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 鏑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
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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.
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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
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 擢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
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
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.
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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 ﾗ x) + (12 ﾗ 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.
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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
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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ｽ 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
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ｽ x and sales from May to December are 9ｽ 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.
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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.
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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
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