After incorporation, a firm is formed. The founders of an organisation should compile several preparatory paperwork before registering the organisation. A registration certificate is given upon submitting an application to the Registrar of Companies (ROC). Upon issuing the business registration certificate, the firm is said to have been founded. A business can make money after it has been formed. Before a business was officially incorporated or before it was given its certificate of incorporation, its founders could have gained money. Pre-incorporation earnings are those that are made prior to the company’s incorporation.
Since these earnings were made before the company’s formation, they must be considered capital profits. Post-incorporation profit or post-acquisition profit refers to profits made following a business’s purchase or a firm’s acquisition. Pre-incorporation profit is the profit made before incorporation. Loss before incorporation is included under the heading “Miscellaneous Expenditures” on the assets side of the balance sheet.
Profit of a Company Before Incorporation
Both the pre- and post-incorporation periods of a firm are considered to be that company’s respective periods.
Public firms must wait until they get the business initiation certificate before starting a business, but private companies can start operating right after formation. Pre-incorporation earnings are those made by a private limited company before its incorporation or before the start of operations by a public firm.
Allocation of Profit Prior to Incorporation
Pre-incorporation gains must be distinguished from divisible profits since they cannot be distributed as dividends. Creating separate profit and loss accounts for the before and after incorporation periods is required.
Profit and loss statements are generated separately for pre- and post-incorporation periods to distinguish between profits made or losses incurred for each period.
Assessment of Profit is made before the incorporation of a Company
Before incorporation, profit or loss is determined using the following steps:
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Create a trading account that covers the whole time frame
We must first set up a trading account in order to determine the gross profit for the full-time period. We won’t set up separate trading accounts before and after incorporation since we can split the gross profit of a year depending on time once we’ve calculated the gross profit of a year.
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The time ratio and the selling ratio should be calculated
Important to note: Before and after company incorporation, gross profit and other items from the profit and loss account can be allocated using the sales and time ratios, two extremely important ratios. If the firm was incorporated after 4 months from January 1st, 2022, i.e., 1st of April 2022, the time ratio would be 4 months: 8 months, or 1:2 precisely.
The selling ratio is 1:4 for a sale of Rs.100,000, which is made prior to or before incorporation, and 400,000 after incorporation.
Create a separate net profit statement for the periods prior to and following incorporation.
- Based on the sales ratio for the prior to and following incorporation periods, a distinct allocation of gross profits should be created.
- Rent, copies, office supplies, mailings, phone calls, and other fixed costs must be evenly distributed across the two periods in a timely manner.
- You must divide varying costs, such as marketing, transportation, insurance, fees, bad debts, etc., between the two time periods.
- Interest on the acquisition price, partner salaries, and vendor financing are pre-incorporation costs.
- Post-incorporation costs, such as board dues, the managing director’s compensation, interest on debentures, issue discounts, and so forth, must be deducted.
- Auditing fees may be divided between before and after incorporation using the duration ratio.
A list of the costs that have been split up based on revenue or turnover
- The expenses for selling the products or services
- Salaries of production employees or sales employees
- The gross profit
- The advertisement cost
- Carriage outward
- Carriage inward
- Rent for the factory unit/ manufacturing unit/godown
- Discounts which are allowed or permitted
- Commissions to sales employees
- Promotional expenses incurred for marketing and sales
- Expenses related to distributions, which are variable portions of the expenses incurred
- Provision created for the free samples provided
- Expenses incurred for customer services which are provided after sale
- Expenses incurred for the distribution and delivery vans.
Expenses are allocated according to the time
- Expenses for administrative and office
- Salaries paid to staff for official and administrative services
- Taxes, rental expenses for office and other rates
- Depreciation for Fixed Stationery and printing
- Insurance expenses
- Audit fees (statutory/ internal audit or such other audits)
- Miscellaneous Expenses
- Distributional Expenses
- General expenses like travelling
- Interest paid on loans
- Interest paid on, say, debentures
- Other general Expenses
- Expenses which are fixed.
Pre-Incorporation Profits
Profit Before Incorporation
It is moved to the capital reserve account in this instance. It has a variety of purposes, including:
- The goodwill involved in the acquisition is written down
- Assets that are overvalued should be written down
- Initial costs which are incurred before incorporation should be subtracted
- There is an issue of bonus shares
- The payment of partially paid shares has begun.
Pre-Incorporation Loss
The price is factored into the price of buying a firm. It has a variety of purposes, including:
- The earnings after incorporation are offset
- When buying, goodwill is added.
- Gains on investments are written off.
Step 1:
To determine the gross profit, a trading account should first be established for the entire time, from the date of purchase to the date of final accounting.
Step 2:
Calculate the following two ratios:
(i) Sales Ratio:
Both before and after the company’s establishment, the amount of sales should be computed.
(ii) Time Ratio:
It is determined after considering the period, i.e., one must calculate the period between the date of purchase and the date of incorporation, as well as the time span between those dates and the date on which final accounts are presented.
Step 3:
According to the following logic, a statement should be created to independently calculate the net profit before and after incorporation:
(i)The allocation of gross profit for the two periods, pre-incorporation and post-incorporation, should be done based on the sales ratio, which will show the gross profit for the two distinct periods.
(ii) Fixed costs, or costs incurred over a certain period, such as rent, salary, depreciation, interest, etc., should be divided between the two periods according to the time ratio.
(iii) Changeable based on the sales ratio, costs or expenses related to sales should be distributed between the two periods.
(iv) Since they pertain to a certain period, some expenditures, such as partners’ salaries, directors’ salaries, preliminary expenses, interest on debentures, etc., are not allocated. For instance, partners’ salaries should be deducted from pre-acquisition profit, whereas directors’ compensation, debenture interest, and other expenses should be deducted from post-acquisition profit.
How do we treat a company’s pre-incorporation profits?
Because they are considered capital earnings, a firm’s pre-incorporation profits cannot be paid out as dividends to shareholders of the incorporated company. It can be used to deduct goodwill or capital losses. You can move the capital profit’s unused share to the capital reserve account.
Problems for Profits Prior-Incorporation
Problem 1:
With effect from 1 April 2021, ABC Ltd.’s promoters assumed control of the company’s operating operations. The corporation was established on August 1st, 2021. According to the annual records, which were completed through March 31, 2022, sales for the entire year were Rs. 1,600 lakhs, of which sales until July 31, 2021, were Rs. 400 lakhs. 25% was the gross profit ratio. The following costs were incurred from 1 April 2021 to 31 March 2022:
| SN# | Particulars | Amounts (in lakhs) |
| 1 | Rent, rates and insurance | 24 |
| 2 | Salary | 69 |
| 3 | Sundry office expenses | 66 |
| 4 | Discount provided | 12 |
| 5 | Travel Allowance | 16 |
| 6 | Director’s fee | 25 |
| 7 | Bad debts | 4 |
| 8 | Depreciation on tangible assets | 12 |
| 9 | Debenture interest | 11 |
| 10 | Tax Audit fee | 9 |
Create a statement detailing how profits were calculated for pre- and post-corporation periods.
Answer:
A statement that details how profits were determined during both the pre-and post-incorporation periods.
| Particulars | Total Amount (in lakhs) | Basis of Allocation | Pre-Incorporation (in lakhs) | Post-Incorporation (in lakhs) |
| Gross profit | 400 | Sales | 100 | 300 |
| (25% of Rs. 1600) | ||||
| Less: | ||||
| Salary | 69 | Time | 23 | 46 |
| Rent, insurance and rates | 24 | Time | 8 | 16 |
| Sundry office expenses | 66 | Time | 22 | 44 |
| Travel Allowance | 16 | Sales | 4 | 12 |
| Discount provided | 12 | Sales | 3 | 9 |
| Bad debts | 4 | Sales | 1 | 3 |
| Director’s fee | 25 | Post | – | 25 |
| Tax Audit fee | 9 | Sales | 2.25 | 6.75 |
| Depreciation, which is provided on tangible assets | 12 | Time | 4 | 8 |
| Debenture interest | 11 | Post | – | 11 |
| Net Profit | 152 | 32.75 | 119.25 |
Workings
- Sales ratio(` in lakh)
Sales for the whole year are Rs. 1,600
Sales up to 31st July 2021 Rs. 400
Therefore, sales for the period from 1st August 2021 to 31st March 2022 is Rs. 1,200 (1,600 – 400).
Thus, sale ratio = 400:1200 = 1:3
- Time ratio
1st April, 20X1 to 31st July, 2021: 1st August, 2021 to 31st March, 2022
= 4 months: 8 months = 1:2
Thus, the time ratio is 1:2.
