T.Y.B.

Com:2016-17 Accounts Paper-I

PROFIT PRIOR TO INCORPORATION

1. WHAT IS PROFIT PRIOR TO INCORPORATION

Let us take an example to understand the term – profit before incorporation. Suppose, some businessmen
decide to purchase an existing business of a firm on 1-1-2013 on the basis of its balance sheet on 31-12-
2012. For this purpose, the businessmen promote a limited company which actually gets a certificate of
incorporation on 1-10-2013. The firm carries on the business, in the meanwhile, on behalf of the
promoters. From 1-10-2013, the same business is continued by the company in its own name. The
company adopts the agreement between the promoters and the firm for purchasing the business. On the
basis of this agreement, the profit of the business right from the date of agreement i.e. 1-1-2013 now
belongs to the company. The profit of the business earned from 1-1-2013 to 30-9-2013 is known as “profit
prior to incorporation”. The profit earned after incorporation i.e. from 1-10-2013 to 31-12-2013 is normal
revenue profit earned by the company. The profit earned before incorporation is capital profit of the
company. The date of incorporation is taken as the dividing point for ascertaining the period before
incorporation and the period after incorporation.

2. HOW TO ASCERTAIN & RECORD PRE-INCORPORATION PROFIT

The profit before incorporation can be ascertained in two ways: by preparing separate P & L account for
the period upto incorporation; or by preparing a combined profit and loss account for the entire year and
then dividing the total profit on some suitable basis between the two periods – before and after
incorporation.

2.1 SEPARATE PROFIT AND LOSS ACCOUNT

In this method, the actual amount of profit upto incorporation is calculated by preparing a separate profit
and loss account from the date of agreement to the date of incorporation [in our example, such P & L A/c
will be from 1-1-2013 to 30-9-2013]. However, this method, being inconvenient, is not used normally.

2.2 COMBINED PROFIT AND LOSS ACCOUNT

In this method, first combined profit and loss account is prepared for the entire year and then the total
profit is divided between the two periods on a logical basis. This method gives only an estimate of the profit
before incorporation. The steps involved in this method are as follows (see worksheet 1).

2.2.1 Divided P & L A/c

For ascertaining the profits of each period separately, the combined profit and loss account is divided into
two parts: Part I – before incorporation and Part II – after incorporation [ see worksheet 2 below].

2.2.2 Division of Profits

Continuing the above example of a company incorporated on 1-10-2013 (which purchases a business from
1-1-2013), the P & L A/c for the year ending 31-12-2013 will be divided on the basis of the following
factors. (see worksheet 3):

1. Gross Profit
a) Gross profit (or loss) is normally divided in the ratio of sales.
b) This is based on the assumption that the Gross profit ratio has changed (due to change in sales
price or cost per unit), gross profit should be divided accordingly.
c) If the details regarding sales are not available, the gross profit is divided in the ratio of time.

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2. Specific income/expenses
a) Expenses which only a company can incur are charged to the period after incorporation (e.g.
Directors’ fees, Preliminary Expenses etc.)
b) Expenses incurred by the vendors are charged to the period before incorporation (e.g. partners’
salary paid by the vendor firm).
c) Items about which specific information is available, are divided accordingly. Thus, if as per
details given, out of general expenses, Rs.10,000 related to the period before incorporation and
Rs.5,000 to period after incorporation, Rs.10,000 will be shown in Part I and Rs.5,000 in Part II of
the P & L Account. If some machinery is sold in June 2013, profit on such sale will be shown in
Part I of the P & L Account. If there was a loss of cash by theft in December 2013, it will be
shown in Part II of the P & L Account.
3. Common Items: Common items i.e. items of income or expenses common to both the periods are
divided either in the ratio of time or ratio of sales.
a) Ratio of Time : The income arising on the basis of time (e.g. interest) or fixed expenses or
administrative/establishment/management overheads (e.g. rent; salary; insurance; telephone;
rates and taxes etc.) are divided in the ratio of number of months in each period i.e. in the ratio
of 9 months: 3 months in our example and shown accordingly in Part I and Part II of the P & L
Account.

EXIBIT 1 : ASCERTAINING RATIO OF TIME

Ratio of Time

9:3
Acquisition of Incorporatio Accounting
Pre-incorporation Post-incorporation
Business n Year Ending
9 Months 3 Months
1st January st
1 October 31st December

Notes:
1) The Time Ratio, as calculated above, is used for dividing expenses which arise evenly within each
period.
2) If the expenses arise unevenly within each period, the expenses will be divided differently, on the
basis of the details available i.e. in Weighted Time Ratio.
b) Ratio of Sales : Items linked with the volume or value of sales (e.g. variable expenses or selling
and distribution overheads like freight outward; commission to salesmen; discount allowed; bad
debts etc.) are divided in the ratio of sales or turnover of each period. In the above example, if
sales are Rs.5,00,000 during January 2013 to September 2013 and Rs.3,00,000 during October
2013, variable expenses will be divided in the ratio of 5:3 and shown accordingly in Part I and
Part II of the P and L Account.

EXIBIT 2 : ASCERTAINING RATIO OF SALES.

Ratio of Time

5:3

Acquisition of Sales Before Incorporatio Sales After Accounting

Business Incororation n Invorporation Year Ending
1st January 5,00,000 1st October 3,00,000 31st December

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Notes :

1) The Sales Ratio, as calculated above, is used for dividing gross profits/expenses, if the sales arise
evenly within period.
2) It the sales arise unevenly within each period, the gross profits/expenses will be divided differently,
on the basis of the details, i.e. in the Weighted Sales Ratio.
2.3 ACCOUNTING TREATMENT
1) The profit prior to incorporation is the capital profit of the company. According to the Companies
Act, a company cannot carry on any business and earn profits before its incorporation. Hence the
profit before incorporation cannot be taken as normal profits “earned” by the company. The profit
before incorporation is transferred to Capital Reserve A/c. The profit before incorporation or such
capital reserve may be used to write off goodwill, shares issue expenses or write down the value of
fixed assets acquired etc.
2) The loss before incorporation, if any, should be debited to Goodwill A/c.
3) The profits after incorporation are transferred to the Profit & Loss Appropriation Account.
3. WORKSHETS/RAPID REVISION

WORKSHEET 1: STEPS FOR ASCERTAINING PRE-INCORPORATION PROFITS

Step What is to be done? How it is to be done?

1. Divide a/c year in two periods. a. Period upto incorporation.
b. Period after incorporation.
2. Divide Gross Profit between a. On basis of sales
These two periods.
3. Divide income between a. Specifically arising in a particular period
These two periods. (e.g. Share Transfer Fees)
b. on basis of time(e.g. interest on Bank FD)
4. Divide expenses between a. Specifically arising in a particular period
These two periods (e.g. preliminary expenses)
b. on basis of time(e.g. fixed expenses)
c. on basis of sales (e.g. variable expenses)
5. Divide Net Profits [NP] a. NP upto incorporation(capital reserve)
Between these two periods b. NP after incorporation (P & L A/c)

WORKSHEET 2 : COLUMNAR PROFIT AND LOSS ACCOUNT

Expenses Basis Pre Post Income Basis Pre Post

To Fixed Expenses/ By Gross Profit Sales xxxx xxxx
Admn. Overheads Time xxxx xxxx BY Rent Recd. Etc. Time xxxx xxxx
To VariableExpenses/ By Income before Specific xxxx Nil
Selling Overheads Sales xxxx xxxx inc.
To Expenses before Specific xxxx Nil By Income after Specific Nil xxxx
inc. inc.
To Expenses after inc. Specific Nil xxxx
To Capital Reserve xxxx Nil
To Net Profit c/d Nil xxxx
xxxx xxxx xxxx xxxx

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WORKSHEET 3 : DIVISION OF INCOME / EXPENSES

No. Pre- Post-Incorporation Ratio of Time Ratio of Sales

Incorporation
1. Interest to vendor Fees to directors Fixed Expenses Gross Profits
2. Salary to vendor Salary to directors Administrative Exp. Variable Expenses
3. Interest on Debentures - Rent Selling Overheads
4. Discount on debentures w/o. - Insurance - Salary to
5. Preliminary Expenses w/o. - Printing salesmen
6. Shares Issue Expenses w/o. - Depreciation - Sales commission
7. Share Transfer Fees received - Audit fees - Advertisement
8. Appropriations by company - Postage - Freight outward
- Discount Allowed

Notes :

1) Audit fees should be divided, in the opinion of the authors, in the Ratio of Time. (Some authorities
charge audit fees to post-incorporation period, because audit is compulsory for a limited company.
Further, fees for Tax Audit which is compulsory if the turnover exceeds prescribed limit, are
divided in Sales Ratio.)
2) Interest to vendors (interest on purchase consideration) from the due date of payment upto the
date of incorporation should be charged to the pre-incorporation period.
3) Income-tax is charge against profits. It is calculated as Profits x Rate of Tax (e.g. 30% of profits).
Hence, income-tax, should be divided between pre and post incorporation periods in the ratios of
respective profits.

Problem No. 1

Goodwill w/off

Profit before making the following adjustment were as under:

Pre-Incorporation Period Post-Incorporation Period

Profit Rs.37,000 Rs.18,600

Adjustments to be made:

1) The purchase consideration was agreed at Rs.2,50,000 for assets valued at Rs.2,40,000, 20% of the
goodwill is to be written off.
2) In lieu of interest on purchase consideration, the vendor would get 40% of the profit earned prior to
incorporation.

Find out profit prior to incorporation and after incorporation.

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Problem No. 2

Vasant Ltd. Was incorporated on 1st August, 2010 to take over the running business of M/s. Ankush Bros. a
partnership firm, w.e.f. 1st April, 2010. The company received the certificate of commencement of business
on 1st October, 2010. The following Profit and Loss A/c was prepared for the year ended 31 st march, 2011.

Profit and Loss A/c

for the year ended 31/03/2011
Expenses Rs. Income Rs.
To Office & Administrative Expenses 71,400 By Gross Profit 1,60,000
To Partner’s Salaries 16,100 By Share Transfer Fees 2,000
To Selling & Distribution Expenses 24,800
To Director’s Fees 2,000
To Debenture Interest 3,200
To Interest on Partner’s Capital 3,600
To Bank Charges 900
To Preliminary Expenses 2,000
To Net Profit 38,000
1,62,000 1,62,000

Additional Information:
Sales arose evenly upto date of certificate of commencement of business. Thereafter they recorded an
increase of two-third of the average monthly sales.
Prepare Profit and Loss A/c for the year ended 31st March, 2011, in a columnar form showing the profit or
loss during ‘Pre’ and ‘Post’ incorporation period separately.

Problem No. 3
Share in profit in lieu of interest
Baneshwar Ltd. Was incorporated on 1st September 2009 to take over the business of Ekta &
Gomati, a partnership firm with effect from 1st April, 2009. Following is their Profit and Loss Account for
the year ended 31st March, 2010.

Dr. Side Rs. Cr. Side Rs.

To Salaries 39,000 By Gross Profit 1,80,000
To Rent 8,000 By Interest on Fixed Deposit 12,000
To Bad Debts 11,000
To Office Expenses 2,400
To Directors Fees 1,000
To Debenture Interest 2,800
To Selling Expenses 24,300
To Salary to Partners 5,000
To Printing & Stationary 6,000
To Prelininary Expenses 1,500
To Net Profit 91,000
1,92,000 1,92,000

Additional Information :
1) Average monthly turnover from October 2009 to March 2010 was twice the average monthly
turnover from April, 2009 to September 2009.
2) Rent is doubled from 1st December 2009.

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3) Bad Debts include Rs.2,000 in respect of sales effected two years ago, remaining Bad Debts are out
of sales effected throughout the year.
4) Salaries include salary of three employees at equal monthly remuneration. However one of them
was appointed as manager from 1st January 2010. His salary was doubled from that date.
5) In lieu of interest on purchase consideration the vendor would get 40% of the profit earned in Pre-
incorporation period.
6) Interest on Fixed Deposit was received for the entire year.
Prepare Profit and Loss Account of Baneshwar Ltd. For the year ended 31 st March, 2010 in the
columnar form apportioning all the income and expenditure items between Pre-incorporation and Post-
incorporation period on suitable basis.

Problem No. 4
Following Trial Balance is extracted from the books of Invent Ltd. As on 31 st March 2009. The
company was incorporated on 1st July, 2008 to take over the business of a proprietary concern with effect
from 1st April, 2008. The authorized share capital of the company was 50,000 Equity shares of Rs.10
each. The purchase consideration Rs.1,25,000 was settled on 1st October, 2008 by issue of 10,000 equity
shares of Rs.10 each at par and balance in the form of 12% Debentures of Rs.100 each issued at par.

Trial Balance as on 31st March, 2009

Debit Balance Rs. Credit Balance Rs.
Opening Stock 23,600 Sales 2,10,000
Purchases 1,75,800 Sundry Creditors 30,200
Carriage Inward 5,200 Bills Payable 29,000
Salaries 24,000 Equity Share Capital 1,00,000
Office Expenses 63,600 Profit on Sale of Investment 5,800
Commission on Sales 14,100 12% Debentures 25,000
Directors Fees 3,200
Interest on Purchase Consideration 6,250
Preliminary expenses
(to be written off) 7,500
Sundry Debtors 54,000
Bills Receivable 4,750
Investments 18,000
4,00,000 4,00,000

Additional Information :
a) Stock as on 31st March, 2009 was Rs.15,200 and Stock as on 1-7-2008 was Rs.4,000.
b) Purchases of Rs.1,75,800 included purchase of computer on 1st March, 2009 for Rs.1,00,000 on
which depreciation is to be charged at 60% p.a.
c) Total purchases for the post incorporation period (excluding purchase of computer) are three times
that of pre incorporation period.
d) Interest at 10% p.a. was paid on purchase consideration.
e) Investments were sold on 1st May, 2008.
f) Provide for outstanding interest on debentures.
g) Gross Profit for pre incorporation period was Rs.30,150.
h) Sales in the pre incorporation period were Rs.70,000.
Prepare Trading and Profit and Loss Account of Invent Ltd. For the year ended 31 st March, 2009 in the
columnar form apportioning various expenses and incomes between pre and post incorporation period on
suitable basis.

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Problem No. 5

ICL Ltd. Was incorporated to take over the running business of BC and CI Brothers with effect from 1st
April, 2008. The Company was incorporated on 1st August, 2008.
The following information was available from the books of accounts, which were closed on 31 st
March, 2009.

Rs. Rs.
Gross Profit 7,00,000
Share Transfer Fees received 10,000 7,10,000
Expenses:
Office Salaries 2,10,000
Partner’s Salaries 60,000
Advertising 63,000
Printing Stationery 15,000
Travelling Expenses 40,000
Office Rent 96,000
Auditor’s Remuneration 6,000
Director’s Fees 10,000
Bad Debts 12,000
Sales Commission 49,000
Prelininary Expenses 7,000
Debenture Interest 16,000
Interest on Capital 18,000
Depreciation 21,000

Additional Information :
1. Monthly sales were Rs.5,00,000 for pre-incorporation period, while total sales for the year were
Rs.70,00,000.
The sales were arose evenly throughout the concerned periods.
2. Office rent was Rs.84,000 p.a. upto 30th September, 2008.
It became Rs.1,08,000 p.a. thereafter.
3. Travelling expenses included Rs.7,000 towards sales promotion.
4. Auditor’s Remuneration was payable for the whole year.
5. Bad debts written off included a debt of Rs.4,000 taken over from the vendor, while the remaining
were in respect of goods sold in September, 2008.
6. Depreciation includes Rs.6,000 for asset acquired in the post incorporation period.
Prepare Profit and Loss Account for the year ended 31st March, 2009 in the columnar form showing
profit/loss for the pre and post incorporation period.

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