GROUP - I PAPER - 1 ACCOUNTING V1 CHAPTER 3

3 PROFIT OR LOSS PRIOR TO INCORPORATION Learning Objectives After studying this chapter, you will be able to: ♦ Account for pre-incorporation profit. ♦ Learn various methods for computing profit or loss prior to incorporation. ♦ Understand the concept of Vendor’s debtors and creditors and the treatment thereof 1. Introduction When a running business is taken over by the promoters of a company, from a date before the company which is to manage and own is registered, the amount of profit or loss of such a business for the period prior to the date the company came into existence is referred to as pre-incorporation profits or losses. Such profits or losses, though belonging to the company or payable by it, are of capital nature; it is necessary to disclose them separately from trading profits or losses. The general practice in this regard is that: i. If there is a loss, a) it is either written off by debit to the Profit and Loss Account or to a special account described as “Loss Prior to Incorporation” and show as an “asset” in the Balance Sheet: , b) in the alternative, it is debited to the Goodwill Account. ii. On the other hand, if a profit has been earned by business prior to the same being taken over and the same is not fully absorbed by any interest payable for the period, it is credited to Capital Reserve Account or to the Goodwill Account, if any goodwill has been adjusted as an asset. The profit will not be available for distribution as a dividend among the members of the company. © The Institute of Chartered Accountants of India Profit or Loss Prior to Incorporation 2. Methods of Computing Profit or Loss Prior to Incorporation The determination of such profit or loss would be a simple matter if it is possible to close the books and take the stock held by the business before the company came into existence. In such a case, the trial balance will be abstracted from the books and the profit or loss computed: Thereafter, the books will be either closed off or the balance allowed continuing undistributed; only the amount of profit or loss so determined being adjusted in the manner described above. When this is not possible, one or the other of the following methods will have to be followed for the purpose. (1) The simplest, though not always the most expedient method is to close off old books and open new books with the assets and liabilities as they existed at the date of incorporation. In this way, automatically the result to that date will be adjusted, the difference between the values of assets and liabilities acquired and the purchase consideration being accounted for either as goodwill or as reserve. The accounts, therefore, would relate exclusively to the post-incorporation period and any adjustment for the pre-incorporation period, whether an adjustment of profit or loss, would not be required. (2) Since the decision to take over a business is usually reached long after the date from which it is agreed to be taken over it is normally not possible to follow any of the method aforementioned. The only alternative left, in the circumstances, is to split up the profit of the year of the transfer of the business to the company between ‘pre’ and ‘post’ incorporation periods. This is done either on the time basis or on the turnover basis or by a method which combines the two. 3. Basis of Apportionment • The amount of gross profit of a business is not dependent on time. It is, therefore, more appropriate to distribute it on the basis of turnover. Similarly, the expenses incurred in earning the gross profit, not having any direct relationship thereto, should be distributed on a basis considered appropriate, having regard to the circumstances of each case. • Common charges which are fixed e.g., insurance, salaries, depreciation etc., are allocated on time basis, while those which are fluctuating e.g., bad debts, discount and carriage outwards are allocated according to turnover unless, in the light of available information time at which these were incurred or in consideration of the relationship that these bear to the profit of the two periods. • For example, interest payable on the credit balance of vendors is charged against the profit of the period before the business was taken over on the consideration that it is in respect of that period before the business was taken over or on the consideration that it is in respect of that period that the profit accrued to the company, though the purchase consideration had not been discharged. But if the 3.2 © The Institute of Chartered Accountants of India Accounting purchase consideration is not paid on taking over the business, the interest for the subsequent period is charged to the post-incorporation period. • Again, preliminary expenses on the formation of the company though incurred in point of time, before the company was incorporated are charged against the profit of the period subsequent to incorporation. ` Suppose Sales in Pre-incorporation Period 6,000 Sales in Post-incorporation Period 19,000 25,000 The company deals in one type of product. The unit cost of sales was reduced by 10% in post incorporation period as compared to the pre-incorporation period in the year. In this case the cost of sales will be divided between the two periods in the ratio of 6,000: 17,100 i.e., 19,000– 1,900. 4. Pre-incorporation Profits & Losses S. No Pre-incorporation Profits Pre-incorporation Losses 1. It is transferred to Capital Reserve It is treated as a part of business Account (i.e. capitalized). acquisition cost (Goodwill). 2. It can be used for : It can be used for : • writing off Goodwill on acquisition • setting of against Post- • writing off Preliminary Expenses incorporation Profit • writing down over-valued assets • addition to Goodwill on • issuing of bonus shares acquisition • paying up partly paid shares • writing off Capital Profit Illustration 1 Bidyut Limited was incorporated on 1st July, 2012 to acquire from Bijli as and from 1st January, the individual business carried on by him. The purchase price of the fixed assets and goodwill was agreed to be the sum equal to 80% of the profits made each year on ascertainment of the sum due. The following Trial Balance as on 31st Dec., 2012 is presented to you to enable you to prepare a Balance Sheet as at that date. Also prepare a statement of appropriation of profit writing off one-third of the preliminary expenses. Dr. Cr. ` ` Share Capital - 1,500 equity shares of ` 100 each, ` 80 paid up 1,20,000 3.3 © The Institute of Chartered Accountants of India Profit or Loss Prior to Incorporation Sundry Debtors 82,000 Stock on 31st Dec., 2012 67,000 Cash at bank and on hand 24,000 Directors’ fee 3,000 Preliminary expenses 24,000 Sundry Creditors 32,000 Net Profit for the year after providing for all expenses under agreement entered into with Bijli 48,000 2,00,000 2,00,000 Solution Balance Sheet of M/s Bidyut Ltd. as on 31st Dec., 2012 Particulars Notes Rs. Equity and Liabilities 1 Shareholders' funds a Share capital 1 1,20,000 b Reserves and Surplus 2 37,000 2 Current liabilities a Trade Payables 32,000 b Other current liabilities 38,400 Total 2,27,400 Assets 1 Non-current assets a Fixed assets 3 38,400 2 Current assets a Inventories 67,000 b Trade receivables 82,000 c Cash and cash equivalents 24,000 d Other current assets 16,000 Total 2,27,400 Notes to accounts Rs. 1 Share Capital Equity share capital Issued & Subscribed Capital 1,500 Equity Shares of ` 100 each, ` 80 paid up 1,20,000 3.4 © The Institute of Chartered Accountants of India Accounting 2 Reserves and Surplus Capital Reserve 24,000 Profit and loss Account 13,000 Total 37,000 3. Fixed assets Goodwill and fixed assets∗ 38,400 Statement of Appropriation of Profit Pre-incorporation Post-incorporation ` ` ` Net Profit for the Year 24,000 24,000 Less: Directors’ fee 3,000 Preliminary Expenses 8,000 11,000 24,000 13,000 Amount Payable to Bijli: Profit for the year 48,000 80% due as cost of goodwill, assets, etc. 38,400 Illustration 2 Inder and Vishnu, working in partnership registered a joint stock company under the name of Fellow Travellers Ltd. on May 31, 2012 to take over their existing business. It was agreed that they would take over the assets of the partnership for a sum of ` 3,00,000 as from January 1st, 2012 and that until the amount was discharged they would pay interest on the amount at the rate of 6% per annum. The amount was paid on June 30, 2012. To discharge the purchase consideration, the company issued 20,000 equity shares of ` 10 each at a premium of Re. 1 each and allotted 7% Debentures of the face value of ` 1,50,000 to the vendors at par. The Profit and Loss Account of the “Fellow Travellers Ltd.” for the year ended 31st December, 2012 was as follows : ` ` Purchase, including stock 1,40,000 Sales: Freight and carriage 5,000 1st January to 31st May 2012 60,000 Gross Profit c/d 60,000 1st June to 31st Dec., 2012 1,20,000 Stock in hand 25,000 2,05,000 2,05,000 Salaries and Wages 10,000 Gross profit b/d 60,000 ∗ In Travancore Sugars and Chemicals Ltd. v. CIT (62 CIT 566), the Supreme Court has held that such payment is a revenue expenditure and deductible from the profits of the company, for tax purposes. 3.5 © The Institute of Chartered Accountants of India Profit or Loss Prior to Incorporation Debenture Interest 5,250 Depreciation 1,000 Interest on Purchase Consideration (up to 30-6-2012) 9,000 Selling Commission 9,000 Directors’ Fees 600 Preliminary Expenses 900 Provision for taxes 6,000 Dividend on equity shares @ 5% 5,000 Balance c/d 13,250 60,000 60,000 Prepare statement apportioning the balance between the ‘post’ and ‘pre-incorporation’ periods and also show how these figures would appear in the Balance Sheet of the company. Solution: Fellow Travellers Ltd. Statement showing apportionment of profit between periods prior to and since incorporation Pre- Post- Ratio incorporation incorporation Gross profit allocated on the basis of sale 1:2 20,000 40,000 Administrative Expenses allocated On time basis: (i) Salaries and wages 10,000 (ii) Depreciation 1,000 5:7 4,583 6,417 Selling Commission on the basis of sales 1:2 3,000 6,000 Interest on Purchase Consideration (Time basis) 5:1 7,500 1,500 Expenses applicable wholly to the Post-incorporation period: Debenture Interest 5,250 Director’s Fees 600 Appropriations: 5,850 Preliminary Expenses w/o 900 Provision for Tax 6,000 Dividend on equity share 5,000 11,900 Balance c/d to Balance Sheet 4,917 8,333 20,000 40,000 3.6 © The Institute of Chartered Accountants of India Accounting Fellow Travellers Ltd. Extract from the Balance Sheet as on 31st Dec., 2012 Particulars Notes Rs. Equity and Liabilities 1 Shareholders' funds 2,00,000 a Share capital 1 33,250 b Reserves and Surplus 2 2 Non-current liabilities 1,50,000 a Long-term borrowings 3 3 Current liabilities 6,000 a Short term provisions 4 3,89,250 Total Notes to accounts Rs. 1. Share Capital 2,00,000 20,000 equity shares of ` 10 each fully paid 2. Reserves and Surplus Profit Prior to Incorporation 4,917 Securities Premium Account 20,000 8,333 Profit and loss Account 33,250 Total 3. Long term borrowings Secured 7% Debentures 1,50,000 4. Other Current liabilities Provision for Taxes 6,000 Illustration 3 The partners of Maitri Agencies decided to convert the partnership into a private limited company called MA (P) Ltd. with effect from 1st January, 2010. The consideration was agreed at ` 1,17,00,000 based on the firm’s Balance Sheet as at 31st December, 2009. However, due to some procedural difficulties, the company could be incorporated only on 1st April, 2010. Meanwhile the business was continued on behalf of the company and the consideration was settled on that day with interest at 12% per annum. The same books of account were 3.7 © The Institute of Chartered Accountants of India Profit or Loss Prior to Incorporation continued by the company which closed its account for the first time on 31st March, 2011 and prepared the following summarized profit and loss account. ` Sales 2,34,00,000 Cost of goods sold: 1,63,80,000 Salaries 11,70,000 Depreciation 1,80,000 Advertisement 7,02,000 Discounts 11,70,000 Managing Director’s remuneration 90,000 Miscellaneous office expenses 1,20,000 Office-cum-show room rent 7,20,000 Interest 9,51,000 2,14,83,000 Profit 19,17,000 The company’s only borrowing was a loan of ` 50,00,000 at 12% p.a. to pay the purchase consideration due to the firm and for working capital requirements. The company was able to double the average monthly sales of the firm, from 1st April, 2010 but the salaries trebled from that date. It had to occupy additional space from 1st July, 2010 for which rent was ` 30,000 per month. Prepare a statement of profit and loss in a columnar form apportioning cost and revenue between pre-incorporation and post-incorporation periods. Also, suggest how the pre- incorporation profits are to be dealt with. Solution MA (P.) Ltd. Statement of Profit & Loss for 15 months ended 31st March, 2010 Pre-inc. Post-inc. Pre-inc. Post-inc. ` ` ` ` To Cost of goods sold 18,20,000 1,45,60,000 By Sales 26,00,000 2,08,00,000 ” Salaries 90,000 10,80,000 ” Loss 19,000 ” Depreciation 36,000 1,44,000 ” Advertisement 78,000 6,24,000 ” Discounts 1,30,000 10,40,000 ” M.D.’s remuneration — 90,000 ” Misc. Office Expenses 24,000 96,000 ” Rent 90,000 6,30,000 ” Interest 3,51,000 6,00,000 ” Net Profit — 19,36,000 ________ _________ 26,19,000 2,08,00,000 26,19,000 2,08,00,000 3.8 © The Institute of Chartered Accountants of India Accounting Working Notes: (1) Calculation of ratio of sales: Let the average sales per month in pre-incorporation period be x. Then the average sales in post-inc. period are 2x. Thus total sales are (3 × x) + (12 × 2x) or 27x. Ratio of sales will be 3x : 24x or 1:8. Time ratio is 3 months : 12 months or 1:4 (2) Expenses apportioned on turnover ratio basis are cost of goods sold, advertisement, discounts. (3) Expenses apportioned o n time ratio basis are Depreciation, and misc. office expenses. (4) Ratio for apportionment of Salaries: If pre-incorporation monthly average is x, for 3 months 3x. Average for balance 12 months 3x, for 12 months 36x. Hence ratio for division, 1:12. (5) Apportionment of Rent: ` Total Rent 7,20,000 Additional rent for 9 months (From 1st July to 31st March, 2011) 2,70,000 Rent for old premises for 15 months or ` 30,000 p.m. 4,50,000 Pre-inc. Post-inc. Old Premises 90,000 3,60,000 Addl.:” — 2,70,000 90,000 6,30,000 Note on treatment Since the profits prior to incorporation are in the negative, they would: (a) Either be considered as a reduction from any capital reserve accruing in relation to the transaction, or (b) Be treated as goodwill. Illustration 4 ABC Ltd. was incorporated on 1.5.2010 to take over the business of DEF and Co. from 1.1.2010. The summarised Profit and Loss Account as given by ABC Ltd. for the year ending 31.12.2009 is as under: Profit and Loss Account ` ` To Rent and Taxes 90,000 By Gross Profit 10,64,000 To Salaries including By Interest on 36,000 3.9 © The Institute of Chartered Accountants of India Profit or Loss Prior to Incorporation manager’s salary of 3,31,000 Investments ` 85,000 To Carriage Outwards 14,000 To Printing and Stationery 18,000 To Interest on Debentures 25,000 To Sales Commission 30,800 To Bad Debts (related to 91,000 sales) To Underwriting Commission 26,000 To Preliminary Expenses 28,000 To Audit Fees 45,000 To Loss on Sale of 11,200 Investments To Net Profit 3,90,000 ________ 11,00,000 11,00,000 Prepare a Statement showing allocation of pre-incorporation and post-incorporation profits after considering the following information: (i) G.P. ratio was constant throughout the year. (ii) Sales for January and October were 1½ times the average monthly sales while sales for December were twice the average monthly sales. (iii) Bad Debts are shown after adjusting a recovery of ` 7,000 of Bad Debt for a sale made in July, 2007. (iv) Manager’s salary was increased by ` 2,000 p.m. from 1.5.2010. (v) All investments were sold in April, 2010. Solution Pre-incorporation period is for four months, from 1st January, 2010 to 30th April, 2010. 8 months’ period (from 1st May, 2010 to 31st December, 2010) is post-incorporation period. Statement of Profit and Loss for the year ended 31st December, 2010 Pre-Inc Post –Inc Pre-Inc Post inc ` ` ` ` To Rent and Taxes 30,000 60,000 By Gross Profit 3,42,000 7,22,000 To Salaries By Interest on Manager’s Salary 23,000 62,000 Investments 36,000 − Other Salaries 82,000 1,64,000 By Bad Debts 7,000 − Recovery To Printing and 6,000 12,000 3.10 © The Institute of Chartered Accountants of India Accounting Stationery To Audit fees 15,000 30,000 To Carriage Outwards 4,500 9,500 To Sales Commission 9,900 20,900 To Bad Debts 31,500 66,500 (91,000 + 7,000) To Interest on − 25,000 Debentures To Underwriting − 26,000 Commission To Preliminary Expenses − 28,000 To Loss on sale of 11,200 − investments To Net Profit 1,71,900* 2,18,100 ______ ______ 3,85,000 7,22,000 3,85,00 7,22,00 * Pre-incorporation profit is a capital profit and will be transferred to Capital Reserve. Working Notes (i) Calculation of ratio of Sales Let average monthly sales be x. Thus Sales from January to April are 4½ x and sales from May to December are 9½ x. Sales are in the ratio of 9/2x : 19/2x or 9 : 19. (ii) Gross profit, carriage outwards, sales commission and bad debts written off have been allocated in pre and post incorporation periods in the ratio of Sales i.e. 9 : 19. (iii) Rent, salaries, printing and stationery, audit fees are allocated on time basis. (iv) Interest on debentures, underwriting commission and preliminary expenses are allocated in post incorporation period. (v) Interest on investments, loss on sale of investments and bad debt recovery are allocated in pre-incorporation period. Illustration 5 A company was incorporated on 1st July, 2011 to take over the business of Mr. M as and from 1st April, 2011. Mr. M’s summarised Balance Sheet, as at that date was as under: Liabilities ` Assets ` Trade Creditors 36,000 Building 80,000 Capital 1,94,000 Furniture and Fittings 10,000 Debtors 90,000 3.11 © The Institute of Chartered Accountants of India Profit or Loss Prior to Incorporation Stock 30,000 Bank 20,000 2,30,000 2,30,000 Debtors and Bank balances are to be retained by the vendor and creditors are to be paid off by him. Realisation of debtors will be made by the company on a commission of 5% on cash collected. The company is to issue M with 10,000 equity shares of ` 10 each, ` 8 per share paid up and cash of ` 56,000. The company issued to the public for cash 20,000 equity shares of ` 10 each on which by 31st March, 2012 ` 8 per share was called and paid up except in the case of 1,000 shares on which the third call of ` 2 per share had not been realized. In the case of 2,000 shares, the entire face value of the shares had been realized. The share issue was underwritten for 2% commission, payable in shares fully paid up. In addition to the balances arising out of the above, the following were shown by the books of accounts of the company on 31st March, 2012: ` Discount (including ` 1,000 allowed on vendor’s debtors) 6,000 Preliminary expenses 10,000 Directors’ fees 12,000 Salaries 48,000 Debtors (including vendor’s debtors) 1,60,000 Creditors 48,000 Purchases 3,20,000 Sales 4,60,000 Stock on 31st March, 2012 was ` 52,000. Depreciation at 10% on Furniture and Fittings and at 5% on Building is to be provided. Collections from debtors belonging to the vendor were ` 60,000 in the period. Prepare Statement of Trading and Profit & Loss for the period ended 31st March, 2012 of the limited company and its Balance Sheet as at that date. Solution Statement of Trading and Profit and Loss for the year ended 31.03.12 Dr. Dr. ` ` To Opening Stock 30,000 By Sales 4,60,000 To Purchases 3,20,000 By Closing Stock 52,000 To Gross Profit c/d 1,62,000 5,12,000 5,12,000 3.12 © The Institute of Chartered Accountants of India Accounting Pre- Post- Pre- Post- Incorpo Incorpo Incorpo Incorpo ration ration ration ration ` ` ` ` To Salaries 12,000 36,000 By Gross Profit 40,500 1,21,500 c/d To Directors’ fee - 12,000 By Commission - 3,000 To Discount 1,250 3,750 To Depreciation: Building 1,000 3,000 Furniture 250 750 To Pre- incorporation Profit transferred to 26,000 - Capital Reserve Account To Net Profit - 69,000 40,500 1,24,500 40,500 1,24,500 Note: Apportionment has been made in the Statement of Profit and Loss between pre- incorporation and post-incorporation period using the following basis. Item Base Ratio Gross Profit Time 1 : 3 Salaries Time 1 : 3 Discount Time 1 : 3 Directors’ Fees 100% to post-incorporation period Commission 100% to post-incorporation period Balance Sheet as on 31.3.2012 Particulars Notes Rs. Equity and Liabilities 1 Shareholders' funds 2,42,000 a Share capital 1 79,000 b Reserves and Surplus 2 2 Current liabilities 52,000 a Trade Payables 3 3,73,000 Total 3.13 © The Institute of Chartered Accountants of India Profit or Loss Prior to Incorporation Assets 1 Non-current assets a Fixed assets 85,000 Tangible assets 4 2 Current assets 52,000 a Inventories 1,31,000 b Trade receivables 91,000 c Cash and cash equivalents 14,000 d Other current assets 5 3,73,000 Total Notes to accounts Rs. 1. Share Capital Equity share capital 30,000 equity shares of ` 10 each ` 8 called-up 2,40,000 Less: Calls in Arrear (of the above 10,000 shares are allotted pursuant to a contract without payments being received in cash) 2,000 2,38,000 Share Suspense A/c (400 shares to be issued to the underwriter in consideration of under-writing commission on completion of share issue) 4,000 2,42,000 Total 2. Reserves and Surplus Capital Reserve 26,000 Less: Goodwill w/o 16,000 10,000 69,000 Profit and loss Account 79,000 Total 3. Trade payables Sundry Creditors 48,000 52,000 Calls in advance 4,000 4. Fixed assets Building 80,000 76,000 Less: Depreciation 4,000 Furniture & Fittings 10,000 3.14 © The Institute of Chartered Accountants of India Accounting Less: Depreciation 1,000 9,000 85,000 Total 5. Other current assets Preliminary Expenses 10,000 Underwriting Commission 4,000 14,000 Working Notes: (1) Goodwill on acquisition Purchase consideration: ` ` 10,000 equity shares of ` 10 each, ` 8 paid up 80,000 Cash 56,000 1,36,000 Less: Assets taken over Building 80,000 Furniture and Fittings 10,000 Stock 30,000 1,20,000 Goodwill 16,000 (2) Cash Inflows from public issue of equity shares ` 20,000 equity shares of ` 10 each ` 8 called up 1,60,000 Less: Calls in arrear on 1,000 shares @ ` 2 per share 2,000 1,58,000 Add: Calls-in-advance on 2000 shares @ ` 2 4,000 1,62,000 (3) Underwriting Commission 2% on face value ` 2,00,000 4,000 Underwriting Commission becomes due on completion of the job relating to shares underwritten. It appears that the job relating to public issue was not finished till 31st March, 2010. So a Share Suspense Account should be created showing the amount of shares to be issued to the underwriter in discharge of his claim for commission (4) Cash collection from Company’s debtors Total Debtors Account Vendor’s Company’s Vendor’s Company’s Debtors Debtors Debtors Debtors ` ` ` ` To Balance b/d 90,000 - By Discount 1,000 5,000 3.15 © The Institute of Chartered Accountants of India Profit or Loss Prior to Incorporation To Sales 4,60,0001 By Cash 60,000 3,24,0002 By Balance c/d 29,000 1,31,0003 90,000 4,60,000 90,000 4,60,000 (5) Cash payment for purchases Dr. Total Creditors Account Cr. ` ` To Cash (Balancing 2,72,000 By Purchases 3,20,0004 figure) To Balance c/d 48,000 3,20,000 3,20,000 (6) Summary Cash Book Cr. ` ` Share Capital A/c 1,62,000 By Total Creditors A/c Total Debtors A/c: Payment to creditors 2,72,000 Collection from By Vendor’s A/c: company’s debtors 3,24,000 Collection from vendor’s Purchase consideration debtors 60,000 56,000 By Preliminary Expenses 10,000 By Directors’ Fees 12,000 By Salaries 48,000 By Vendor’s A/c (Collection less commission ` 3,000) 57,000 By Balance c/d 91,000 5,46,000 5,46,000 1 Assumed that all sales were on credit. 2 Balancing figure. 3 Total Debtors Rs.1,60,000 minus Vendor’s Debtors Rs.29,000. 4 Assumed that all purchases were on credit. 3.16 © The Institute of Chartered Accountants of India Accounting 5. Debtors and Creditors Suspense Accounts As mentioned already, a company taking over a running business may also agree to collect its debts as an agent for the vendors and may further undertake to pay the creditor on behalf of the vendors. In such a case, the debtors and creditors of the vendors will be included in the accounts for the company by debit or credit to separate Total Accounts in the General Ledger to distinguish them from the debtors and creditors of the business and contra entries will be made in corresponding Suspense Accounts. Also details of debtors’ and creditors’ balance will be kept in separate ledgers. In order that the collections from debtors and payments of creditors of vendors may not get mixed up with those of the company, it is a desirable procedure further to distinguish them by having separate columns for them in the Cash Book. The book entries that should be passed for debtors in such a case are shown below: Debit Sundry Debtors Account for opening balance Credit Debtors suspense A/c Debit Cash for cash received from debtors Debit Debtors’ Suspense A/c for allowance etc. to debtors Credit Sundry Debtors A/c for cash and allowance etc. Debit Debtors’ Suspense A/c for cash received from debtors Credit Vendor A/c & payable to vendors. The vendor is thus treated as a creditor for the cash received by the purchasing company in respect of the debts due to the vendor, just as if he has himself collected cash from his debtors and remitted the proceeds to the purchasing company. For entries in respect of creditors, the reverse of those outlined in respect of debtors will be passed. The vendor is considered a debtor in respect of cash paid to his creditors by the purchasing company. The balance of the cash collected, less paid, will represent the amount due to or by the vendor, arising from debtors and creditors’ balances which have been taken over, subject to any collection expenses. The balance in the suspense accounts will be always equal to the amount of debtors and creditors taken over remaining unadjusted at any time. Illustration 6 Messrs. X, Y & Z, the balance sheet of whose business is given below transferred their business to a limited company with the same name on January 1, 2010. It was agreed that the company would take over the assets except cash and book debts at their book values, would pay ` 20,000 for the goodwill of business and would collect the book debts at a commission of 5%. Out of the collection from the debtors, the liabilities to sundry creditors would be first discharged as and when the amount is available, and the balance, if any, would be paid to vendors after six months. The partners undertook to pay off bank overdraft. You are required to show the computation of the purchase consideration and the Vendors Collection Account, assuming that only ` 65,000 colected out of debtors’ balance and the remaining debtors were taken over by the vendors at the end of six months. Collection from 3.17 © The Institute of Chartered Accountants of India Profit or Loss Prior to Incorporation debtors were : January, ` 30,000; February, ` 15,000; March, ` 10,000; April, ` 5,000; May, ` 5,000, June Nil. Summarised Balance Sheet of M/s X, Y, Z as on 31st December, 2009 Liabilities ` ` Assets ` Capital Accounts of Partners: Land & Building 25,000 X 75,000 Machinery 1,50,000 Y 60,000 Stock 60,000 Z 40,000 1,75,000 Book Debts 75,000 General Reserve 80,000 Cash 5,000 Sundry Creditors 56,000 Bank Overdraft 4,000 3,15,000 3,15,000 Solution Purchase consideration payable: ` Total of Assets 3,15,000 Add: Amount of Goodwill 20,000 Less: Assets not taken over: 3,35,000 Cash Balance 5,000 Book Debts 75,000 80,000 2,55,000 Vendors Debtors’ Account Dr. Cr. 2010 ` 2010 ` Jan. To Balance of 75,000 Jan.31 By Cash (Amount 30,000 1 Debtors taken collected) over for collection Feb. 28 By Cash (Amount 15,000 collected) Mar. 31 By Cash (Amount 10,000 collected) Apr. 30 By Cash (Amount 5,000 collected) May 31 By Cash (Amount 5,000 collected) June 30 By Balance transferred to 3.18 © The Institute of Chartered Accountants of India Accounting Debtors’ 10,000 Suspense Account 75,000 75,000 Debtors’ Suspense Account 2010 ` 2010 ` Jan. 31 To Amount transferred to 28,500 Jan. 1 By Balance of vendors’ 75,000 Vendors’ Collection A/c debtors taken over for collection To Commission A/c 1,500 Feb. 28 To Amount transferred to 14,250 Vendor’s Collection A/c To Commission A/c 750 Mar. 31 To Amount transferred to 9,500 Vendors’ Collection A/c To Commission A/c 500 Apr. 30 To Amount transferred to 4,750 Vendors’ Collection A/c To Commission A/c 250 May. To Amount transferred to 4,750 31 Vendors’ Collection A/c To Commission A/c 250 June To Amount transferred from 30 Vendors’ Debtors A/c 10,000 75,000 75,000 Creditors’ Suspense Account Dr. Cr. 2010 ` 2010 ` Jan. 1 To Amount recoverable from 56,000 Jan. 31 By Vendors’ 28,500 vendors in respect of liabilities Collection A/c taken over Feb. 28 By Vendors’ 14,250 Collection A/c Mar. 31 By Vendors’ 9,500 Collection A/c Apr. 30 By Vendors’ 3,750 Collection A/c 56,000 56,000 3.19 © The Institute of Chartered Accountants of India Profit or Loss Prior to Incorporation Vendors’ Creditors’ Account 2010 ` 2010 ` Jan. 31 To Cash 28,500 Jan. 1 By Amount payable on behalf of vendors 56,000 Feb. 28 To Cash 14,250 Mar. 31 To Cash 9,500 Apr. 30 To Cash 3,750 56,000 56,000 Vendors’ Collection Account 2010 ` 2010 ` Jan. 31 To Amount transferred to 28,500 Jan. 31 By Amount transferred 28,500 Creditors’ Suspense A/c from Debtors’ Suspense A/c Feb. 28 To Amount transferred to 14,250 Feb. 28 By Amount transferred 14,250 Creditors’ Suspense A/c from Debtors’ Suspense A/c Mar. 31 To Amount transferred to 9,500 Mar. 31 By Amount transferred 9,500 Creditors’ Suspense A/c from Debtors’ Suspense A/c Apr. 30 To Amount transferred to 3,750 Apr. 30 By Amount transferred 4,750 Creditors’ Suspense A/c from Debtors’ Suspense A/c June To Cash (amt. paid to 5,750 May 31 By Amount transferred 4,750 30 vendors) from Debtors’ Suspense A/c 61,750 61,750 Summary • Profit or loss of a business for the period prior to the date the company came into existence is referred to as Pre-Incorporation Profits or Losses. • Generally there are two methods of computing Profit & Loss prior to Incorporation i. One is to close off old books and open new books with the assets and liabilities as they existed at the date of incorporation. In this way, automatically the result to that date will be adjusted. ii. Other is to split up the profit of the year of the transfer of the business to the 3.20 © The Institute of Chartered Accountants of India Accounting company between ‘pre’ and ‘post’ incorporation periods. This is done either on the time basis or on the turnover basis or by a method which combines the two. • A company taking over a running business may also agree to collect its debts as an agent for the vendor and may further undertake to pay the creditor on behalf of the vendors. In such a case, the debtors and creditors of the vendors will be included in the accounts for the company by debit or credit to separate total accounts in the General, Ledger to distinguish them from the debtors and creditors of the business and contra entries will be made in corresponding Suspense Accounts. Also details of debtors and creditors balance will be kept in separate ledger • The vendor is treated as a creditor for the cash received by the purchasing company in respect of the debts due to the vendor, just as if he has himself collected cash from his debtors and remitted the proceeds to the purchasing company. • The vendor is considered a debtor in respect of cash paid to his creditors by the purchasing company. The balance of the cash collected, less paid, will represent the amount due to or by the vendor, arising from debtors and creditors balances which have been taken over, subject to any collection expenses. • The balance in the suspense accounts will be always equal to the amount of debtors and creditors taken over remaining unadjusted at any time. 3.21 © The Institute of Chartered Accountants of India