As already discussed, first section of trading and profit and loss account is called trading account. The aim of preparing trading account is to find out gross profit or gross loss while that of second section is to find out net profit or net loss.
Perperation of Trading Account
Trading account is prepared mainly to know the profitability of the goods bought (or manufactured) sold by the businessman. The difference between selling price and cost of goods sold is the,5 earning of the businessman. Thus in order to calculate the gross earning, it is necessary to know:
(a) cost of goods sold.
Total sales can be ascertained from the sales ledger. The cost of goods sold is, however, calculated. n order to calculate the cost of sales it is necessary to know its meaning. The 'cost of goods' includes the purchase price of the goods plus expenses relating to purchase of goods and brining the goods to the place of business. In order to calculate the cost of goods " we should deduct from the total cost of goods purchased the cost of goods in hand. We can study this phenomenon with the help of following formula:
Opening stock + cost of purchases - closing stock = cost of sales
As already discussed that the purpose of preparing trading account is to calculate the gross profit of the business. It can be described as excess of amount of 'Sales' over 'Cost of Sales'. This definition can be explained in terms of following equation:
Gross Profit = Sales-Cost of goods sold or (Sales + Closing Stock) -(Stock in the beginning + Purchases + Direct Expenses)
The opening stock and purchases along with buying and bringing expenses (direct exp.) are recorded the debit side whereas sales and closing stock is recorded on the credit side. If credit side isJeater than the debit side the difference is written on the debit side as gross profit which is ultimately recorded on the credit side of profit and loss account. When the debit side exceeds the credit side, the difference is gross loss which is recorded at credit side and ultimately shown on the debit side of profit & loss account.
Usual Items in a Trading Account:
A) Debit Side
1. Opening Stock. It is the stock which remained unsold at the end of previous year. It must have been brought into books with the help of opening entry; so it always appears inside the trial balance. Generally, it is shown as first item at the debit side of trading account. Of course, in the first year of a business there will be no opening stock.
2. Purchases. It is normally second item on the debit side of trading account. 'Purchases' mean total purchases i.e. cash plus credit purchases. Any return outwards (purchases return) should be deducted out of purchases to find out the net purchases. Sometimes goods are received before the relevant invoice from the supplier. In such a situation, on the date of preparing final accounts an entry should be passed to debit the purchases account and to credit the suppliers' account with the cost of goods.
3. Buying Expenses. All expenses relating to purchase of goods are also debited in the trading account. These include-wages, carriage inwards freight, duty, clearing charges, dock charges, excise duty, octroi and import duty etc.
4. Manufacturing Expenses. Such expenses are incurred by businessmen to manufacture or to render the goods in saleable condition viz., motive power, gas fuel, stores, royalties, factory expenses, foreman and supervisor's salary etc.
Though manufacturing expenses are strictly to be taken in the manufacturing account since we are preparing only trading account, expenses of this type may also be included in the trading account.
(B) Credit Side
1. Sales. Sales mean total sales i.e. cash plus credit sales. If there are any sales returns, these should be deducted from sales. So net sales are credited to trading account. If an asset of the firm has been sold, it should not be included in the sales.
2. Closing Stock. It is the value of stock lying unsold in the godown or shop on the last date of accounting period. Normally closing stock is given outside the trial balance in that case it is shown on the credit side of trading account. But if it is given inside the trial balance, it is not to be shown on the credit side of trading account but appears only in the balance sheet as asset. Closing stock should be valued at cost or market price whichever is less.
Valuation of Closing Stock
The ascertain the value of closing stock it is necessary to make a complete inventory or list of all the items in the god own together with quantities. On the basis of physical observation the stock lists are prepared and the value of total stock is calculated on the basis of unit value. Thus, it is clear that stock-taking entails (i) inventorying, (ii) pricing. Each item is priced at cost, unless the market price is lower. Pricing an inventory at cost is easy if cost remains fixed. But prices remain fluctuating; so the valuation of stock is done on the basis of one of many valuation methods.
The preparation of trading account helps the trade to know the relationship between the costs be incurred and the revenues earned and the level of efficiency with which operations have been conducted. The ratio of gross profit to sales is very significant: it is arrived at :
Gross Profit X 100 / Sales
With the help of G.P. ratio he can ascertain as to how efficiently he is running the business higher the ratio, better will be the efficiency.
Closing Entries pertaining to trading Account
For transferring various accounts relating to goods and buying expenses, following closing entries recorded:
(i) For opening Stock: Debit trading account and credit stock account
(ii) For purchases: Debit trading account and credit purchases account, the amount being the et amount after deducting purchases returns.
(iii) For purchases returns: Debit purchases return account and credit purchases account.
(iv) For returns inwards: Debit sales account and credit sales return account
(v) For direct expenses: Debit trading account and credit direct expenses accounts individually.
(vi) For sales: Debit sales account and credit trading account. We will find that all the accounts as mentioned above will be closed with the exception of trading account
(vii) For closing stock: Debit closing stock account and credit trading account After recording above entries the trading account will be balanced and difference of two sides ascertained. If credit side is more the result is gross profit for which following entry is recorded.
(viii) For gross profit: Debit trading account and credit profit and loss account If the result is gross loss the above entry is reversed.
Profit and Loss Account
The profit and loss account is opened by recording the gross profit (on credit side) or gross loss (debit side).
For earning net profit a businessman has to incur many more expenses in addition to the direct expenses. Those expenses are deducted from profit (or added to gross loss), the resultant figure will be net profit or net loss.
The expenses which are recorded in profit and loss account are ailed 'indirect expenses'. These be classified as follows:
Selling and distribution expenses.
These comprise of following expenses:
(a) Salesmen's salary and commission
(b) Commission to agents
(c) Freight & carriage on sales
(d) Sales tax
(e) Bad debts
(g) Packing expenses
(h) Export duty
(a) Office salaries & wages
(c) Legal expenses
(d) Trade expenses
(e) Rates & taxes
(f) Audit fees
(i) Printing and stationery
(j) Postage and telegrams
(k) Bank charges
(a) Discount allowed
(b) Interest on Capital
(c) Interest on loan
(d) Discount Charges on bill discounted
Maintenance, depreciations and Provisions etc.
These include following expenses
(b) Depreciation on assets
(c) Provision or reserve for doubtful debts
(d) Reserve for discount on debtors.
Along with above indirect expenses the debit side of profit and loss account comprises of various business losses also.
On the credit side of profit and loss account the items recorded are:
(a) Discount received
(b) Commission received
(c) Rent received
(d) Interest received
(e) Income from investments
(j) Profit on sale of assets
(g) Bad debts recovered
(h) Dividend received
(i) Apprenticeship premium etc.
Preparation of Profit and Loss Account
As already stated profit and loss account is commenced with gross profit or gross loss as ascertained by trading account. Then the profit and loss account is debited with all indirect expenses and losses. This results in closing of indirect expenses and losses account. The profit and loss account is then credited with various incomes and gains accounts by which all these accounts are closed.
Explanation of Certain items of Profit and Loss Account
Salaries are paid for the services of employees and are debited to profit and loss ac- count being indirect expense. If any salary has been paid to proprietor or partners, it should be shown separately because it requires special treatment at the time of income tax assessment.
2. Salaries and Wages
When wages account is included with salaries it treated is as indirect expense and is taken into profit and loss account.
Rent of the office shop showroom or godown is an indirect expense and so is debited to profit & loss account. However, rent of factory is debited to trading account. When a part of the building has been sublet the rent received should be shown on the credit side of profit and loss account as a separate item.
4. Rates and Taxes
These are levied by the local authorities to meet public expenditure. It being an indirect expenditure is shown on the debit side of profit and loss account.
Interest on loan, overdraft or overdue debts is payable by the firm. It is an indirect expense; so debited to profit and loss account. Interest on loan advanced by the firm on depositor investments is an income of the firm and so is credited to the profit and loss account.
If business has paid any interest on capital to its proprietor or partners it should also be debited in the profit and loss account but separately because this item needs special treatment at the time of income-tax assessment.
In business sometimes agents are appointed to effect sales, who are paid commission as their remuneration. So this being a selling expenses is shown on the debit side of profit and loss account. Sometimes commission is also paid on purchases of goods, such 'as expense should be debited in the trading account. Sometimes the firm can also act as an agent to the other business houses and in such cases it receives commission from them. Commission so received is shown on the credit side of profit and loss account.
7. Trade Expenses
They are also termed as 'sundry expenses'. Trade expenses represent expenses of such a nature for which it is not worthwhile to open separate accounts. Trade expenses are not taken to trading account.
Repairs to the plant, machinery, building are indirect expenses are treated expense and are debited to profit and loss account..
9. Traveling Expenses
Unless mentioned otherwise, traveling expenses are treated as indirect expenses and are debited to profit and loss account.
10. Horse & stable Expentses
Expenses incurred for the fodder of horses and wages paid for looking after stable are treated as indirect expenses and debited to profit and loss account.
11. Apprentice Premium
This is the amount charged from persons to whom training is imparted by the business. It is an income and is credited to profit and loss account. In case apprentice premium is charged in advance for two or three years, then the amount is distributed over number of years and each year's profit and loss account is credited with its share of income.
12. Bad debts
It is the amount which could not be recovered by the trader on account of credit sales. It is a business loss, so is debited in the profit and loss account.
13. Life Insurance Premium
If the premium is paid on the life policy of the proprietor of the business; it is treated as his drawings and is shown by way of deduction from the capital account. It should not be taken to profit and loss account.
14. Insurance Premium
If insurance premium account appears in the trial balance, it stands for the insurance of the business. This is taken to profit and loss account. Insurance premium on goods purchased, factory building, factory machines are treated as direct expense and are taken to trading account.
15. Income Tax
In the case of merchant income-tax paid is treated as a personal expense and is shown by way of deduction from capital account. Income-tax in case of companies is treated differently.
16. Discount allowed and Received
Discount is a reward for prompt payment. It is belief to show discount received and discount allowed separately on the credit and debit side of profit and loss account respectively instead of showing the net balance of this account.
Depreciation is a loss incurred on account of use of fixed assets in the business. Generally, it is charged from profit and loss account at a fixed percentage. The students should exercise great care as regards the rate of depreciation. If rate is without words 'per annum', then the rate will be taken irrespective of the period of accounts. This is very important when the period of accounts is less than one year. On the other hand, if the rate of depreciation is 'per annum' the depreciation should be calculated on the assets with due consideration to the period for which the asset has been used in business during the year. In case of additions to assets during the year, it is advisable to ignore depreciation on additions if the date of additions is not given. Same rule shall hold good for the sale of assets during the year.
18. Stock at the end appearing in the trial balance.
It is important to emphasize the rule that balance appearing in the trial balance is taken to one and only one place. It may either be trading account or profit and loss account or balance sheet. Since stock at the end is an asset, it will betaken to balance sheet. On the other hand, so long as there is stock in trade, account for that must be kept open and thus be taken to the assets side of balance sheet.