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Chapter 2: Profit Prior to Incorporation 2.1

2 Profit Prior to Incorporation

Concept of Profit Prior to Incorporation

➢ Entire profit of the company is divided into two parts. Profit for the period from date of purchase
to the date of incorporation is called as “profit prior to incorporation “.
➢ Profit for the period after incorporation is called as “post incorporation period profit”.
➢ Profit for the pre-incorporation period is treated as capital profit so it is shown on liability side
of balance sheet as capital reserve under the head reserve & surplus. Loss for the pre-
incorporation period is treated as capital loss so it is shown on asset side of balance sheet as
goodwill or it is shown under miscellaneous expenditure a/c as loss prior to incorporation.

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Chapter 2: Profit Prior to Incorporation 2.1

Cut-off Date

➢ A private company can commence business soon after its incorporation, while a public
company can commence business only after obtaining the certificate of commencement of
business. This means that in case of private company, any profit made before incorporation
and in case of a public company any profit made before commencement of business should be
taken as a capital profit.
➢ Important Note- As per the recent amendment provision relating to the certificate of
commencement of business (in case of public company) has been omitted.

Loss prior to incorporation can be dealt with in any of the following manner:

It may be written off It may be treated as Such loss can be treated as Deferred
against capital profits of Goodwill and debited to Revenue Expenditure and written
the company Goodwill Account off out of the profits of the
company over a period of years.

Methods to ascertain profit or loss prior to incorporation

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Chapter 2: Profit Prior to Incorporation 2.1

Profit or loss prior to incorporation can be ascertained in any of the following methods:

a) Preparation of Trading and Profit and Loss A/c for the period up to the date of incorporation:
Under this method, a trial balance has to be prepared as on the date of incorporation of the company
by balancing off of the books and the value of stock has to be ascertained as on that date. Then, a
trading and profit and loss a/c has to be prepared for the period which will disclose the profit or loss
prior to incorporation. Profit or loss prior to incorporation can be ascertained accurately under this
method. All transactions thereafter would naturally relate exclusively to the post-incorporation
period and thus give post-incorporation profit or loss.
But stock trading and balancing off of the books in the intervening period is often
very inconvenient as the same will adversely affect the normal functioning of the business. In view
of this difficulty, this method is not generally adopted in actual practice.

b) Preparation of Profit and Loss A/c by the apportionment of items of income and expenditure
into pre-incorporation and post-incorporation periods

Under this method, a trial balance is prepared only at the end of the accounting period and Profit
and Loss for the pre and post incorporation period is ascertained by preparing profit and loss
account. The profit or loss is ascertained by apportioning items of income and expenses between
the two periods, i.e., the pre-incorporation and post-incorporation periods on same basis. Thus
under this method, profit or loss for the two periods, cannot be ascertained as accurately as under
the first method, this method can only give an estimate of the profit or loss of the two periods. As
the first method involves a lot of inconvenience, there is no other alternative than to depend on
this method.
The apportionment of profit or loss, in such a case, between the pre-incorporation and post-
incorporation period can be done on any of the following basis:

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Chapter 2: Profit Prior to Incorporation 2.1

Time Basis

Turnover Basis

Equitable Basis

a) Time Basis
The profit or loss for the whole accounting period is apportioned between the periods prior to and
after incorporation on the basis of time i.e., in proportion of the time of the respective periods.

b) Turnover Basis
The profit or loss for the whole accounting period is apportioned between the periods prior to and
after incorporation on the basis of turnover, i.e., in proportion of the turnover of the respective
periods.

c) Equitable Basis
The manner of apportionment of profit or loss between the pre-incorporation and post-
incorporation periods actually depends upon the nature of each particular item.

For this, following principles are, generally followed:

No. Nature of the item Basis of apportionment

1. Gross Profit or Gross Loss Sales

2. All fixed or standing charges, such as rent, rates, taxes, On the basis of time in
insurance, general expenses, salaries, printing and stationery, the respective periods.
telephone, postage, and telegrams, depreciation, audit fees,
etc.

3. All variable expenses directly varying with the turnover, such On the basis of turnover
as, commission, discount, brokerage, salesmen’s salaries, or sales
advertisement carriage outwards, etc.

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Chapter 2: Profit Prior to Incorporation 2.1

4. All expenses wholly applicable to the period prior to Exclusively to be shown

incorporation like vendors’ salary, interest on vendors’ in the pre-incorporation
capital, interest on purchase consideration upto the date of period.
incorporation, etc.

5. All expenses wholly applicable to the post-incorporation Exclusively to be shown

period like, directors’ fees, debenture interest, discount on in the post-
issue of debentures, preliminary expenses or formation incorporation period.
expenses, etc.

Basis of Apportionment

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Chapter 2: Profit Prior to Incorporation 2.1

In order to apportion the profit between pre- and post-incorporation periods, the following steps
should be taken as:

i. The gross profit to the business should generally be calculated for the full period without
apportioning it between pre-and post-incorporation periods.
ii. The gross profit calculated as above should be divided between pre-and post-
incorporation periods on the basis of sales of the two periods.
iii. Expenses which vary in proportion to sale, e.g. bad debts, commission on sales etc., should
be divided in sales ratio between pre-and post-incorporation periods.
iv. Expenses which vary according to time e.g. rent, salary, depreciation, interest etc., should
be divided in time ratio between pre-and post-incorporation periods.
v. Expenses which solely relate to the post-incorporation period, should be charged only
against the profits of that period. Examples of such expenses are, interest on debentures,
dividends, preliminary expenses, etc.
vi. Expenses which relate to both pre and post-incorporation periods should be charged to
both the periods on time basis.
Example 1: Auditor’s fee may be charged to both pre and post-incorporation periods.
However, since getting accounts audited is compulsory in case of companies, the entire
amount of audit fee may be charged solely to the post incorporation period.

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Chapter 2: Profit Prior to Incorporation 2.1

Example 2: Similarly, interest paid to the vendors for delay in payment of purchase
consideration to them should be charged over both the pre- and post-incorporation
periods depending upon the period up to which the interest has been paid.

vii. Profit made during pre-incorporation period, should be transferred to capital reserve. It is
not available for distribution as dividend among the shareholders of the company.

Preliminary Expenses

Preliminary expenses refer to those expenses which are incurred in forming a joint stock company.
These comprise the expenses incidental to the creation and floatation of a company and the
following items are usually included therein:

a) Stamp duty and fees payable on registration of the company and stamp papers purchased
for preliminary contracts of the company.
b) The legal charges for preparing the Prospectus. Memorandum and Articles of Association
and contracts and of the registration of the company.
c) Accountants’ and Valuer’s fees for reports, certificates, etc.
d) Cost of printing the Memorandum and Articles of Association, printing, advertising and
issuing the prospectus.
e) Cost of preparing, printing and stamping letters of allotment and share certificates.
f) Cost of preparing printing and stamping Debenture Trust Deed, if any.
g) Cost of company’s seal and books of account, statutory books and statistical books.

But preliminary expenses should not include the following expenses which are incurred before
commencement of business:
a) Cost of preparation of the feasibility report.
b) Cost of preparation of the project report.
c) Cost of conducting market survey or any other survey necessary for the business of the
company.
d) Consultancy fees payable for engineering services in connection with the business.

The accounting for preliminary expenses will be as follows:

Preliminary Expenses A/c. Dr. (With the amount of expenditure)

To Cash or Bank A/c.

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Chapter 2: Profit Prior to Incorporation 2.1

Preliminary expenses are of capital nature and as such should be shown on the assets side of the
Balance Sheet under the heading “Miscellaneous Expenditure”

SUMMARY OF THE CHAPTER:

➢ Any profit (or loss) to which the company is entitled (or liable) before its incorporation is termed as
‘profit (or loss) prior to incorporation’ and is of capital nature.
➢ Profit for the period from date of purchase to the date of incorporation is called as “profit prior to
incorporation “.
➢ Profit for the period after incorporation is called as “post incorporation period profit”.
➢ Profit for the pre-incorporation period is treated as capital profit so it is shown on liability side of
balance sheet as capital reserve under the head reserve & surplus.
➢ Loss for the pre-incorporation period is treated as capital loss so it is shown on asset side of balance
sheet as goodwill or it is shown under miscellaneous expenditure a/c as loss prior to incorporation.
➢ Profit or loss for the post incorporation period are treated as revenue profit or loss so they are
transferred to P & L a/c.
➢ The date of incorporation should be taken as the relevant date for apportionment of profits
between pre- and post-incorporation periods.
➢ Preliminary expenses refer to those expenses which are incurred in forming a joint stock company.
These comprise the expenses incidental to the creation and floatation of a company.
➢ Preliminary expenses are of capital nature and as such should be shown on the assets side of the
Balance Sheet under the heading “Miscellaneous Expenditure”

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Chapter 2: Profit Prior to Incorporation 2.1

QUESTION 1 :

Star Ltd was incorporated on 1st July, 1998 to acquire a running business with effect from 1st April, 1998.
The accounts for the year ended 31st March, 19999 disclosed the following:

(i) There was a gross profit of Rs 3, 00,000.

(ii) The sales for the year amounted to Rs 12, 00,000 of which Rs 2, 40,000 were for the first six
months.

(iii) The expenses debited to the Profit & Loss Account included - director' fees: Rs 15,000; bad debts:
Rs 3,600; advertising: Rs 12,000 (under a contract amounting to Rs 1,000 per month); salaries and
general expenses: Rs 64,000; preliminary expenses written off Rs 5,000; and donation to a political
party given by the company Rs 5,000.

Prepare a statement showing the amount of profit made before and after incorporation.

Solution :

P & L a/c

Particulars Rs. Basis Pre Post Particulars Rs Basis Pre Post

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Chapter 2: Profit Prior to Incorporation 2.1

To balance c/d

To capital reserve

Working Note :

Sales ratio :

Time ratio :

1.

2.

3.

4.

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Chapter 2: Profit Prior to Incorporation 2.1

QUESTION 2 :

Pawan Ltd. was incorporated on 1st March, 1993 and received its certificate of commencement of
business on 1st April, 1993. The Company bought the business of Pramod with effect from 1st
November, 1992. From the following figures relating to the year ending October, 1993, find out the
profit available for dividends:

(i) Sales for the year were Rs 3, 00,000 out of which sales up to 1st March were Rs 1,25,000.

(ii) Gross profit for the year was Rs 90,000.

(iii) Expenses debited to the Profit and Loss Account were:

Rs

Rent 4,500

Salaries 7,500

Director's fees 2,400

Interest on debentures 2,500

Audit fees 750

Discount on sales 1,800

Depreciation 12,000

General expenses 2,400

Advertising 9,000

Stationery and printing 1,800

Commission on sales 3,000

Bad debts *750

Interest on vendor on purchase consideration up to 01.05.1993 1,500

*Rs 250 relate to debts created prior to incorporation.

Solution :

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Chapter 2: Profit Prior to Incorporation 2.1

P & L a/c

Particulars Rs. Basis Pre Post Particulars Rs Basis Pre Post

To balance c/d

To capital reserve

Working Note :

1. Sales ratio :

Time ratio :

2.

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Chapter 2: Profit Prior to Incorporation 2.1

3.

QUESTION 3 :

PQR Ltd. Was incorporated on 1st may, 2011 to takeover the business of kapil & Co., from 1st January,
2011. The following particulars are extracted from the statement of profit and loss of PQR Ltd. For the
year ended 31st Dec, 2011 :

Particulars Rs.

Gross profit 10,64,000

Interest on investment 36,000

Rent and taxes 90,000

Salaries including managers salary of 85000 3,31,000

Carriage outward 14,000

Printing and stationary 18,000

Interest on debentures 25,000

Salesman commission 30,800

Bad debt ( related to sales ) 91,000

Underwriting commission 26,000

Preliminary exepenses 28,000

Audit fees 45,000

Loss on sale of investment 11,200

Net profit 3,90,000

Prepare a statement showing allocation of pre-incorporation and post-incorporation profit after

considering following information :

- GP ratio was constant throughout the year

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Chapter 2: Profit Prior to Incorporation 2.1

- Sales during January and October were 1 ½ times the avg monthly sales while sales during
December were twice the average monthly sales.
- Bad were shown after adjusting a recovery of Rs. 7,000 od bad debts for sale made in july 2008
- Managers salary increased by Rs. 2,000 per month from 1st may, 2011.
- All investment were sold in April, 2011. ( JUNE 2014) ( 5 marks)

Solution :

P & L a/c

Particulars Rs. Basis Pre Post Particulars Rs Basis Pre Post

To balance c/d

To capital reserve

Working Note :

1. Sales ratio :

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Chapter 2: Profit Prior to Incorporation 2.1

Time ratio :

2.

3.

4.

5.

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