In the case of a new company, it is possible that the company may be taken over by a running business from a certain date, while the company may be incorporated later. In the absence of an agreement with the vendors, the company would be entitled to all profits earned after the date the business was purchased.
It should be noted that profits made before the company became incorporated must be treated as capital profits, since they have been earned even before the company was incorporated. Such profits are referred to as profits prior to incorporation. Public companies cannot commence business until they receive a certificate of commencement.
So, all profits earned before the start of the business should be treated as capital profits. It is important to note that the term profit prior to incorporation format only refers to profits earned before incorporation, not profits earned until the certificate of incorporation has been issued.
In order to allocate profits correctly, a profit and loss account should be prepared on incorporation, but this would require taking stock. The usual practice is to prepare the profit and loss account at year-end. Profits will be allocated between the prior and post-incorporation periods.
Allocations Are Made as Follows:
- It is important to allocate gross profit in accordance with the ratio of sales for the two periods.
- There should be a ratio in the allocation of expenses connected with sales, such as discounts, bad debts, commissions to salesmen, advertising, etc.
- A ratio between the time before and after incorporation should be used to allocate expenses that are incurred on a time basis (such as salaries, rent, interest, etc.).
- The post-incorporation period is the only time during which expenses incurred for the company (e.g., preliminary expenses, interest on debentures, directors’ fees) should be charged.
- The profit prior to incorporation is calculated by subtracting the gross profit from the pre-incorporation expenses.
- As with other capital profits, Profit Prior to Incorporation will appear on the balance sheet along with other capital profits. The remaining profits will be treated as revenue profits and can be distributed to shareholders.
Here is an illustration:
The company was incorporated on the 1st of August, 2011, and received its certificate of commencement of business on the 1st of September, 2011. On the 1st of April, 2011, it acquired Active and Slow with effect from the first day of August.
Using the following figures, determine the profits that are available for dividends for the year ending 31st March 2012:
- Sales for the year totaled Rs 60 crore, of which 25 crore were sold up to 1st August and 30 crores up to 1st September.
- A gross profit of Rs 18 crore was recorded for the year.
- (c) Expenses deducted from profit and loss were as follows:
- It is estimated that sales will be 25 crores: 35 crores, or 5:7. Time will be four months (up to 1st August) to eight months, or 1:2, except for interest payments to vendors. Interest has been paid for 6 months (up until 1st August), of which four months are credited to the period prior to incorporation. Bad debts have been allocated in accordance with the indication given.