METHODS TO ASCERTAIN PROFIT OR LOSS PRIOR TO INCORPORATION :

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

Preparation of Trading and Profit and Loss Account for the period upto 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 Account 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 pos tin corporation profit or loss.

But stock-taking and the 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.

Preparation of Profit and Loss Account by apportionment of items of income and expenses into pre-incorporation and post-incorporation periods

Under this method, a trial balance is prepared only at the end of the accounting period and the profit or 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 the post-incorporation periods on some 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 periods can be done on any one of the following basis:

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. For example, if the time of the pre -incorporation and post-incorporation period be 3 months and 9 months respectively, the profit or loss for the whole period would be apportioned between the two periods in the ratio 3 : 9, i.e. 1 : 3. Thus, 1/4th of the profit would be treated as pre-incorporation profit while 3/4th of the profit would be treated as post incorporation profit.

This principle is based on the assumption that profits are earned by the business evenly throughout the year. But in reality since no business can be expected to earn its profits evenly throughout the year, apportionment of profit or loss solely on the basis of time is not at all satisfactory.

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. For example, if the turnover of the pre-incorporation and post-incorporation periods be ` 1,00,000 and ` 4,00,000 respectively, the profit or loss for the whole period would be apportioned between the two periods in ratio of 1 : 4. Thus, 1/5th of the profit would be treated as pre-incorporation profit while 4/5th of the profit would be treated as post -incorporation profit.

This principle is also based on the assumption that turnover is spread evenly throughout the year. But in reality, this may not be always true. Besides, all the expenses of business need not necessarily depend on the turnover. As such, apportionment of profit or loss solely on the basis of turnover is also not satisfactory.

Equitable basis

The manner of apportionment of profit or loss between the pre-incorporation and the post-incorporation periods actually depends upon the nature of each particular item. The most equitable method is normally to apportion the gross profit or gross loss of the whole accounting period on the basis of the turnover and the expenses on their respective merits, those, varying with turnover being apportioned on that basis and those which do not vary with the turnover being apportioned on the basis of time.

What is actually to be done in this case is to prepare a Trading Account for the whole period and to find out the gross profit or gross loss in the usual way. The Profit and Loss Account is split up into the two periods (i.e., pre-incorporation and post- incorporation periods) and all the items appearing in the Profit and Loss Account are then apportioned on the basis of their respective merits. For this, following principles are, generally followed:

 

Nature of the item	Basis of apportionment
1. Gross Profit or Gross Loss	On the basis of turnover in the respective   periods.     OR In the absence of turnover in the respective periods, on the basis of expenses which are directly related to turnover in the respective periods.   OR In the absence of any such information, on the basis of time in the respective periods.

2. All fixed or standing charges, such as rent, rates, taxes, insurance, general expenses, salaries, printing and stationery,telephone, postage, and telegrams, depreciation, audit fees, etc.	On the basis of time in the respective periods.
3. All variable expenses directly varying with the turnover, such as, commission, discount, brokerage, salesmen’s salaries, advertisement carriage outwards, etc.	On the basis of turnover in the respective periods.
4. All expenses wholly applicable to the period prior to incorporation like vendors’ salary, interest on vendors’ capital, interest on purchase consideration upto the date of incorporation, etc.	Exclusively to be shown in the pre-incorporation period.
5. All expenses wholly applicable to the post- incorporation period like, directors’ fees, debenture interest, discount on issue of debentures, preliminary expenses or formation expenses, etc.	Exclusively to be shown in the post-incorporation period.

 

Illustration :
Smart Ltd. was incorporated on 1st August, 2011 with an authorised capital of 5,00,000 equity shares of Rs.10 each to acquire the business of Mr. Smart with effect from 1st April, 2011.

The purchase consideration was agreed at ` 7,00,000 to be satisfied by the issue of 40,000 equity shares of Rs.10 each as fully paid-up and 3,000, 9% debentures of ` 100 each as fully paid-up.

The entries relating to the transfer were not made in the books which were carried on without a break until 31st March, 2012. On 31st March, 2012 the trial balance extracted from the books showed the following:

	Rs.	Rs.
Sales		10, 43,700
Purchases	7,76,580
Advertising	37,800
Postage and Telegram	8,820
Rent and Rates	18,420
Packing Expenses	16,800
Office Expenses	12,540
Opening Stock as on 1.4.2010	1,05,220
Directors’ fees	20,000
Debenture Interest	18,000
Land and Buildings	3,00,000
Plant and Machinery	1,80,000
Furniture and Fixture	20,000
Sundry Debtors	1,39,500
Cash at Bank	40,000
Cash-in-hand	4,900
Bills Payable		30,000
Sundry Creditors		53,240
Preliminary Expenses	7,360
Smart’s Capital Account		5, 89,000
Smart’s Drawings Account	10,000	———————–
	17,15,940	17,15,940

 

You are also given the following additional information:

(i) Stock on 31st March, 2012 amounted to ` 98,920.

(ii) The average monthly sales for April, May and June were one half of those for the remaining months of the year and the gross profit margin was constant throughout the year.

You are required to calculate the profit prior and post incorporation as on 31st March, 2012

Solution:

M/s Smart Ltd.
Trading Account for the year ended 31st March, 2012

Dr.                                                                                                                                                                                                           Cr.

Particulars	Rs.	Particulars	Rs.
To Opening Stock	1,05,220	By Sales	10,43,700
To Purchases	7,76,580	By Closing Stock	98,920
To Gross Profit c/d	2,60,820		—————————–
	11,42,620		11,42,620

Profit and Loss Account for the year ended 31st March, 2012

	Pre-incor-poration period, i.e., 1.4.2011 to 31.7.2011	Post-incor-poration period, i.e., 1.8.2011 to 31.3.2011		Pre-incor-poration period, i.e., 1.4.2011 to 31.7.2011	Post-incor-poration period, i.e., 1.8.2011 to 31.3.2011
To Advertising                            (5 : 16)	9,000	28,800	By Gross Profit b/d               (5 : 16)	62,100	1,98,720
To Postage and Telegra(1 : 2)	2,940	5,880
To Rent and Rates                      (1 : 2)	6,140	12,280
To Packing Expenses                 (5 : 16)	4,000	12,800
To Office Expenses (1 : 2)	4,180	8,360
To Directors’ fees		20,000
To Debenture Interest		18,000
To Preliminary Expenses		7,360
To Pre-Incorporation profit	35,840
To Net Profit c/d		85,240
	62,100	1,98,720		62100	1,98,720

 

Working Notes:

1. Ratio of Time between pre-incorporation period and post-incorporation period = 4 months : 8 months = 1 : 2

2. Ratio of turnover between pre-incorporation period and post-incorporation period –

Let the turnover for the months of April, May and June be 1, turnover for the remaining months will be 2.

Now, turnover for the pre-incorporation period

(i.e. 1.4.2010 to 31.7.2010 = 1+1+1+2 = 5

and turnover for the post-incorporation period

(i.e., 1.8.2010 to 31.3.2010 = 8 x 2 = 16

Ratio of turnover between the two periods = 5 : 16

3. As the amount of preliminary expenses is negligible. it has been assumed that the same has to be written off against the revenue.

Illustration 
A company, incorporated on 1st May, 2012 acquired a business as a going concern with effect from 1st January, 2012. The first accounts were drawn up to September 30, 2012.

The gross profit is` 2,24,000. The general expenses are ` 56,880, directors remuneration ` 4,000 p.m.; formation expenses amounted to ` 6,000, rent which till June 30, 2012 was ` 400 p.m. was increased to ` 12,000 per annum from July 1, 2012.

The manager of the earlier firm whose salary was ` 2,000 p.m. was made as director upon the incorporation and his remuneration thereafter is included in the figure of Directors’ remuneration given earlier.

Prepare Profit and Loss Account for the period and find out the profits available for dividends and the profit prior to incorporation.

Solution:

Profit and Loss Account for the period of 9 months ended 30th September, 2012

Dr.                                                                                                                                                                                                    Cr.

	Pre-incor-poration period, i.e., 1.1.2012 to 30.4.2012                Rs.	Post-incor-poration period, i.e., 1.5.2012 to 31.9.2012                               Rs.		Pre-incor-poration period, i.e., 1.1.2012 to 30.4.2012                Rs.	Post-incor-poration period, i.e., 1.5.2012 to 31.9.2012                       Rs.
To General Expenses (4 : 5)	25,280	31,600	By Gross Profit b/d               (5 : 16)	99,556	1,24,444
To Rent	1,600	3,800
To Salary to Manager	8,000
To Directors’ Remuneration		20,000
To Pre-incorporation profit transferred to Capital Reserve A/c	64,676
To Net Profit c/d	69,044
	99,556	1,24,444		99,556	1,24,444

 

1. Profit available for dividend = ` 69,044.

2. Profit prior to incorporation ` 64,676 being capital profits transferred to Capital Reserve Account which can be utilised in writing off formation expenses of ` 6,000. Then the Capital Reserve Account will show a balance of ` 58,676.

Working Notes:
1. As the information is available about the turnover in the respective periods, gross profit has been apportioned between the pre-incorporation and post-incorporation periods on the basis of time, i.e., in the ratio 4 : 5

2. Directors’ remuneration for the period 1st May, 2012 to September, 2012, i.e., for 5 months =Rs.4,000 x 5 = Rs.20,000.
3. Rent for the period prior to incorporation =Rs.400 x 4 =Rs.1,600

For the post incorporation period
Rs.400 x 2 + = ` (800 + 3,000) = Rs.3,800

4. Salary to manager for the period prior to incorporation =Rs.2,000 x 4 =Rs.8,000.

5. General expenses have been apportioned on the basis of time, i.e., in the ratio 4 : 5.

6. It is assumed that the formation expenses are not be written off.

Illustration

Vijay Ltd. was incorporated on 1st March, 2012 and received its certificate of commencement of business on 1st April, 2012. The company bought the business of M/s Small and Co. with effect from 1st November, 2011. From the following figures relating to the year ending October, 2012, find out the profit available for dividends:

(i) Sales for the year were ` 6,00,000 out of which sales upto 1st March were ` 2,50,000.

(ii) Gross profit for the year was ` 1,80,000.

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

Rent                                                                                                                                                             9,000
Salaries                                                                                                                                                     15,000
Directors’ fees                                                                                                                                          4,800
Interest on debentures                                                                                                                          5,000
Audit fees                                                                                                                                                  1,500
Discount on sales                                                                                                                                    3,600
Depreciation                                                                                                                                           24,000
General expenses                                                                                                                                    4,800
Advertising                                                                                                                                             18,000
Stationery and printing                                                                                                                       3,600
Commission on sales                                                                                                                             6,000
Bad debts                                                                                                                                                 1,500*
Interest to vendor on purchase consideration upto May 1, 2012                                              3,000
* ` 500 relates to debts created prior to incorporation.

Solution:

Statement showing profit prior to and after incorporation

	Basis of Allocation	Prior to  incorporation (Rs.)	After incorporation (Rs.)
Gross profit	Sales	75,000	1,05,000
Less: Expenses:
Rentx	Time	3,000	6,000
Salaries	Time	5,000	10,000
Directors’ fees	Actual	–	4,800
Interest on debentures	Actual	–	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 and printing	Time	1,200	2,400
Commission on sales	Sales	2,500	3,500
Bad debtsx	Actual	500	1,000
Interest to vendor	Time	2,000	1,000
Total Expenses		33,300	66,500
Profit (gross profit – expenses)		41,700	38,500

Working Notes:
(i) The ratio of sales is ` 2,50,000 : ` 3,50,000 i.e. 5 : 7.

(ii) The ratio of time is 4 months (upto 1st March) to 8 months or 1 : 2 except in case of interest to vendor.

(iii) Interest paid to vendor is for 6 months out of which interest for four months (upto 1st March) is charged to the period prior to incorporation.

(iv) Bad debts have been allocated as per the instruction.

(v) Directors’ fees and interest on debentures, arising only on formation of the company, have been charged wholly to the post incorporation period.