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Profit Prior to Incorporation – Concept & Ratio Basis

Introduction

When a company buys an existing business, it often takes it over from a date earlier than its actual Date of Incorporation.

  • Example: Company Incorp on 1st July 2024. Business taken over from 1st April 2024.
  • Period (April - June): Pre-Incorporation Period.
  • Period (July - March): Post-Incorporation Period.

Crucial Logic:

  • Pre-Incorporation Profit: It is a Capital Profit. It CANNOT be used for dividends. Transferred to Capital Reserve.
  • Post-Incorporation Profit: It is a Revenue Profit. Available for dividends.

1. Basis of Apportionment

We must split the total P&L incomes and expenses between "Pre" and "Post" periods using appropriate ratios.

A. Time Ratio (TR)

  • Used for expenses fixed by Time (e.g., Rent, Salaries, Insurance).
  • Pre Period Months : Post Period Months.

B. Sales Ratio (SR)

  • Used for expenses connected to Sales (e.g., Gross Profit, Sales Commission, Advertisement, Discount Allowed, Bad Debts).
  • Pre Period Sales : Post Period Sales.

2. Allocation Guide (Cheat Sheet)

ItemBasis of Allocation
Gross ProfitSales Ratio
Rent, Rates, TaxesTime Ratio
Salaries (Office)Time Ratio
Salesmen Salaries/CommSales Ratio
AdvertisementSales Ratio
Audit FeesTime Ratio (or Sales Ratio if based on turnover)
Director's FeesPost Only (Company entity needed)
Partner's SalaryPre Only (Partnership exits in Pre)
Preliminary ExpensesPost Only (Company formation cost)
Interest to VectorsActual time basis (Pre/Post till payment)

3. Calculation Steps

  1. Determine Dates: Cut-off date is Date of Incorporation.
  2. Calculate Ratios: Find Time Ratio and Sales Ratio.
  3. Statement: Prepare a Columnar P&L with "Pre" and "Post" columns.
  4. Result:
    • Total Pre Column -> Capital Reserve.
    • Total Post Column -> Net Profit.

Illustration (Ratios)

Facts:

  • Acquisition: 1st April.
  • Incorporation: 1st August.
  • Year End: 31st March.
  • Total Sales: ₹12,00,000.
    • Sales up to 31st July: ₹3,00,000.
    • Sales from 1st Aug: ₹9,00,000.

Analysis:

  1. Time Ratio:
    • Pre (April to July) = 4 Months.
    • Post (Aug to March) = 8 Months.
    • TR = 1:2.
  2. Sales Ratio:
    • Pre Sales = 3,00,000.
    • Post Sales = 9,00,000.
    • SR = 1:3.

Exam Notes: Writing the Answer

Question: "Where is Loss Prior to Incorporation debited?" (2 Marks)

Answer: Loss Prior to Incorporation is a Capital Loss. It is debited to Goodwill Account (or adjusted against Capital Reserve).

Question: "Director's fees are allocated in which ratio?"

Answer: Allocated entirely to Post-Incorporation Period, as Directors exist only after the company is incorporated.

Summary

  • Pre Profit: Capital Reserve.
  • Pre Loss: Goodwill.
  • Fixed Exp: Time Ratio.
  • Variable Exp: Sales Ratio.

Quiz Time! 🎯

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