Profit Prior Incorporation

Profit prior to incorporation is that profit which a company gets between the period of date of buying and date of incorporation. Suppose, A company buys XYZ company on 1st Jan. 2010 and it has to incorporate at 1st April 2010. Then profit between 1st Jan. 2010 and 1st April 2010 will be profit prior to incorporation. This profit can not be used for paying dividend to shareholders. Because current shareholder’s capital is not involved for this profit, so this will be capitalized profit and it will be transferred to capital reserve account. If company gets loss prior to incorporation, it will be transferred to goodwill account.

Ascertainment of Profit or Loss Prior to Incorporation

Following steps are taken for calculating the profit or loss prior to Incorporation :

1st Step : Make Trading Account of Whole Period

First of all, we have to make trading account for calculating gross profit of whole period. We will not make different trading account for prior and after incorporation because after calculating gross profit of a year, we can divide it prior incorporation on the basis of time.

2nd Step : Calculate Time Ratio and Sale Ratio

Time and sale ratios are two very important ratio which can be used for allocation of gross profit and other items of profit and loss account into prior and after to incorporation. Suppose, if After buying company, if it was incorporate after 4 months from 1st Jan. 2010, then time ratio will be 4 months : 8 months or 1:2
If before incorporation sale is Rs. 1,00,000 and after incorporation sale is Rs. 3,00,000, then sale ratio is 1:3

3rd Step : Make Profit and loss account prior and after incorporation in different Columns

a) Gross profit will divide on the basis of sale ratio

b) All expenses which are relating to sale will be divide on the basis of sale ratio

c) All fixed charges like salaries, rent, audit fees, insurance, depreciation, administrative expenses will divide on the basis of time ratio. All expenses which done after incorporation will be charged totally to after
incorporation.

Example

Subhash ltd. was incorporated on 1st march, 2010 and received its certificate of commencement of business on 1st April, 2010. The company bought the business of M/S small and co. with effect from 1st Nov. 2009. From the following figures relating to the year ending 31st oct. 2010, find out the profits available for dividends.

a) Sales for the year were Rs. 6,00,000 out of which sales up to 1st march , were Rs. 2,50,000
b) Gross profit for the year was Rs. 1,80,000
c) The expenses debited to the profit and loss account were :

rent 9000
salaries 15000
director's fees 4800
interest on debentures 5000
discount on sales 3600
depreciation 24000
general expenses 48000
advertising 18000
stationery expenses 3600
commission on sales 6000
bad debts 500 relate to debts created prior to incorporation 1500
interest to vendor on purchase consideration up to 1st may 2010

Solution


Working Notes :

a) Sales ratio is 250000 : 350000 or 5:7

b) time ratio except for interest to vendor 4 months : 8 months or 1:2

c) time ratio for interest to vendor 4 months : 2 months or 2:1

d) Director fees and interest on debentures relate to post - incorporation period.