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Study Note - 7.3, Page 535-541

Study Note - 7.3, Page 535-541

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05/11/2013

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535
Financial Accounting
7.3.
 
Profit Prior to Incorporation
Sometimes a company purchases a running business from a date prior to its incorporation. Ithe company has earned any profit from the date of purchase to the date of incorporation suchprofit is called as profit prior to incorporation.As for example
 ,
a company incorporated on 1st April, 2004 may purchase a business from 1stJanuary, 2004, the date on which the accounting year of the vendor starts. Generally the businessis purchased from vendor on the last date of the balance sheet so that assets and liabilities aretaken over on the basis of the figures given in the Balance Sheet.Such profit cannot be said to have been earned by the company as it is not available fordistribution as dividend to the shareholders. Such profit is treated as capital profit and istransferred to Capital Reserve Account.If there is any loss prior to incorporation such loss is in the nature of capital loss and is debitedto Goodwill Account. It should be noted that, the date of incorporation and not the date of commencement of should be taken into consideration for calculating profit or loss prior toincorporation.
Ascertainment of Profit or Loss Prior to Incorporation
Profit or loss prior to incorporation can be ascertained only when fresh stocktaking and balancingof accounts is done on this date. But it will involve a great deal of inconvenience. In order toavoid this inconvenience, the following steps may be taken:(1)Prepare the trading account for the whole period
i.e.,
from the date of purchase of businessto the last date
o
accounts closing in order to calculate the gross profit. Date of incorporationwill not affect the calculation of gross profit:(2)Calculate time ratio and sales ratio.
Time ratio
is calculated by taking into considerationthe time falling from the last date of balance sheet to the date of incorporation and theperiod between the date of incorporation to .the last date of presenting [mal accounts. Forexample, if the business is purchased on 1st April 2006 and certificate of incorporation isgranted on 1st July 2006 and final accounts are being prepared on 31st March 2007, thenthe time ratio is 3 months : 9 months or 1:3. S
ales ratio
is calculated taking into considerationthe sales of pre-incorporation period to that of sales of post-incorporation period. Forexample, if sales of pre-incorporation period are Rs. 5,00,000 and that of post-incorporationRs. 20,00,000, then the sales ratio is 1 : 4.(3)Prepare the profit and loss account for the pre-incorporation and post Incorporation periodsseparately.This is done on the following basis:a.Gross profit should be apportioned between the two periods on the basis of their respectivesales ratio.
 
Financial Accounting
536
JOINT STOCK COMPANIES
b.Such expenses which are directly related on sales such as commission on sales, discountallowed, bad debts, advertising, etc. should be apportioned on the basis of sales ratio of the two periods.c.Fixed expenses such as salaries, rent, audit fees, insurance, depreciation, etc. should beallocated on the basis of time ratio as these expenses are incurred on the basis of time.d.Expenses which are incurred after the incorporation of the company such as directors’fees, preliminary expenses, interest on debentures etc. should be charged wholly to theperiod after incorporation. Similarly expenses viz. salary of partners is debited to the Pre-incorporation period.
Illustration
BK Ltd. was incorporated on 1st August, 2006 and received its certificate of commencement of business on 1st Dec, 2005. The company bought the business of M/S BK & Co. with effect from1st April, 2006. From the following figures relating to the year ending March 31, 2007, find outthe profits available for dividends:
(a)
Sales for the year were Rs. 6,00,000 out of which sales up to 1st August were Rs.
2,50,000.(b)
Gross Profit for the year was Rs. 1,80,000.
(c)
The expenses debited to the Profit and Loss Account were:
Solution
Workings:-1>Time Ratio:Pre incorporation period4 MonthsPost incorporation period8 MonthsRs RsRent 9000 Advertising 18000Salaries 15000 Stationery and Printing 3600Directors' fees 4800 Commission on sales 6000Interest on debentures 5000 Bad debts(500 relate todebts created prior toincorporation1500Audit fees 1500 Interest to vendor onpurchase consideration (upincorporation date Rs2000)3000Discount on sales 3600Depreciation 24000General expenses 4800
 
537
Financial Accounting
PROFIT AND LOSS ACCOUNT For the year ending March 31 2007So the ratio is 1:22> Sales Ratio.Sales up to incorporation periodRs 2,50,000Sales in post incorporation periodRs 3,50,000So the ratio is 5:7** Related to Post incorporation period only.Basis Prior to After Basis Prior to Afterof alto- Incor- Incor- of allo- Incor- Incor-cation poration poration cation poration porationRs. Rs. Rs. Rs.To Rent Time 3,000 6,000 By GrossProfit Sales 75,000 1,05,000-Salaries Time 5,000 10,000- Directors' **fees 4,800-Interest on **debentures 5,000-Audit fees Time 500 1,000-Discounton sales Sales 1,500 2,100-Depreciation Time 8,000 16,000-Generalexpenses Time 1,600 3,200-Advertising Sales 7,500 10,500-Stationery& Printing Time 1,200 2,400-Commissi-on sales Sales 2,500 3,500-Bad Debts Actual 500 1,000-Interest to Actual 2,000 1,000Vendor-CapitalProfit 41,700 --Net Profit 38,50075,000 1,05,000 75,000 1,05,000

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