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.
Preparation 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 the purchase of goods and bringing 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 the 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 the 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 on the debit side whereas sales and closing stock is recorded on the credit side. If credit side is Jeater 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 the first item at the debit side of the trading account. Of course, in the first year of a business there will be no opening stock.
2. Purchases. It is normally the second item on the debit side of the trading account. ‘Purchases’ mean total purchases ie 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 related 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 salable condition viz., motive power, gas fuel, stores, royalties, factory expenses, foreman and supervisor’s salary etc.
Although 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 ie cash plus credit sales. If there are any sales returns, these should be deducted from sales. So net sales are credited to the 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 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 GP 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 resulting figure will be net profit or net loss.
The expenses which are recorded in profit and loss account are called ‘indirect expenses’. These be classified as follows:
Selling and distribution expenses.
These include the 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 the 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
(f) Profit on sale of assets
(g) Bad debts recovered
(h) Dividend received
(i) Apprenticeship premium etc.