Things to Know About Profit Prior to Incorporation

Profit Prior to Incorporation refers to earnings before a company's official existence. It involves meticulous allocation, and legal considerations, and offers advantages in funding initial expenses for a new business.

Overview

The formation of a company occurs after incorporation. Prior to the registration of an organization, the founders should prepare several preliminary documents. After an application has been filed with the Registrar of Companies (ROC), a registration certificate is issued. The company is considered to have been formed upon the company registration certificate issuance. After a company is incorporated, it can earn profits. The founders of a company may have made a profit prior to incorporation, that is, before receiving the certificate of incorporation. Those profits generated before the company is incorporated are referred to as pre-incorporation profits.

Since these profits earned before the company was formed should be treated as capital profits. Profits earned after an acquisition of a business or a business acquired are referred to as post-incorporation profit or post-acquisition profit. Profit prior to incorporation is referred to as pre-incorporation profit. On the assets side of the balance sheet, “Loss prior to incorporation” is shown under the heading “Miscellaneous Expenditures”. 

Pre-Incorporation Period Profits of a Company

Before a company is officially incorporated, there exists a pre-incorporation period during which the founders may engage in business activities. Profits made during this period are termed pre-incorporation profits. It’s important to note that these profits are considered capital profits and cannot be legally distributed as dividends, as a company technically doesn’t exist during this time.

Allocation of Profit in the Pre-Incorporation Period

To handle pre-incorporation profits, a separate profit and loss account is prepared for both the pre and post-incorporation periods. This involves apportioning profits based on reasonable criteria like turnover or time. The profits from the pre-incorporation period are transferred to the capital reserve account, while any losses are treated as capital losses and transferred to the goodwill account.

Steps to Determine Pre-Incorporation Profits of a Company

To calculate pre-incorporation profits, various steps are involved. First, a trading account is prepared for the entire accounting period. Then, time and sales ratios are calculated. The net profit statement is prepared separately for the pre and post-incorporation periods, taking into account the allocation of gross and fixed expenses based on sales and time ratios.

Treatment of Pre-Incorporation Profits of a Company

Pre-incorporation profits can be advantageous for a new business, providing funds for initial expenses without resorting to debt or equity. However, improper incorporation can lead to legal and tax complications. Working with professionals during the incorporation process is crucial to ensure correct handling of pre-incorporation profits.

Advantages of Pre-Incorporation Profit

One key advantage of pre-incorporation profit is its potential to facilitate a smooth start for a new business. If earned through sales or investments, these profits can cover initial expenses such as rent and equipment, reducing the need for external funding. However, caution is necessary to address legal and taxation considerations, emphasising the importance of professional guidance during the incorporation process.

Before Incorporation, an Assessment of Profit or Loss is Made

Profit or loss is calculated before incorporation according to these steps:

1. Compile a Trading Account for the Entire Period

 To calculate the gross profit for the entire period, we must first create a trading account. Since we can divide the gross profit of a year based on time after calculating the gross profit of a year, we will not create separate trading accounts before and after incorporation.

2.  Determination of the Time Ratio and the Sale Ratio

It is critical to note that the sales and time ratios are two very relevant ratios that can be used to allocate gross profit and other items of the profit and loss account before and after incorporation. The time ratio would be 4 months: 8 months or 1:2 if the company was incorporated after 4 months from the first of January 2010.

 In the case of a sale of ₹100,000 prior to incorporation and ₹3,00,000 after incorporation, the sale ratio is 1:3.

3. Prepare a Net Profit Statement Separately for Pre- And Post-incorporation Periods

• A separate allocation of gross profits should be made based on the sales ratio for the pre-and post-incorporation period
• A timely allocation of fixed expenses, such as rent, copying, office supplies, mailings, phone calls, amortization, etc., must be done across both periods
• You’ll need to allocate variable expenses between the two periods, like marketing, transportation, insurance, fees, bad debts, etc
• Pre-incorporation expenses include interest on the purchase price, partner salary, and vendor financing 
• Post-incorporation expenses, like board fees, the salary of the managing director, interest on debentures, issue discount, issuance discount, etc., must be taken out
• The duration ratio allows auditing fees to be allocated before and after incorporation. 

List of Expenses That Have Been Allocated According to Sales/Turnover

•   The gross profit 
•   The selling expenses 
•   The advertisement 
•   Carriage in an outward direction 
•   Rent for the godown 
•   Discounts are permitted 
•   Salaries of salespeople 
•   Commissions to salespeople 
•   Promotional expenses for sales 
•   Expenses related to distributions (variable portions) 
•   Provision of free samples 
•   Expenses incurred for After-Sale Service
•   Expenses for delivery vans.

Expense Allocation According to Time

•   Office and administrative expenses 
•   Salaries paid to office staff 
•   Rates, taxes, and rent 
•   Fixed asset depreciation 
•   Stationery and printing 
•   The insurance industry 
•   Fees for audits 
•   Miscellaneous Expenses 
•   Distributional Expenses (Fixed Portion) 
•   General Travel Expenses 
•   Interest on debentures 
•   General Expenses 
• Expenses that are fixed in nature. 

Pre-Incorporation Profit & Loses

Pre-Incorporation Profit

In this case, it is transferred to the capital reserve account. There are several uses for it:

• During the acquisition process, goodwill is written off
• Preliminary expenses should be deducted
• Overvalued assets should be written down
• Bonus shares are issued
• Partially paid shares are being paid up.

Pre-Incorporation Loss

The cost is included in the cost of acquisition of a business. There are several uses for it:

• Offsetting the profit after incorporation
• On acquisition, goodwill is added
• Capital gains are written off.

For instance

Subhash Ltd. was incorporated on the 1st of March, 2010 and received its certificate of commencement of business on the 1st of April, 2010. With effect from 1st November 2009, the company acquired the business of M/S Small and Co. Calculate the dividends available from the following figures for the year ending 31st October 2010.

1. Sales for the year were ₹6,00,000, of which ₹2,50,000 were sales up to 1st March
2. A gross profit of ₹1,80,000 was realised for the year
3. The expenses deducted from the profit and loss account were:

•  Rent of ₹9000
•  Salaries of ₹15000
•  Directors’ fees of ₹4800
•  Debenture interest of ₹5000
•  Discount on sales of ₹3600
•  Depreciation of ₹24000
•  General expenses amount to ₹48000
•  An advertising budget of ₹18000
•  Stationery expenses amount to ₹3600
•  Commissions on sales of ₹6000
•  There are ₹500 bad debts arising from debts incurred before incorporation
•  Up to the 1st of May 2010, the vendor will receive interest on the purchase price.

Working Notes

1.    A) There is a sales ratio of ₹250000 to ₹350000 (5:7)
2.   B) Other than interest to the vendor, 4 months to 8 months or 1:2
3.   C) 4-to-2 interest-to-vendor time ratio
4.   D) Debenture interest and director fees relating to the post-incorporation period.

Frequently Asked Questions

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