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7.3. Profit Prior to Incorporation

Sometimes a company purchases a running business from a date prior to its incorporation. Ifthe company has earned any profit from the date of purchase to the date of incorporation suchprofit is called as profit prior to incorporation.

As for example, a company incorporated on 1st April, 2004 may purchase a business from 1stJanuary, 2004, the date on which the accounting year of the vendor starts. Generally the businessis purchased from vendor on the last date of the balance sheet so that assets and liabilities aretaken over on the basis of the figures given in the Balance Sheet.

Such profit cannot be said to have been earned by the company as it is not available fordistribution as dividend to the shareholders. Such profit is treated as capital profit and istransferred to Capital Reserve Account.

If there is any loss prior to incorporation such loss is in the nature of capital loss and is debitedto Goodwill Account. It should be noted that, the date of incorporation and not the date ofcommencement of should be taken into consideration for calculating profit or loss prior toincorporation.

Ascertainment of Profit or Loss Prior to Incorporation

Profit or loss prior to incorporation can be ascertained only when fresh stocktaking and balancingof accounts is done on this date. But it will involve a great deal of inconvenience. In order toavoid this inconvenience, the following steps may be taken:

(1) Prepare the trading account for the whole period i.e., from the date of purchase of businessto the last date of accounts closing in order to calculate the gross profit. Date of incorporationwill not affect the calculation of gross profit:

(2) Calculate time ratio and sales ratio. Time ratio is calculated by taking into considerationthe time falling from the last date of balance sheet to the date of incorporation and theperiod between the date of incorporation to .the last date of presenting [mal accounts. Forexample, if the business is purchased on 1st April 2006 and certificate of incorporation isgranted on 1st July 2006 and final accounts are being prepared on 31st March 2007, thenthe time ratio is 3 months : 9 months or 1:3. Sales ratio is calculated taking into considerationthe sales of pre-incorporation period to that of sales of post-incorporation period. Forexample, if sales of pre-incorporation period are Rs. 5,00,000 and that of post-incorporationRs. 20,00,000, then the sales ratio is 1 : 4.

(3) Prepare the profit and loss account for the pre-incorporation and post Incorporation periodsseparately.

This is done on the following basis:

a. Gross profit should be apportioned between the two periods on the basis of their respectivesales ratio.

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b. Such expenses which are directly related on sales such as commission on sales, discountallowed, bad debts, advertising, etc. should be apportioned on the basis of sales ratio ofthe two periods.

c. Fixed expenses such as salaries, rent, audit fees, insurance, depreciation, etc. should beallocated on the basis of time ratio as these expenses are incurred on the basis of time.

d. Expenses which are incurred after the incorporation of the company such as directors’fees, preliminary expenses, interest on debentures etc. should be charged wholly to theperiod after incorporation. Similarly expenses viz. salary of partners is debited to the Pre-incorporation period.

Illustration

BK Ltd. was incorporated on 1st August, 2006 and received its certificate of commencement ofbusiness on 1st Dec, 2005. The company bought the business of M/S BK & Co. with effect from1st April, 2006. From the following figures relating to the year ending March 31, 2007, find outthe profits available for dividends:

(a) Sales for the year were Rs. 6,00,000 out of which sales up to 1st August 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:

Solution

Workings:-

1> Time Ratio: Pre –incorporation period 4 MonthsPost –incorporation period 8 Months

Rs Rs Rent 9000 Advertising 18000 Salaries 15000 Stationery and Printing 3600 Directors' fees 4800 Commission on sales 6000 Interest on debentures 5000 Bad debts(500 relate to

debts created prior to incorporation

1500

Audit fees 1500 Interest to vendor on purchase consideration (up incorporation date Rs 2000)

3000

Discount on sales 3600 Depreciation 24000 General expenses 4800

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PROFIT AND LOSS ACCOUNT For the year ending March 31 2007

So the ratio is 1:2

2> Sales Ratio.

Sales up to incorporation period Rs 2,50,000

Sales in post incorporation period Rs 3,50,000

So the ratio is 5:7

** Related to Post incorporation period only.

Basis Prior to After Basis Prior to After of alto- Incor- Incor- of allo- Incor- Incor- cation poration poration cation poration poration Rs. Rs. Rs. Rs. To Rent Time 3,000 6,000 By Gross Profit Sales 75,000 1,05,000 -Salaries Time 5,000 10,000 - Directors' ** fees 4,800 -Interest on ** debentures 5,000 -Audit fees Time 500 1,000 -Discount on sales Sales 1,500 2,100 -Depreciation Time 8,000 16,000 -General expenses Time 1,600 3,200 -Advertising Sales 7,500 10,500 -Stationery & Printing Time 1,200 2,400 -Commissi- on sales Sales 2,500 3,500 -Bad Debts Actual 500 1,000 -Interest to Actual 2,000 1,000 Vendor -Capital Profit 41,700 - -Net Profit 38,500 75,000 1,05,000 75,000 1,05,000

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Calculation of Sales Ratio

The calculation of sales ratio may be simple in those cases where the turnover is spread duringthe whole financial period. But where the turnover fluctuates from month to month accordingto the nature of product (as woolen garments where the sales are more in the month of Octo-ber, November, December, and January as compared to other months), the calculation of salesratio becomes difficult Moreover, the sales of month of October may be different from themonth of December or January. Under such’ circumstances the sales ratio is determined takinginto consideration the relationship of monthly sales with that of total sales.

The following illustration may clarify the point more clearly.

Ludhiana woolen Mills Company Ltd., incorporated on 1st April, 2006, took over runningbusiness from 1st January, 2006. The company prepares its first final accounts on 31st Decem-ber 2006. From the following information, you are required to calculate the sales ratio of pre-incorporation and post-incorporation periods.

(a) Sales for January, 1995 to December, 1995 Rs. 4,80,000,

(b) The sales for the month of January twice of the average sales; for the month of Februaryequal to average sales, sales for four months May to August-1/4th of the average of eachmonth; and sales for October and November three times the average sales.

Solution

Calculation of Average Sales per month

Rs 4,80,000/12 =Rs. 40,000

Sales for the months of

January 2 x Rs. 40,000 80,000 February 1 x Rs. 40,000 40,000

1/4 x Rs. 40,000 10,000 May

1/4 x Rs. 40,000 10,000 June

1/4 x Rs. 40,000 10,000 July

1/4 x Rs. 40,000 10,000 August

October 3 x Rs. 40,000 1,20,000 November 3 x Rs. 40,000 1,20,000 Total Sales for 8 Months

4,00,000

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Sales for the remaining 4 months = Rs, 4,80,000 - Rs. 4,00,000

= Rs. 80,000

Average sales for remaining months: = Rs 80,000/4 = Rs 20,000

Sales for Pre-incorporation Period:` Rs

January 80,000

February 40,000

March 20,000

1,40,000

Sales for the Post incorporation period = Rs 4,80,000 – 1,40,000

= Rs 3,40,000

So the Sales Ratio between Pre and Post = 7:17

EXERCISE

1. State whether the following statements are true or false:

a> Loss prior to incorporation is a capital loss and is debited to Goodwill Account.

b> Expenses viz. preliminary expenses, interest on debentures and directors’ fees whichare incurred after incorporation of the company should be charged wholly to postacquisition period.

c> Gross profit should be apportioned between prior to and after incorporation periodon the basis of time ratio of the two periods.

Answer :

(1) True; (b) False; (c) True

PROBLEMS

1. A company incorporated on 1st August, 2006 acquires a business as from 1st April, 2006.The first accounts are drawn up upto 31 st December, 2006. The gross profit for this periodof 9 months was Rs. 56,000,000, the general expenses Rs. 14,220,000 the directors’ fees Rs.12,000,000 per annum, formation expenses Rs. 1,500,000.

Rent upto 30th September was Rs. 1,200,000 per annum, after which it was increased toRs. 3,000,000 per annum. Salary of the manager who upon incorporation of the companybecame a director was Rs. 6,000,000 per annum (since incorporation included in directors’fees mentioned above).

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Show Profit and Loss Account assuming that the net sales were Rs. 820,000,000 themonthly average of which for the first four months of 2003 being one half of that of theremaining period. The profit was earned uniformly on sales.

Ans. [Profit prior to incorporation Rs. 7,280,000; after incorporation Rs. 24,650,000.

2. Kaipy Private Ltd. was incorporated on 1st July, 2005 with an authorized capital of Rs.500,000,000 in equity shares of Rs. 10 each to take over a going concern as from 1st April2005. The agreement for taking over provided that all profits made from 1st April, 2005should belong to the company. The purchase consideration of Rs. 200,000,000 together,with interest @ 8.75 % p.a. was satisfied on 1st October, 2005 by the allotment to the vendors17,500,000 equity shares fully paid and the balance in cash.

The Trial Balance of the company on 31st March, 2006 was as follows:

You are required to prepare the Profit and Loss Account of the company for the year ended31st March, 2006, and a Balance Sheet as on that date after taking into account the followingadjustments:

(a) Stock on 31.3.93, Rs. 140,000,000.

(b) Bad Debts, Rs. 500,000 (including Rs. 200,000 out of book debts taken over from the vendors)to be written off.

(c) Provision for Doubtful Debts to be made at Rs. 2,500,000.

(d) Depreciate Buildings by 5 per cent and Furniture by 10 per cent.

Dr (Rs’000) Cr (Rs’000) Share Capital 2.25.000 Freehold land-at cost 25,000 Building-at cost 65,000 Furniture at cost 7,500 Salaries 12,000 Purchases (including stock taken over) 4,85,000 Sales (including sales prior to incorporation Rs.75,000) 4,50,000 Sundry Debtors 45,000 Sundry Creditors 30,000 Rent Received 6,000 Rent and Taxes 3,000 Repairs 1,500 Directors' Fees 1,200 Miscellaneous Expenses 7,200 Interest to Vendors 8,750 Cash in hand 1,800 Cash at Bank 48,050 7,11,000 7,11,000

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3. Rajasthan Udyog Limited, incorporated on Aug 1, 2005, received the certificate tocommence business on August 31, 2005. It had acquired a running business from M/sPTA & Co. with effect from April 1, 2005. The purchase consideration was Rs. 5,000Lakh of which Rs. 1,000 Lakh was to be paid in cash and Rs. 4,000 Lakh in the form offully paid shares. The company also issued shares for Rs. 4,000 Lakh for cash. Machinerycosting Rs. 2,500 lakh was then installed. Assets acquired from the vendors were:Machinery Rs. 3,000 Lakh Stock Rs. 600 Lakh, Patents Rs. 400 Lakh.

During the year 1995, the total sales were Rs. 18,000 Lakh ; the sales per month in the first half-year were one-half of what they were in the later half year. The net profit of the company aftercharging the following expenses was Rs. 1,000. Depreciation Rs. 540 Lakh. Audit fees Rs. 75Lakh, Directors’ fees Rs. 250 lakh, Preliminary expenses Rs. 60 lakh, Office expenses Rs. 390lakh. Selling expenses Rs. 360 Lakh, Interest to vendors upto August 31, 1995 Rs. 25 Lakh.

Ascertain the pre-incorporation and post incorporation amount of profit, and prepare theBalance Sheet of the company as on 31st March, 2006. Closing stock was valued at Rs. 700Lakh.

Ans.[profit prior to incorporation Rs.165 Lakh; Post incorporation profit Rs. 835 Lakh; BalanceSheet Total Rs. 9, 000 Lakh].