Accounting And Finance

Profit Prior to Incorporation: Meaning & Accounting Treatment

A company’s journey starts with its incorporation, which is a formal and legal process of providing the company an individual legal appearance. However, some financial transactions and gains may exist even prior to the registration of the company. These profits, often referred to as “profits prior to incorporation,” have distinctive features and require special accounting treatments.

In this blog, we shall try to explore what profits prior to incorporation are, what their nature is, and what accounting process needs to be followed for allocation and proper treatment.

Understanding Profits Before Incorporation

Before entering into the accounting details, let’s understand what profits prior to incorporation mean. A company comes into legal existence only after receiving a company registration certificate from the ROC. Until this formality, any business conducted in the name of the prospective company is technically carried out by its promoters or founders.

Although the company is not yet a legal entity, some business activities may be conducted during this “pre-incorporation period,” such as selling goods, obtaining orders, or making preliminary contracts. Any profits made in this period are considered pre-incorporation profits.

Key Features of Pre-Incorporation Profits

• Capital in Nature:

Pre-incorporation profits are regarded as capital profits, not revenue profits. The company, during this period, legally does not exist and therefore cannot earn operational revenue.

• Not Distributable as Dividend:

These profits are not distributable as dividends to the shareholders but form part of the capital reserves of the company.

• Allocation for Specific Uses:

Pre-incorporation profits often are used to offset capital losses, write down goodwill, or fund other non-operational expenses.

Accounting for the Pre-Incorporation Period

The accounting of income earned or losses incurred during the pre-incorporation period is a very cumbersome process. It essentially involves distinguishing between the pre and post-incorporation periods with respect to financial transactions. This is how the process proceeds:

1. Separation of Periods:

The financial year of the company is divided into two different periods:

• Pre-Incorporation Period: The time from the commencement of the business transaction until the date of incorporation.
• Post-Incorporation Period: The period starting from the date of incorporation till the end of the financial year.

2. The Challenges of Segregation

It is difficult to segregate the profits and losses of these two periods. The closing of books of accounts and taking stock for both the periods separately is impractical and involves more complexity. Instead, an estimate of the figures is made by using reasonable apportionment methods.

3. Methods of Apportionment:

The allocation of income and expenses between the pre and post-incorporation periods is based on logical and equitable methods, such as:

• Time Ratio: Fixed expenses that build up with time consistently, such as rent and salaries.
• Sales Ratio: Applied to the variable expenses connected with the turnover such as commission, advertisement, and carriage outwards.

Steps to Determine Pre-Incorporation Profits

The following are steps for computation of pre-incorporation profits:

STEP 1. Opening a trading account:

The first step is the preparation of a trading account for the entire accounting period, that is, both the pre and post-incorporation periods combined. It represents all sales, purchases, and other trading transactions to determine the gross profit.

STEP 2. Calculate Time and Sales Ratios:

• Time Ratio: This refers to the number of months or days in the pre-incorporation period related to the post incorporation period.
• Sales Ratio: Determine the ratio of pre-incorporation period sales to the post-incorporation period.

STEP 3. Allocate Profits and Expenses:

Based on the calculated ratios, attribute the gross profits, fixed expenses, and variable expenses as follows:

• Gross Profit: Appropriated on the basis of the sales ratio.
• Fixed Expenses: The time ratio is utilized for apportionment.
• Variable Expenses: Apportioned based on the sales ratio.

Classification of Expenses for Allocation

1. Pre-Incorporation Period Expenses:

Certain expenses are directly related to the pre-incorporation period, including:

• Interest in purchase consideration
• Salaries or remuneration paid to the promoters
• Interest on vendor capital

2. Post-Incorporation Period Expenses:

Expenses that purely arise in the post-incorporation period include:

• Directors’ fees
• Managing directors’ salaries
• Interest on debenture
• Issue of shares or debentures at a discount

3. Common Expenses:

Expenses, such as rent, telephone charges, and audit fees, are apportioned on either the time ratio or sales ratio, whichever is applicable by the nature of the expense.

Treatment of Pre-Incorporation Profits

1. Transferred to Capital Reserve:

The pre-incorporation profits are not considered as a part of the revenue profits of the company. They are transferred to the capital reserve account, which strengthens the capital base of the company.

2. Writing Off Losses:

In case the company incurs losses prior to the date of incorporation, such losses must be treated as capital losses that the company can write off against its own goodwill or adjusted in books through the capital reserve account.

3. Restricted Utilization:

It holds pre-incorporation profit, although there are quite limited in its usages for such a capital reserve. This capital reserve is not available for routine operational uses, although in certain instances, it might support some restructuring of capital and may cover prior period debt.

Significance of Accounting for Pre-Incorporation Profits

1. Legal Compliance:

Segregation done accurately ensures compliance with legal and financial reporting requirements.

2. Fair Treatment of Shareholders:

Proper allocation prevents the benefit of a pre-incorporation activity, in case the shareholders would receive unfair benefits from such transactions that were technically outside the scope of operation of the company.

3. Clarity in Financial Reporting:

The differentiation between capital and revenue profits provides greater transparency and helps all stakeholders understand the financial state of the company. Revenue recognition is crucial for accurate financial reporting.

To Wrap Up

Profits prior to incorporation represent a peculiar position in corporate accounting, representing a transition phase between the conceptualization and formal establishment of a company. Though not being payable as dividends, they are added to the company’s capital reserves and form a vital part of financial structuring.

The principles and processes of accounting treatment of pre-incorporation profits create an understanding that businesses have to be compliant, transparent, and equitable in their financial practices. This specialized approach protects the integrity of the company’s financial records while laying a solid foundation for its future growth. To get expert assistance in accounting treatment and revenue recognition, visit https://enterslice.com/.

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