When a company takes over a running business or incorporates itself after starting a business, in this situation the amount of profit or loss of such a business, for the period prior to the incorporation is known as the pre-incorporation profits or losses of the company. The company comes into existence after getting a certificate of incorporation from the Registrar of Companies (ROC). Any profit earned by the business acquired or conducted by the company before obtaining a certificate of incorporation is pre-incorporation profit. Just like profit, any losses incurred in this period are known as pre-incorporation losses. Treatment of pre-incorporation profits or losses is different from post-incorporation profits or losses. In this article, we are going to understand the treatment of pre-incorporation profits or losses of the company.
Treatment of Profits of Pre-incorporation Period
Pre-incorporation profits of the company are of a capital nature. It is necessary to disclose them separately from trading profits or Profit and Loss A/c. Generally, any pre-incorporation profit earned by the company is credited to the capital reserve account. This profit in the capital reserve account can be used for:
- Writing down (reducing) the value of over-valued assets.
- Writing off Goodwill on acquisition.
- Writing of preliminary expenses.
- Paying up partly paid shares.
- Issuing of bonus shares.
Treatment of Losses of Pre-incorporation Period
Any pre-incorporation losses of the company are either to be written off by debit to the profit and loss account or may be debited to the Goodwill Account. In most cases, pre-incorporation losses are charged to the Goodwill Account. Therefore, it is treated as a part of the business acquisition cost (Goodwill). This cost can be settled for:
- Setting off against post-incorporation profits.
- Addition to goodwill on acquisition.
- Writing off the capital profit.
Computation of Profits or Losses Prior To Incorporation
Computation of profits or losses would be a very simple task if it was possible to close off old books before incorporation and subsequently open new books after incorporation. In this case, the trial balance will be abstracted from the books, and profit or loss will be computed. Thereafter, the books will be either closed off or the balance allowed continuing undisturbed. Although it is the simplest method, it is not always appropriate to close off old books and open new books with the asset and liabilities.
The best and most appropriate way to compute profits and losses is by splitting up the profits and losses of the whole year between the ‘pre’ and ‘post’ incorporation periods. This apportionment can be done either on a time basis or on a turnover basis or by any other method or ratio which combines time and turnover. We will understand this concept by examples at the end of the article.
Time Basis for Apportionment of Incomes and Expenses
In this method of apportionment, we calculate the time period ratio for the pre and post-incorporation periods. This ratio is used for splitting up some items of expenses and incomes in the time ratio. Let’s try to calculate the time ratio in the following example.
Example
XYZ Ltd is a company that was incorporated on 01/06/2022, XYZ ltd took over the business of ABC partnership firm from the effect of 01/04/2022. The account of the business continued for the year ended 31/03/2023. Calculate the time basis on which appropriate expenses will be split between the pre and post-incorporation periods.
Solution
Pre-incorporation period (01/04/2022 to 01/06/2022) = 2 months.
Post-incorporation period (01/06/2022 to 31/03/2023) = 10 months.
Time ratio = 2 months: 10 months = 1:5
Sales Basis for Apportionment of Incomes and Expenses
Some expenses and Incomes are split between the pre and post-incorporation period items on the basis of sales/Turnover. Let’s try to calculate the sales ratio in the following example.
Example
PYQ Ltd was incorporated on 01/08/2022. PYQ Ltd took over the existing business of M/s ABC with effect from 01/04/2022. The accounts of the company were closed on 32/03/2023. The average monthly sales during the first four months of the year 2022-23 was twice the average monthly sales during the remaining 8 months. Calculate the sales ratio for the pre and post-incorporation periods.
Solution
Let the ‘X’ be the average monthly sales during the post-incorporation period. Therefore, the sales in the pre-incorporation period will be 2X
Weighted sales ratio = 4 * 2X : 8 * X = 8X : 8X = 1:1
Some Items and Their Basis of Apportionment
| Items | Basis of Apportionment Between the Pre and Post-incorporation Period |
| Salaries, Rent, Rates, Insurance, Sundry office expenses, Depreciation, Interest, etc. | Time Ratio |
| Traveler’s commission, Discount allowed, Bad debts, Tax audit fees, sales, cost of goods sold, Advertisement and selling expenses, variable expenses, etc. | Sales Ratio |
| Director’s fee, Debentures interest, MD’s remuneration, preliminary expenses, provisions for taxes, Underwriting commission, etc | Post-incorporation expenses |
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