Practice Questions: Profit Prior to Incorporation
Chapter Thirty-Six
Syllabus topic Module III entire
Pages 107 to 110 of 168
How to use this chapter
Do three things before writing a line. Count the months and write the time ratio. Compute the sales ratio and write it beside. Then read every expense once and mark it T, S, Post or Pre in the margin. The statement then writes itself.
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Question 1 (15 marks)
Sharada Ltd was incorporated on 1 September 2026 to take over the business of a partnership firm with effect from 1 April 2026. The accounts for the year ended 31 March 2027 showed a gross profit of Rs 2,88,000 and the following expenses:
| Rs | |
|---|---|
| Salaries | 60,000 |
| Rent, rates and taxes | 36,000 |
| Insurance | 12,000 |
| Depreciation | 24,000 |
| Advertising | 32,000 |
| Carriage outward | 16,000 |
| Bad debts | 8,000 |
| Directors' fees | 24,000 |
| Preliminary expenses written off | 6,000 |
| Partners' salaries | 15,000 |
| Total | 2,33,000 |
Sales for the year were Rs 9,60,000, of which Rs 2,40,000 arose in the five months to 31 August 2026. Goodwill of Rs 50,000 arose on the purchase.
Compute the profit or loss prior to and after incorporation, and state how each is to be treated.
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Question 2 (8 + 7 marks)
(a) Explain why the profit of the period prior to incorporation is treated as capital, and set out the ways in which a pre-incorporation profit and a pre-incorporation loss may respectively be dealt with. (8)
(b) A company was incorporated on 1 August and took over a business from 1 April, paying the vendor interest at 12 per cent per annum on the consideration of Rs 5,00,000 from the date of acquisition until it was discharged on 30 November. Compute the interest and apportion it, explaining why the general time ratio does not apply. (7)
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Question 3 (15 marks)
(a) State the basis of apportionment of each of the following, with a reason: (10)
- Gross profit
- Rent, rates and taxes
- Directors' fees
- Commission on sales
- Depreciation on a machine bought two months after incorporation
- Partners' salaries
- Bad debts
- Preliminary expenses written off
- Audit fee described as the statutory audit fee of the company
- Insurance
(b) Answer in one sentence each: (5)
- Which period does the month of incorporation fall in?
- What do you do where the question says nothing about the incidence of sales?
- Where is a pre-incorporation loss usually debited?
- May a pre-incorporation loss be set against the post-incorporation profit?
- What check proves the whole columnar statement?
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Answers
Answer 1
Working note one: the time ratio.
| From | To | Months | |
|---|---|---|---|
| Pre-incorporation | 1 April 2026 | 31 August 2026 | 5 |
| Post-incorporation | 1 September 2026 | 31 March 2027 | 7 |
| Total | 12 |
Time ratio 5:7.
Working note two: the sales ratio.
| Rs | |
|---|---|
| Sales, pre-incorporation | 2,40,000 |
| Sales, post-incorporation | 7,20,000 |
| Total | 9,60,000 |
Sales ratio 1:3.
The statement.
| Particulars | Total, Rs | Basis | Pre, Rs | Post, Rs |
|---|---|---|---|---|
| Gross profit | 2,88,000 | Sales 1:3 | 72,000 | 2,16,000 |
| Less: expenses on time | ||||
| Salaries | 60,000 | Time 5:7 | 25,000 | 35,000 |
| Rent, rates and taxes | 36,000 | Time 5:7 | 15,000 | 21,000 |
| Insurance | 12,000 | Time 5:7 | 5,000 | 7,000 |
| Depreciation | 24,000 | Time 5:7 | 10,000 | 14,000 |
| Less: expenses on sales | ||||
| Advertising | 32,000 | Sales 1:3 | 8,000 | 24,000 |
| Carriage outward | 16,000 | Sales 1:3 | 4,000 | 12,000 |
| Bad debts | 8,000 | Sales 1:3 | 2,000 | 6,000 |
| Less: wholly one period | ||||
| Directors' fees | 24,000 | Post | nil | 24,000 |
| Preliminary expenses written off | 6,000 | Post | nil | 6,000 |
| Partners' salaries | 15,000 | Pre | 15,000 | nil |
| Total expenses | 2,33,000 | 84,000 | 1,49,000 |
Practice Questions: Profit Prior to Incorporation
| Total, Rs | Pre, Rs | Post, Rs | |
|---|---|---|---|
| Gross profit | 2,88,000 | 72,000 | 2,16,000 |
| Less: total expenses | 2,33,000 | 84,000 | 1,49,000 |
| Result | 55,000 | (12,000) | 67,000 |
So there is a LOSS of Rs 12,000 prior to incorporation and a PROFIT of Rs 67,000 after it, together being the year's profit of Rs 55,000.
Partners' salaries are the item to notice. They belong wholly to the pre-incorporation period, because the partnership arrangement ended when the business was sold, and charging Rs 15,000 to a five-month period carrying only Rs 72,000 of gross profit is what turns the result negative.
The treatment.
| Rs | |
|---|---|
| Goodwill as raised on the purchase | 50,000 |
| Add: loss prior to incorporation | 12,000 |
| Goodwill carried forward | 62,000 |
Goodwill A/c Dr 12,000; To Loss prior to incorporation A/c 12,000.
And the reason, which carries the mark: the loss is capital, being incurred in a period before the company existed, and it is treated as part of the cost of acquiring the business, so it is added to goodwill rather than charged against the profit available for dividend.
The profit after incorporation of Rs 67,000 is an ordinary trading profit, taken to the statement of profit and loss and available for distribution.
Answer 2
(a) A company cannot earn a profit before it exists: until incorporation it had no legal personality, could hold no property and could carry on no business. It receives the earlier period's profit only because the purchase agreement made the takeover effective from a date before its incorporation, so that profit is part of what it acquired on purchase, and what is acquired on purchase is capital. The practical consequence is that it cannot be distributed as dividend, since paying it out would return part of the purchase price to the shareholders as though it were income.
A pre-incorporation profit may be transferred to capital reserve, which is what to do where the question is silent; or written off against goodwill; or written off against preliminary expenses. All three are capital treatments and none increases the distributable profit.
A pre-incorporation loss, being equally capital, is usually debited to goodwill as part of the cost of acquiring the business; or debited to an existing capital reserve; or carried separately under reserves and surplus as a loss prior to incorporation and written off as directed. In no case is it set against the post-incorporation profit, which would let a capital loss shelter distributable profit.
Practice Questions: Profit Prior to Incorporation
(b)
| Rs | |
|---|---|
| Rs 5,00,000 at 12 per cent for a full year | 60,000 |
| For eight months, 1 April to 30 November | 40,000 |
| Months | Rs | |
|---|---|---|
| 1 April to 31 July, pre-incorporation | 4 | 20,000 |
| 1 August to 30 November, post-incorporation | 4 | 20,000 |
| Total | 8 | 40,000 |
Why the general time ratio does not apply. The time ratio for the year is 1:2, being four months before incorporation and eight after. But this interest did not run for the whole year. It ran for eight months only, from acquisition to discharge, and those eight months divide evenly at incorporation. An expense is apportioned over the months it actually covers, and applying the year's ratio would have given Rs 13,333 to the pre-incorporation period instead of Rs 20,000, an error of Rs 6,667 that would leave the statement still balancing.
Answer 3
(a) The bases
| Item | Basis | Reason | |
|---|---|---|---|
| 1 | Gross profit | Sales | It is a margin on sales and moves exactly with them |
| 2 | Rent, rates and taxes | Time | Payable for the passage of time whatever the trade |
| 3 | Directors' fees | Post | A company must exist before it can have a board |
| 4 | Commission on sales | Sales | Computed as a percentage of sales |
| 5 | Depreciation on a machine bought two months after incorporation | Post | The asset was not held before, so no part of the charge relates to the earlier period |
| 6 | Partners' salaries | Pre | The partnership arrangement ended when the business was sold |
| 7 | Bad debts | Sales | They arise out of credit sales |
| 8 | Preliminary expenses written off | Post | They are the cost of forming the company and cannot precede it |
| 9 | Statutory audit fee | Post | The statutory audit is an obligation of a company under the Companies Act |
| 10 | Insurance | Time | A premium for a period, accruing evenly |
Item five is the one to read carefully. Depreciation is ordinarily apportioned on time, but where the asset itself was acquired after incorporation the whole charge is post-incorporation.
(b) Answers in one sentence
1. The post-incorporation period, since the company existed on that date.
2. Take sales as uniform, so the sales ratio equals the time ratio, and say in the answer that you are doing so and why.
3. To goodwill, as part of the cost of acquiring the business.
4. No, because it is a capital loss and netting it would let it shelter profit available for dividend.
Practice Questions: Profit Prior to Incorporation
5. That the pre-incorporation result and the post-incorporation result add back to the profit or loss of the whole year.
Marking yourself
| If your answer | Then |
|---|---|
| Apportioned partners' salaries | They are wholly pre-incorporation, and they are what makes the result a loss |
| Showed a pre-incorporation profit in Question 1 | Check the partners' salaries and the sales ratio on the gross profit |
| Set the Rs 12,000 loss against the Rs 67,000 profit | A capital loss never reduces distributable profit |
| Split the vendor's interest 1:2 | It is apportioned over its own eight months, which divide 4:4 |
| Put the gross profit on time | It is a margin on sales; this is the costliest error in the module |
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.