionment of Salaries:

If pre-incorporation monthly average is x, for 3 months 3x.

Average for balance 12 months 3x, for 12 months 36x.

 

3.108

 

 

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Company Accounts  

 

Hence ratio for division, 1:12.

(5) Apportionment of Rent:

 

   Rs.

Total Rent

   7,20,000

Additional rent for 9 months (From 1st July to 31st March, 2005)    2,70,000

Rent for old premises for 15 months or Rs. 30,000 p.m.    4,50,000

 

 

Pre-inc.  Post-inc.

Old Pr emises

90,000  3,60,000

Addl.:_

 —  2,70,000

 

90,000 6,30,000

Note on treatment

Since the profits prior to incorporation are in the negative, they would:

(a)  either be considered as a reduction from any capital reserve accruing in relation to the

transaction, or 

(b)  be treated as goodwill.

Illustration 4

ABC Ltd. was incorporated on 1.5.2006 to take over the business of DEF and Co. from

1.1.2006.  The Profit and Loss Account as given by ABC Ltd. for the year ending 31.12.2005 is

as under:

Profit and Loss Account

   Rs.   Rs.

To Rent and Taxes  90,000     By  Gross Profit  10,64,000

To  Salaries including manager’s 

 

By  Interest on Investments  36,000

salary of Rs. 85,000

3,31,000

To Carriage Outwards  14,000  

 

To Printing and Stationery  18,000  

 

To  Interest on Debentures  25,000    

 

To Sales Commission  30,800  

 

To  Bad Debts (related to sales)  91,000    

 

To Underwriting Commission  26,000  

 

To Preliminary Expenses  28,000  

 

 

3.109

 

 

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  Advanced Accounting

 

To Audit Fees  45,000  

 

To  Loss on Sale of Investments  11,200    

 

To  Net Profit    3,90,000  

________

 

11,00,000  

11,00,000

 

Prepare a Statement showing allocation of pre-incorporation and post-incorporation profits

after considering the following informations:

(i)  G.P. ratio was constant throughout the year.

(ii)  Sales for January and October were 1 times the average monthly sales while sales for

December were twice the average monthly sales.

(iii)  Bad Debts are shown after adjusting a recovery of Rs. 7,000 of Bad Debt for a sale made

in July, 2003.

(iv)  Manager’s salary was increased by Rs. 2,000 p.m. from 1.5.2006.

(v)  All investments were sold in April, 2006.

 

Solution

Pre-incorporation period is for four months, from 1st January, 2006 to 30th April, 2006.  8

months’ period (from 1st May, 2006 to 31st December, 2006) is post-incorporation period.

Profit and Loss Account for the year ended 31st December, 2006

    Pre-Inc               Post –Inc        Pre-Inc         Post inc

 

Rs.  Rs.     Rs.  Rs.

To  Rent and Taxes  30,000  60,000  By  Gross Profit  3,42,000  7,22,000

To Salaries 

 

 

By

Interest on

 

 

Investments

Manager’s Salary 

23,000

62,000

 

36,000

-

By

Bad Debts

Other Salaries

82,000

1,64,000

7,000

-

Recovery

To Printing and

6,000 12,000  

   

Stationery 

To Audit fees  15,000  30,000    

   

To Carriage Outwards  4,500  9,500    

   

To Sales Commission  9,900  20,900    

   

To  Bad Debts 

31,500 66,500  

   

(91,000 + 7,000)

To Interest on

   

  -  25,000  

Debentures

 

3.110

 

 

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Company Accounts  

 

To Underwriting

  -  26,000  

   

Commission

To Preliminary Expenses   -  28,000  

   

To  Loss on sale of

11,200   -     

investments

To Net Profit  1,71,900* 2,18,100    _______ _______

    3,85,000 7,22,000    3,85,000 7,22,000

 

*Pre-incorporation profit is a capital profit and will be transferred to Capital Reserve.

Working Notes

(i)  Calculation of ratio of Sales 

Let average monthly sales be x.

Thus Sales from January to April are 4 x and sales from May to December are 9 x.

Sales are in the ratio of 9/2x : 19/2x or 9 : 19.

(ii)  Gross profit, carriage outwards, sales commission and bad debts written off have been

allocated in pre and post incorporation periods in the ratio of Sales i.e. 9 : 19.

(iii)  Rent, salaries, printing and stationery, audit fees are allocated on time basis.

(iv)  Interest on debentures, underwriting commission and preliminary expenses are allocated

in post incorporation period.

(v)  Interest on investments, loss on sale of investments and bad debt recovery are allocated

in pre-incorporation period.

 

Self Examination Questions

I   Objective type questions

Choose the most appropriate answer from the questions:

1.   Profit prior to incorporation is transferred to

(a)   General reserve.

(b)   Capital reserve.

(c)   Profit and loss account.

(d)   None of the above.

 

2.  The profit earned by the company from the date of purchase to the date of

incorporation is

(a)   Pre- incorporation profit.

 

3.111

 

 

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  Advanced Accounting

 

(b)   Post- incorporation profit.

(c)   Notional profit.

(d)   Estimated profit.

II  Short answer type questions

3.  Write a short note on Profit or loss prior to pre-incorporation.

III   Long answer type questions

4.   Explain various methods of computing profit or loss prior to pre-incorporation in

detail.

IV   Practical problems

5.  Flat Private Ltd. Was incorporated on 1st July, 2005 to take over the running

business of Mr. Round with effect from 1st April, 2005.  The following Profit and Loss

Account for the year ended 31st March, 2006 was drawn up:

 

Rs.  

Rs.

To Commission  2,625 By Gross Profit  98,000

" Advertisement  5,250 " Bad Debt Realised  500

"  Managing director's

9,000  

 

Remuneration

" Depreciation  2,800   

 

" Salaries

18,000   

 

" Insurance

600   

 

" Preliminary Expenses  700   

 

"  Rent & Taxes  3,000    

 

" Discount

350   

 

" Bad Debts

1,250   

 

" Net Profit

54,925   

 

 

98,500  

98,500

 

 

 

  The following details are available:

(i)  The average monthly turnover from July 2005 onwards was double than that of

the previous months.

 

3.112

 

 

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Company Accounts  

 

(ii)   Rent for the first 3 months was paid @ Rs.200 p.m. and thereafter at a rate

increased by Rs.50 p.m.

(iii)  Advertisement expenses were directly proportionate to the sales.

  You are required to find out the profit prior to incorporation and state the

treatment thereof in the books of the company.

6.  B. Ltd. Was incorporated on 30th June, 2005 to take over the business of T. Ltd. As

from 1st January, 2005.  The financial accounts of thebusiness for the year ended

31st December, 2005 disclosed the following information:

 

Rs. Rs.

Sales -  January to June

1,20,000  

  July to December

1,80,000  

 

  3,00,000

Less:  Purchases  - January to June  75,000  

    - July to December  1,20,000  

Gross Profit

  1,05,000

Less: Salaries

 15,000  

Selling Expenses

3,000 

Depreciation

1,500 

Director's Remuneration

750 

Debenture Interest

90 

Administration Expenses

 

 

(Rent, Rates etc.) 

4,500

 

  24,840

 

  80,160

 

   You are required to prepare a statement apportioning the balance of profit between

the periods prior to and since incorporation and show the profit and loss

appropriation account for the year ended 31st December, 2005

 

3.113