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Trading and Profit and Loss Account
As already discussed, the first section of the trading and profit and loss account is called the trading account. The purpose of preparing a trading account is to find the net profit or net loss while the second part is to find the net profit or net loss.
Preparation of Trade Account
A trading account is prepared to know the income of the goods bought (or made) sold by the businessman. The difference between the selling price and the cost of goods sold is 5 percent of the entrepreneur’s profit. So, in order to calculate gross income, it is necessary to know:
(a) cost of goods sold.
Full sales can be found in the sales ledger. The cost of goods sold, however, is calculated. n order to calculate the cost of sales it is necessary to know its meaning. ‘Price of goods’ includes the purchase price of the goods and the costs associated with the purchase of the goods and bringing the goods to the place of business. In order to calculate the cost of goods “we need to subtract from the total cost of goods purchased the cost of goods on hand. We can calculate this with the help of the following formula:
Opening stock + purchase cost – closing stock = selling cost
As already discussed the purpose of preparing a trading account is to calculate the maximum profit of the business. It can be defined as the excess of ‘Sales’ amount over ‘Cost of Sales’. This statement can be expressed in terms of the following equation:
Gross Profit = Sales – Cost of goods sold or (Sales + Closing Stock) – (Beginning Stock + Purchases + Direct Costs)
Opening stock and purchases and purchase and delivery costs (exp direct) are recorded on the debit side while sales and closing stock are recorded on the credit side. If the credit side is Jeater than the debit side the difference is written on the debit side as gross income which is finally recorded on the credit side of the profit and loss account. When the debit side exceeds the credit side, the difference is a capital loss that is recorded on the credit side and finally shown on the debit side of the profit and loss account.
Common features of a Trading Account:
A) Debit side
1. Opening the stock. It is a stock that remained unsold at the end of last year. It must have been brought to the books with the help of an open entry; so it always appears within the case. Usually, it is shown as the first item on the debit side of a trading account. Of course, in the first year of business there will be no opening stock.
2. Shopping. It is usually the second item on the debit side of the trading account. ‘Purchases’ means all purchases, ie cash and credit. Any external returns (purchase returns) must be deducted from the purchase price. Sometimes goods are received before a proper invoice from the supplier. In such a case, on the date of preparation of the final accounts should be passed the entry in the debit account of the purchase and purchase account of the seller at the cost of goods.
3. Purchase costs. All expenses related to the purchase of goods are also deducted from the trading account. This includes – wages, inland carriage, duty, clearance charges, dock charges, excise duty, octroi and import duty etc.
4. Costs of Production. Those expenses are incurred by businessmen to make or deliver goods in marketable condition ie, motive power, gas fuel, stores, royalties, factory expenses, salary of manager and supervisor etc.
Although production costs must be taken strictly from the production account as we are only preparing a trade account, costs of this type can be included in the trade account.
1. Advertisements. Sales means total sales ie cash and credit sales. If there are any sales returns, these should be deducted from sales. So net sales are accounted for in the trading account. If the asset of the firm is sold, it should not be included in the sales.
2. Closing stock. It is the value of goods not sold in a godown or shop on the last day of the census period. Usually the closing stock is issued without a trial balance in which case it is shown on the credit side of the trading account. But if it is given within the trial balance, it should not be shown on the credit side of the trading account but only appears on the balance sheet as an asset. Closing stock should be valued at cost or market value whichever is lower.
Closing stock valuation
To determine the closing price of the stock it is necessary to make a complete list or a list of all the items in stock and the amounts. On the basis of physical observations the stock list is prepared and the total stock value is calculated on the basis of unit cost. Therefore, it is clear that stock taking involves (i) inventory, (ii) prices. Each item has a price, unless the market price is low. Valuing inventory at cost is easy if the price is constant. But prices are always fluctuating; so stock valuation is done on the basis of multiple valuation methods.
The preparation of the trading account helps the business to know the relationship between the costs incurred and the revenues received and the level of efficiency at which the operations are carried out. The ratio of gross revenue to advertising is very important: it comes down to:
Gross profit X 100 / Sales
With the help of the GP ratio you can determine how well you are running the business above average, the better the efficiency.
Closing Entries relating to a Trading Account
To transfer various accounts related to goods and purchase expenses, the following entries are recorded:
(i) Stock Opening: Debit trading account and credit stock account
(ii) Purchases: A trade debit account and a credit account, the amount is the amount after deducting the returns on purchases.
(iii) For purchase returns: Debit purchases return account and credit purchase account.
(iv) For internal returns: Debit sales account and credit sales returns account
(v) For direct costs: Debit trading account and credit direct cost accounts separately.
(vi) Trading: debit account and credit trading account. We will determine that all accounts as mentioned above will be closed except for trading accounts
(vii) Closing stock: Closing the stock account and the credit trading account After recording the above entries the trading account will be reconciled and the two-way difference confirmed. If the credit side is higher the result is a larger gain in which the next entry is written.
(viii) For gross profit: Debit trading account and credit profit and loss account If the result is a large loss the above entry is reversed.
Income and Loss Account
A profit and loss account is opened by recording net profit (on the credit side) or gross loss (on the debit side).
To get net profit an entrepreneur has to incur many expenses in addition to direct expenses. Those costs are subtracted from the profit (or added to the capital loss), the resulting figure will be the net profit or loss.
Costs recorded in the profit and loss account are referred to as ‘indirect costs’. These are classified as follows:
Selling and distribution costs.
These include the following costs:
(a) Salesmen’s salary and commission
(b) Commission to agents
(c) Shipping and handling of goods
(d) Sales tax
(e) Bad debts
(g) Packing costs
(h) Import fee
(a) Office salaries and wages
(c) Legal costs
(d) Commercial expenses
(e) Prices and taxes
(f) Audit fees
(i) Printing and stationery
(j) Post and telegrams
(k) Bank charges
(a) Discount allowed
(b) Interest on Capital
(c) Interest on loans
(d) Discount charges on discounted bill
Savings, Depreciation and Discounts etc.
This includes the following costs
(b) Depreciation of assets
(c) Provision or reserve for doubtful debts
(d) Reservation of discount to creditors.
Along with the above indirect costs the debit side of the profit and loss account includes various business losses as well.
On the liability side of profit and loss the items recorded are:
(a) Discount received
(b) Commission accepted
(c) Rent received
(d) Interest earned
(e) Income from investments
(f) Gain on sale of assets
(g) Bad debts received
(h) Earned income
(i) Apprenticeship premium etc.
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