TRADING PROFIT AND LOSS ACCOUNT PART 1

Trading and Profit and Loss Accounts
The main objective of businesses is referred to as profit maximisation, whereby the managers or owners of the firm will aim to make as much profit as is possible. The calculation of these profits is one of the most important functions of accounting. The owner will wish to know the profit for various reasons, such as:

• Comparing performance - with other firms or with previous periods of time to see if the firm is moving in the appropriate direction
• Planning ahead - profits will allow the firm to expand
• Obtaining a loan - most bank managers and other lenders would want to see that the firm is profitable before lending money
• Income tax purposes - tax payable will usually be based on the profits earned by the firm

The calculation of profit will involve the calculation of both revenue and expenses incurred by the firm over a period of time. In the case of the sole trader, the profit for a firm is calculated in an account known as the trading and profit and loss account.

For a trading organisation it is not only the final profit figure that is important. Managers and owners will also want to know how the profit is made on the actual sales that take place before other general expenses are deducted. So this can be seen, the overall trading and profit and loss account is split into two sections; the trading account, which calculates gross profit and the profit and loss account, which calculates net profit.

• Trading account - to calculate gross profit (the profit earned on the buying and selling of goods - before all other expenses have been deducted)
• Profit and loss account - to calculate net profit (the profit after all overhead expenses have been deducted from the gross profit - this is the overall profit earned by the firm)

It is possible that the firm may make a gross loss, where the cost of purchases is greater than the sales revenue, but this is unusual. More likely, a firm may make a gross profit, but may find that the other expenses are greater than the gross profit and the firm has made a net loss.

You will find that most questions will be concerned with firms that buy and sell goods. In reality, many firms will not sell physical goods, and that they will provide services. In this case, the firm would only need a profit and loss account rather than a full trading and profit and loss account.

We will consider firms that actually make their own goods later in Module 3 (manufacturing accounts). To construct a trading and profit and loss account we will need to use information from the firm's trial balance. In this example, we will use the following trial balance:

D Ball - Trial Balance as at 31 December 2003

-	Dr (£)	Cr (£)
Sales	-	6000
Purchases	4000	-
Insurance	650	-
Lighting & heating	450	-
General expenses	120	-
Machinery	2100	-
Debtors	890	-
Creditors	-	980
Bank	1970	-
Discounts allowed	130	-
Discounts received	-	110
Cash in hand	80	-
Drawings	700	-
Capital	-	3000
Loan	-	1000
-	11090	11090

Stock in trade as at 31 December 2003 was valued at £300

In the double entry accounts we have no single account for stock. The value for closing stock would have to be calculated by taking an actual stock count. As stated in the section on trial balances, any stock which remains unsold (closing stock) will be listed underneath the trial balance.

Contents [hide] 1 Trading account 2 Profit and loss account 3 Opening stock 4 Carriage 5 Returns 6 Also See 7 Comments

Trading account

In the trading account we calculate the firm's gross profit. To calculate the gross profit we use the following calculation

Sales - cost of goods sold = gross profit

The cost of goods sold is simply the cost to the firm for those goods that were actually sold. The total cost of purchases would be the cost of the goods sold. However, if any stock were unsold at the end of the year then we would not count this, as it has not contributed towards the value of sales. Hence, cost of sales:

What we bought during the period	Purchases
Less: Goods bought but not sold during the period	Closing stock
=	Cost of goods sold

From our example, closing stock at the close of business (i.e. 31 December 2003) was valued at £300. The cost of goods sold for D Ball will therefore be:

-	£
Purchases	4000
Closing stock	300
Cost of goods sold	3700

To transfer balances from the double entry accounts we 'close down' the ledger account and transfer all that was paid or received during the year to the trading and profit and loss account. In effect we are 'emptying out' the relevant accounts for the year and we will start filling them, up in next year.

The double entry accounts will have already been balanced off and their balances will have been brought down for us to close off.

For sales, we should make the following entries:

• Debit the sales account, thus closing it.
• Credit the trading account.

Sales

2003	-	£	2003	-	£
Dec 31	Trading account	6,000	Dec 31	Balance b/d	6,000

The balance of the purchases is transferred to the trading account by:

• Debit the trading account.
• Credit the purchases account.

Purchases

2003	-	£	2003	-	£
Dec 31	Balance b/d	4,000	Dec 31	Trading account	4,000

Although there is no double entry account for stock left unsold at the end of the period we actually now create one. The value of closing stock is found by a physical count on the quantity of stock - a process known as stocktaking.

• Debit the stock account with the value of closing stock.
• Credit the trading account.

Stock

2000	-	£	1995	-	£
Dec 31	Trading	300	-	-	-

It is usual for the trading and profit and loss accounts to be shown under one heading. The trading account is the top section and the profit and loss account is the lower section.

It is possible to present the trading account and the profit and loss account as double entry accounts.

This would be known as the horizontal presentation. However the practice is fast becoming outdated and now nearly every trading and profit and loss account you will see will be presented in the vertical manner.

Remember the rules for the titles of financial statements. It should say who it is for, what it is, and for what period of time we are dealing with. Both the trading account and the profit and loss account are drawn up for a period of time and not on a particular date. This is because the profit can only be earned over a period of time.

D Ball - Trading Account for year ended 31 December 2003

-	£	£
Sales	-	6000
Less Cost of goods sold:	-	-
Purchases	4000	-
Less Closing stock	300	3700
Gross Profit	-	2300

Notice how we use both columns, not as debits and credits but for performing sub-totals. Sometimes there will be two, three or even four columns. There are no formal rules as to how many columns you should use. As long as it is presented well then that is fine. In this case, the subtotal for purchases less closing stock is carried over into the right hand column.

Profit and loss account

The profit and loss account can now be drawn up. This is where we use all the other balances for types of income and other expenses that are not connected directly with the buying and selling of goods.

For most firms, there will be only one or two other forms of income. In our example, the only other form of income is the entry for discounts received. This, and other forms of income would be directly added on to the gross profit. All the other expenses (known as overhead expenses) will be listed in one column, then totalled up, and then deducted from the total income for the firm to give us the overall net profit.

As before, we will have to transfer the totals form each account by closing the account down for the year. This is done below:

Insurance

2003	-	£	2003	-	£
Dec 31	Balance b/d	650	Dec 31	Profit and loss	650

Lighting and heating

2003	-	£	2003	-	£
Dec 31	Balance b/d	450	Dec 31	Profit and loss	450

General expenses

2003	-	£	2003	-	£
Dec 31	Balance b/d	120	Dec 31	Profit and loss	120

Discounts allowed

2003	-	£	2003	-	£
Dec 31	Balance b/d	130	Dec 31	Profit and loss	130

Discounts received

2003	-	£	2003	-	£
Dec 31	Profit and loss	110	Dec 31	Balance b/d	110

Although machinery was purchased during the year and is a sort of expense it should not be transferred to the profit and loss account. This is because the purchase of machinery is known as an item of capital expenditure that means that it is not 'used up' completely in this single year and therefore it would be inappropriate to transfer the value of this expense in the profit and loss account. We will see how we deal with this later in module 3.

All the other balances relate to balances on asset, capital and liability accounts. These are not to be used here as they will be used later on when we construct the balance sheet for the firm.

The full trading and profit and loss account will appear as follows:

D Ball - Trading Account for year ended 31 December 2003

-	£	£
Sales	-	6000
Less Cost of goods sold:	-	-
Purchases	4000	-
Less Closing stock	300	3700
Gross Profit	-	2300
Add Discount received	-	110
Less Expenses:	-	2410
Insurance	650	-
Lighting & heating	450	-
General expenses	120	-
Discounts allowed	130	1350
Net profit	-	1060

Note that it is common to refer to the trading and profit and loss account as just the profit and loss account. This may be confusing initially but you will soon get used to the idea.

To summarise:
Gross profit = Sales - cost of goods sold
Net profit = Gross profit - expenses

Opening stock

So far, we have looked at a firm that has only recently begun trading. If a firm has been trading for more than one accounting period then it is likely to have stock that remains unsold from an earlier period. This stock is referred to as opening stock.

Opening stock is available for use and for resale, therefore we should add this on first when calculating he cost of goods sold. Opening stock, the stock in business sat the start of the current accounting period will be in the trial balance as a debit entry. Closing stock, however, is always outside the trial balance.

Stock in the trial balance

Opening stock	Debit entry
Closing stock	As a note to trial balance

Carriage

Carriage refers to the costs of transporting goods to and from the firm. In most cases, the cost of transporting goods to the customers will be paid for by the customers, but on some occasions this will also be paid for by our firm. The terms used to refer to these types of transport and distribution costs are as follows:

Carriage inwards	Cost of transporting goods form the suppliers (in)to the firm
Carriage outwards	Costs of transporting goods (out) of the firm to the customers

Each type of carriage will be an expense and therefore will have a debit balance in the trial balance.

However, these will appear in different sections of the trading and profit and loss account.

Carriage inwards is connected with the cost of getting goods into the firm and ready for sale. As a result, it will be added on in the calculation for the cost of goods sold. Carriage outwards does not have anything to do with the cost of getting goods into saleable condition. Therefore it will appear with all the other overhead expenses and the profit and loss account.

Carriage inwards	Trading account expense
Carriage outwards	Profit & loss account expense

Returns

You may remember that earlier in the section on double-entry bookkeeping (1.1.1) we dealt with the idea that goods purchased and sold could be returned to wherever they originated. Sales could be returned back to us as returns inwards and purchases could be returned by us to the original supplier as returns outwards.

In this case, we should make adjustments in the trading account by adjusting the purchases and sales figures for these deductions.

Returns inwards	Debit balance	Deduct from sales
Returns outwards	Credit balance	Deduct from purchases

When adjusting the cost of goods sold for returns inwards and carriage inwards, there is no exact rule on which one should be adjusted first. The best advice is to decide on one method and stick to it - this way it will help you memorise it earlier.

Carriage outwards would appear as a normal expense in the profit and loss section

You must always be careful when drawing up a trading account. Questions may include some or all of the above adjustments. For example, returns inwards may appear without returns outwards. You should not write down an entry for each adjustment until you have verified that it will be included.