The sole aim of a business is to make profit. However, many a times, businesses incur loss instead of making profits. The calculation of such profits and losses is no doubt the most important objective of the accounting function. The owners of the businesses would want to know whether their business is going down hill or burgeoning. Knowing what profits are made helps the decision makers decide to plan ahead and take important financial decisions such as when and how to take loans, etc.
Note : trading/ profit and loss account is not an account in the real sense, it is a financial statement to be exact.
Trading is basically a term given to business activity including sales and purchase or income and expenses. All sales are credit and all purchases are debit. Expenses incurred on purchases e.g loading, wages, carriage inwards, power, freight, etc are called direct expenses.
Take into account the following formulas : (Memorise them)
Gross profit : Net Sales – cost of goods sold
Net sales = Sales – Sales returns
Cost of goods sold : (opening stock + net purchases+ direct expenses) – closing stock
Net purchase : Purchase – purchase returns
Opening stock is the monetary value of items left for sale and brought down from the previous period.
Trading account
| Debit | Credit |
| Opening stock | Closing stock |
| Net purchases | Net sales |
| Direct expenses | |
| If Debit side is greater then “Balance gross loss” | If credit side is greater then “Balance gross profit” |
Gross profit is transferred to the profit and loss account
Profit and loss account
| Debit | Credit |
| Indirect expenses (Discounts allowed, salaries, rent, insurance, commission, bad debts, advertisement) | Gross profit transfered from trading account |
| Any other income (commission received, interest received, discounts received) | |
| Net loss if Dr is bigger | Net profit (if Cr is bigger) |
Profit and loss account does not record capital, assets and liabilities. The net balance (profit or loss) is transferred to capital account.
Expenses
Direct Expenses
Expenses which may be regarded as the part of cost of purchasing a good. Sometimes direct expenses are also explained as the cost incurred on converting raw materials to finished goods. Another hint to identify direct expenses is that they are always accompanied by the word “In” e.g carriage in wards, etc.
Indirect expenses
Exact opposite of Direct expenses. They are the accompanied by the word “Out”
Trading and profit and loss accounts can both be integrated into a single statement form as follows:
($) ($)
Sales XXXXX
less cost of goods sold
Opening stock XXX
Net purchases XXX
Direct Expenses XXX
less closing stock ______XXX
XXXX
_________________________________________________________________________________
Gross profit/loss XXXXX
less indirect Expenses
Rent XXX
Lighting XXX
Carriage outwards XXX
Salaries XXX
General expenses XXX
XXXX
__________________________________________________________________________________
Net profit / Loss XXXXX