In this article we will discuss about the accounting treatment for profit or loss prior to incorporation of a company.
Sometimes, a company is formed for purchasing certain running or going concern. A company comes into existence only after its registration i.e., its incorporation. A company can earn profits only after its incorporation, but not before its incorporation. In many cases, th6 date of acquisition of business may not coincide with the date of the incorporation.
For instance, a company incorporated on 1st May 2004 may purchase a business from 1st January 2004, the date on which the financial year starts. Generally the business of going concern is purchased on the basis of last Balance Sheet.
It will be more convenient to both—the vendor and the vendee. In case if the business is purchased on a date other than the date of Balance Sheet, accounts of stocks, assets, liabilities etc. have to be taken and verified. The processes are tedious jobs. To avoid such a tedious job, the business may be acquired from the date the firm prepared its last final accounts.
A private company can commence business soon after its incorporation, while a public company can commence business only after obtaining the certificate of commencement of business. That is, any profit made, in case of private company, before incorporation and in case of public company any profit made before the commencement of business, should be taken as a capital profit. However, it should be noted carefully that it is the date of incorporation and not the date of commencement of business which is taken into consideration for calculating profit or loss prior to incorporation.
For instance, a company incorporated on 1.4.2004 agrees to take over a running business from 1.1.2004. It closes its accounts on 31st December. The company is entitled to not only the profit or loss from 1.1.2004 to 31.3.2004 but also the profit or loss from 1.4.2004 to 31.12.2004. The profit earned prior to incorporation i.e., 1.1.2004 to 31.3.2004 is known as PRE-INCORPORATION PROFIT, which cannot be taken as revenue profit, but is CAPITAL PROFIT.
Such profit is to be transferred to CAPITAL RESERVE or may be used in writing down capital loss. When, there arises a loss in the pre-incorporation period, the loss should be debited to GOODWILL ACCOUNT. The profit earned during post period i.e., in the above example, from 1.4.2004 to 31.12.2004, is revenue profit and is available for dividend.
Allocation of ‘Profit/Loss into Pre-and Post-Incorporation Period:
As the profits earned prior to incorporation are not available for dividend, it is necessary to separate it from divisible profits. This is possible, when the profit and loss account is prepared separately for the pre-incorporation period and post-incorporation period. And this is possible only by closing of the books and stock taking for the two periods. These involve tedious work. Therefore, the profit or loss is estimated by apportioning on some reasonable basis – time, turnover, equitable or actual.
In practice, the same sets of books of accounts are maintained throughout the accounting year.
A Profit and Loss Account is prepared at the end of the year and thereafter the profits or losses between the two periods are allocated:
(i) From the date of purchase to the date of incorporation (Pre-incorporation period) and
(ii) From the date of incorporation to the closing of the accounting year (Post-incorporation period).
Method of Accounting:
Steps to find out the profit or loss before and after incorporation are as follows:
1. Prepare one trading account for the whole period. Do not consider the date of incorporation. Thus, one figure of gross profit for the entire period is arrived at.
2. The gross profit is apportioned between the two periods, prior to incorporation and post- incorporation, on the basis of sales in the two periods.
3. The various expenses, which are shown in the profit and Loss Account, should be divided between pre and post incorporation periods on some logical and appropriate basis.
They are given below:
In simple problems, where the sales is evenly spread over the whole period, the sales are apportioned between pre and post-incorporation periods in the proportion of their time periods. But in many cases, the sales are fluctuating from time to time. Therefore, the Sales Ratio is found out by considering pre and post-incorporation periods on the basis of their respective turnover. (Turnover-cum-time basis.)
Treatment of Pre Incorporation Results:
Profit or loss from the date of purchase of business till the date of incorporation belongs to the company. Such profit should not be regarded as trading profit. The profit made before incorporation is not available for distribution as dividends to the shareholders of the purchasing company because it is treated as capital profit.
The treatment of pre-incorporation results is given below:
(A) Profit Prior to Incorporation:
1. The profit is in the nature of capital profit.
2. Capital profit should not be used for payment of dividend.
3. It can be used for writing down goodwill or capital losses.
4. The unutilised portion of the profit can be transferred to Capital reserve.
(B) Loss Prior to Incorporation:
1. It can be treated as goodwill and added to goodwill account.
2. It can also be treated as deferred revenue expenditure and written off against profits, over a number of years.
3. It may be debited to a separate account – Loss Prior to Incorporation Account.