Profit Prior To Incorporation.docx

T.Y.B.Com:2016-17 Accounts Paper-I PROFIT PRIOR TO INCORPORATION 1.

WHAT IS PROFIT PRIOR TO INCORPORATION

Let us take an example to understand the term – profit before incorporation. Suppose, some businessmen decide to purchase an existing business of a firm on 1-1-2013 on the basis of its balance sheet on 31-122012. For this purpose, the businessmen promote a limited company which actually gets a certificate of incorporation on 1-10-2013. The firm carries on the business, in the meanwhile, on behalf of the promoters. From 1-10-2013, the same business is continued by the company in its own name. The company adopts the agreement between the promoters and the firm for purchasing the business. On the basis of this agreement, the profit of the business right from the date of agreement i.e. 1-1-2013 now belongs to the company. The profit of the business earned from 1-1-2013 to 30-9-2013 is known as “profit prior to incorporation”. The profit earned after incorporation i.e. from 1-10-2013 to 31-12-2013 is normal revenue profit earned by the company. The profit earned before incorporation is capital profit of the company. The date of incorporation is taken as the dividing point for ascertaining the period before incorporation and the period after incorporation. 2.

HOW TO ASCERTAIN & RECORD PRE-INCORPORATION PROFIT

The profit before incorporation can be ascertained in two ways: by preparing separate P & L account for the period upto incorporation; or by preparing a combined profit and loss account for the entire year and then dividing the total profit on some suitable basis between the two periods – before and after incorporation. 2.1

SEPARATE PROFIT AND LOSS ACCOUNT

In this method, the actual amount of profit upto incorporation is calculated by preparing a separate profit and loss account from the date of agreement to the date of incorporation [in our example, such P & L A/c will be from 1-1-2013 to 30-9-2013]. However, this method, being inconvenient, is not used normally. 2.2

COMBINED PROFIT AND LOSS ACCOUNT

In this method, first combined profit and loss account is prepared for the entire year and then the total profit is divided between the two periods on a logical basis. This method gives only an estimate of the profit before incorporation. The steps involved in this method are as follows (see worksheet 1). 2.2.1 Divided P & L A/c For ascertaining the profits of each period separately, the combined profit and loss account is divided into two parts: Part I – before incorporation and Part II – after incorporation [ see worksheet 2 below]. 2.2.2 Division of Profits Continuing the above example of a company incorporated on 1-10-2013 (which purchases a business from 1-1-2013), the P & L A/c for the year ending 31-12-2013 will be divided on the basis of the following factors. (see worksheet 3): 1.

Gross Profit a) Gross profit (or loss) is normally divided in the ratio of sales. b) This is based on the assumption that the Gross profit ratio has changed (due to change in sales price or cost per unit), gross profit should be divided accordingly. c) If the details regarding sales are not available, the gross profit is divided in the ratio of time.

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T.Y.B.Com:2016-17 Accounts Paper-I 2.

Specific income/expenses a) Expenses which only a company can incur are charged to the period after incorporation (e.g. Directors’ fees, Preliminary Expenses etc.) b) Expenses incurred by the vendors are charged to the period before incorporation (e.g. partners’ salary paid by the vendor firm). c) Items about which specific information is available, are divided accordingly. Thus, if as per details given, out of general expenses, Rs.10,000 related to the period before incorporation and Rs.5,000 to period after incorporation, Rs.10,000 will be shown in Part I and Rs.5,000 in Part II of

3.

the P & L Account. If some machinery is sold in June 2013, profit on such sale will be shown in Part I of the P & L Account. If there was a loss of cash by theft in December 2013, it will be shown in Part II of the P & L Account. Common Items: Common items i.e. items of income or expenses common to both the periods are divided either in the ratio of time or ratio of sales. a) Ratio of Time : The income arising on the basis of time (e.g. interest) or fixed expenses or administrative/establishment/management overheads (e.g. rent; salary; insurance; telephone; rates and taxes etc.) are divided in the ratio of number of months in each period i.e. in the ratio of 9 months: 3 months in our example and shown accordingly in Part I and Part II of the P & L Account.

EXIBIT 1 : ASCERTAINING RATIO OF TIME Ratio of Time

9:3

Acquisition of Business 1st January

Pre-incorporation 9 Months

Incorporatio n st 1 October

Post-incorporation 3 Months

Accounting Year Ending 31st December

Notes: 1) The Time Ratio, as calculated above, is used for dividing expenses which arise evenly within each period. 2) If the expenses arise unevenly within each period, the expenses will be divided differently, on the basis of the details available i.e. in Weighted Time Ratio. b) Ratio of Sales : Items linked with the volume or value of sales (e.g. variable expenses or selling and distribution overheads like freight outward; commission to salesmen; discount allowed; bad debts etc.) are divided in the ratio of sales or turnover of each period. In the above example, if sales are Rs.5,00,000 during January 2013 to September 2013 and Rs.3,00,000 during October 2013, variable expenses will be divided in the ratio of 5:3 and shown accordingly in Part I and Part II of the P and L Account. EXIBIT 2 : ASCERTAINING RATIO OF SALES. Ratio of Time 5:3

Acquisition of Business 1st January

Sales Before Incororation 5,00,000

Incorporatio n 1st October

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Sales After Invorporation 3,00,000

Accounting Year Ending 31st December

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T.Y.B.Com:2016-17 Accounts Paper-I Notes : 1)

The Sales Ratio, as calculated above, is used for dividing gross profits/expenses, if the sales arise evenly within period. 2) It the sales arise unevenly within each period, the gross profits/expenses will be divided differently, on the basis of the details, i.e. in the Weighted Sales Ratio. 2.3 ACCOUNTING TREATMENT 1) The profit prior to incorporation is the capital profit of the company. According to the Companies Act, a company cannot carry on any business and earn profits before its incorporation. Hence the profit before incorporation cannot be taken as normal profits “earned” by the company. The profit before incorporation is transferred to Capital Reserve A/c. The profit before incorporation or such capital reserve may be used to write off goodwill, shares issue expenses or write down the value of fixed assets acquired etc. 2) The loss before incorporation, if any, should be debited to Goodwill A/c. 3) The profits after incorporation are transferred to the Profit & Loss Appropriation Account. 3. WORKSHETS/RAPID REVISION WORKSHEET 1: STEPS FOR ASCERTAINING PRE-INCORPORATION PROFITS Step 1.

What is to be done? Divide a/c year in two periods.

2.

Divide Gross Profit between These two periods. Divide income between These two periods.

3.

4.

Divide expenses between These two periods

5.

Divide Net Profits [NP] Between these two periods

How it is to be done? a. Period upto incorporation. b. Period after incorporation. a. On basis of sales a. Specifically arising in a particular period (e.g. Share Transfer Fees) b. on basis of time(e.g. interest on Bank FD) a. Specifically arising in a particular period (e.g. preliminary expenses) b. on basis of time(e.g. fixed expenses) c. on basis of sales (e.g. variable expenses) a. NP upto incorporation(capital reserve) b. NP after incorporation (P & L A/c)

WORKSHEET 2 : COLUMNAR PROFIT AND LOSS ACCOUNT Expenses To Fixed Expenses/ Admn. Overheads To VariableExpenses/ Selling Overheads To Expenses before inc. To Expenses after inc. To Capital Reserve To Net Profit c/d

Basis

Pre

Post

Time

xxxx

xxxx

Sales Specific

xxxx xxxx

xxxx Nil

Specific

Nil xxxx Nil xxxx

xxxx Nil xxxx xxxx

Income By Gross Profit BY Rent Recd. Etc. By Income before inc. By Income after inc.

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Basis Sales Time Specific

Pre xxxx xxxx xxxx

Post xxxx xxxx Nil

Specific

Nil

xxxx

xxxx

xxxx

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T.Y.B.Com:2016-17 Accounts Paper-I WORKSHEET 3 : DIVISION OF INCOME / EXPENSES No.

PreIncorporation

Post-Incorporation

Ratio of Time

Ratio of Sales

1. 2. 3. 4. 5. 6. 7. 8.

Interest to vendor

Fees to directors Salary to directors Interest on Debentures Discount on debentures w/o. Preliminary Expenses w/o. Shares Issue Expenses w/o. Share Transfer Fees received Appropriations by company

Fixed Expenses Administrative Exp. - Rent - Insurance - Printing - Depreciation - Audit fees - Postage

Gross Profits Variable Expenses Selling Overheads - Salary to salesmen - Sales commission - Advertisement - Freight outward - Discount Allowed

Salary to vendor

Notes : 1)

2) 3)

Audit fees should be divided, in the opinion of the authors, in the Ratio of Time. (Some authorities charge audit fees to post-incorporation period, because audit is compulsory for a limited company. Further, fees for Tax Audit which is compulsory if the turnover exceeds prescribed limit, are divided in Sales Ratio.) Interest to vendors (interest on purchase consideration) from the due date of payment upto the date of incorporation should be charged to the pre-incorporation period. Income-tax is charge against profits. It is calculated as Profits x Rate of Tax (e.g. 30% of profits). Hence, income-tax, should be divided between pre and post incorporation periods in the ratios of respective profits.

Problem No. 1 Goodwill w/off Profit before making the following adjustment were as under: Pre-Incorporation Period Profit

Post-Incorporation Period

Rs.37,000

Rs.18,600

Adjustments to be made: 1) 2)

The purchase consideration was agreed at Rs.2,50,000 for assets valued at Rs.2,40,000, 20% of the goodwill is to be written off. In lieu of interest on purchase consideration, the vendor would get 40% of the profit earned prior to incorporation.

Find out profit prior to incorporation and after incorporation.

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T.Y.B.Com:2016-17 Accounts Paper-I Problem No. 2 Vasant Ltd. Was incorporated on 1st August, 2010 to take over the running business of M/s. Ankush Bros. a partnership firm, w.e.f. 1st April, 2010. The company received the certificate of commencement of business on 1st October, 2010. The following Profit and Loss A/c was prepared for the year ended 31 st march, 2011. Profit and Loss A/c for the year ended 31/03/2011 Expenses Rs. Income To Office & Administrative Expenses 71,400 By Gross Profit To Partner’s Salaries 16,100 By Share Transfer Fees To Selling & Distribution Expenses 24,800 To Director’s Fees 2,000 To Debenture Interest 3,200 To Interest on Partner’s Capital 3,600 To Bank Charges 900 To Preliminary Expenses 2,000 To Net Profit 38,000 1,62,000

Rs. 1,60,000 2,000

1,62,000

Additional Information: Sales arose evenly upto date of certificate of commencement of business. Thereafter they recorded an increase of two-third of the average monthly sales. Prepare Profit and Loss A/c for the year ended 31st March, 2011, in a columnar form showing the profit or loss during ‘Pre’ and ‘Post’ incorporation period separately.

Problem No. 3 Share in profit in lieu of interest Baneshwar Ltd. Was incorporated on 1st September 2009 to take over the business of Ekta & Gomati, a partnership firm with effect from 1st April, 2009. Following is their Profit and Loss Account for the year ended 31st March, 2010. Dr. Side To To To To To To To To To To To

Salaries Rent Bad Debts Office Expenses Directors Fees Debenture Interest Selling Expenses Salary to Partners Printing & Stationary Prelininary Expenses Net Profit

Rs. 39,000 8,000 11,000 2,400 1,000 2,800 24,300 5,000 6,000 1,500 91,000 1,92,000

Cr. Side By Gross Profit By Interest on Fixed Deposit

Rs. 1,80,000 12,000

1,92,000

Additional Information : 1) Average monthly turnover from October 2009 to March 2010 was twice the average monthly turnover from April, 2009 to September 2009. 2) Rent is doubled from 1st December 2009.

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T.Y.B.Com:2016-17 Accounts Paper-I 3) Bad Debts include Rs.2,000 in respect of sales effected two years ago, remaining Bad Debts are out of sales effected throughout the year. 4) Salaries include salary of three employees at equal monthly remuneration. However one of them was appointed as manager from 1st January 2010. His salary was doubled from that date. 5) In lieu of interest on purchase consideration the vendor would get 40% of the profit earned in Preincorporation period. 6) Interest on Fixed Deposit was received for the entire year. Prepare Profit and Loss Account of Baneshwar Ltd. For the year ended 31 st March, 2010 in the columnar form apportioning all the income and expenditure items between Pre-incorporation and Postincorporation period on suitable basis.

Problem No. 4 Following Trial Balance is extracted from the books of Invent Ltd. As on 31 st March 2009. The company was incorporated on 1st July, 2008 to take over the business of a proprietary concern with effect from 1st April, 2008. The authorized share capital of the company was 50,000 Equity shares of Rs.10 each. The purchase consideration Rs.1,25,000 was settled on 1st October, 2008 by issue of 10,000 equity shares of Rs.10 each at par and balance in the form of 12% Debentures of Rs.100 each issued at par. Trial Balance as on 31st March, 2009 Debit Balance Opening Stock Purchases Carriage Inward Salaries Office Expenses Commission on Sales Directors Fees Interest on Purchase Consideration Preliminary expenses (to be written off) Sundry Debtors Bills Receivable Investments

Rs. 23,600 1,75,800 5,200 24,000 63,600 14,100 3,200 6,250

Credit Balance Sales Sundry Creditors Bills Payable Equity Share Capital Profit on Sale of Investment 12% Debentures

7,500 54,000 4,750 18,000 4,00,000

Rs. 2,10,000 30,200 29,000 1,00,000 5,800 25,000

4,00,000

Additional Information : a) Stock as on 31st March, 2009 was Rs.15,200 and Stock as on 1-7-2008 was Rs.4,000. b) Purchases of Rs.1,75,800 included purchase of computer on 1st March, 2009 for Rs.1,00,000 on which depreciation is to be charged at 60% p.a. c) Total purchases for the post incorporation period (excluding purchase of computer) are three times that of pre incorporation period. d) Interest at 10% p.a. was paid on purchase consideration. e) Investments were sold on 1st May, 2008. f) Provide for outstanding interest on debentures. g) Gross Profit for pre incorporation period was Rs.30,150. h) Sales in the pre incorporation period were Rs.70,000. Prepare Trading and Profit and Loss Account of Invent Ltd. For the year ended 31 st March, 2009 in the columnar form apportioning various expenses and incomes between pre and post incorporation period on suitable basis.

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T.Y.B.Com:2016-17 Accounts Paper-I

Problem No. 5 ICL Ltd. Was incorporated to take over the running business of BC and CI Brothers with effect from 1st April, 2008. The Company was incorporated on 1st August, 2008. The following information was available from the books of accounts, which were closed on 31 st March, 2009.

Gross Profit Share Transfer Fees received Expenses: Office Salaries Partner’s Salaries Advertising Printing Stationery Travelling Expenses Office Rent Auditor’s Remuneration Director’s Fees Bad Debts Sales Commission Prelininary Expenses Debenture Interest Interest on Capital Depreciation

Rs. 7,00,000 10,000

Rs. 7,10,000 2,10,000 60,000 63,000 15,000 40,000 96,000 6,000 10,000 12,000 49,000 7,000 16,000 18,000 21,000

Additional Information : 1. Monthly sales were Rs.5,00,000 for pre-incorporation period, while total sales for the year were Rs.70,00,000. The sales were arose evenly throughout the concerned periods. 2. Office rent was Rs.84,000 p.a. upto 30th September, 2008. It became Rs.1,08,000 p.a. thereafter. 3. Travelling expenses included Rs.7,000 towards sales promotion. 4. Auditor’s Remuneration was payable for the whole year. 5. Bad debts written off included a debt of Rs.4,000 taken over from the vendor, while the remaining were in respect of goods sold in September, 2008. 6. Depreciation includes Rs.6,000 for asset acquired in the post incorporation period. Prepare Profit and Loss Account for the year ended 31st March, 2009 in the columnar form showing profit/loss for the pre and post incorporation period.

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