Accounting Flow Of Purchasing And The Accounts It Hits Trading and Profit and Loss Account

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Trading and Profit and Loss Account

Trading account

As already discussed, the first section of Trading and Profit and Loss Account is called Trading Account. The purpose of creating a trading account is to find out the gross profit or gross loss while the second section is to find out the net profit or net loss.

Creating a trading account

A merchant account is mainly created to know the profit of goods bought (or manufactured) by a businessman. The difference between the selling price and the cost of goods sold is the merchant’s revenue. In order to calculate gross income in this way, it is necessary to know:

(a) Cost of goods sold.

(b) Sale.

Total sales can be determined from sales ledger. However, cost of goods sold is calculated. To calculate the selling price it is necessary to know its meaning. ‘Cost of goods’ includes the purchase price of the goods and the costs associated with purchasing the goods and bringing the goods to the place of business. To calculate the cost of goods ” we have to subtract the cost of goods from the total cost of goods purchased. We can study this phenomenon with the help of the following formula:

Opening Stock + Buying Price – Closing Stock = Selling Price

As already discussed the purpose of creating a trading account is to calculate the total profit of the business. It can be described as more of ‘sale’ amount than ‘sale price’. This definition can be explained in terms of the following equation:

Gross Profit = Cost of Goods Sold or (Sales + Closing Stock) – (Opening Stock + Purchases + Direct Costs)

Opening stock and purchases along with purchase and carrying costs (direct costs) 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 as gross profit on the debit side 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 the total loss which is recorded on the credit side and finally the profit and loss is shown on the debit side of the account.

Common items in a trading account:

a) Debit side

1. Opening stock. This is the unsold stock at the end of the previous year. It must have been brought into the books with the help of an opening entry; So it always appears in the trial balance. Usually, it is shown as the first item on the debit side of the trading account. Of course, there will be no opening stock in the first year of business.

2. Purchase. This is usually the second item on the debit side of the trading account. ‘Purchase’ means total purchase i.e. cash plus credit purchase. Any return (purchase return) must be deducted from the purchase to find the net purchase. Sometimes the goods are received from the supplier before the corresponding invoice. In such a case, an entry should be passed to debit the purchases account and credit the suppliers account with the cost of goods on the date of preparation of final accounts.

3. Purchase costs. All expenses related to the purchase of goods are also debited to the trading account. These include- Wages, Freight, Duty, Clearing Charges, Dock Charges, Excise Duty, Zakat and Import Duty etc.

4. Cost of production. Such expenditure is incurred by businessmen to produce or present goods in salable condition eg, motive power, gas fuel, stores, royalties, factory expenses, salaries of foremen and supervisors etc.

Although production costs must be taken strictly in the manufacturing account as we are only creating a trading account, these types of costs can also be included in the trading account.

(b) Credit Side

1. Sale. Sales means gross sales i.e. cash plus credit sales. If there are any sales returns, they should be deducted from the sales. Hence the net sales are credited to the trading account. If the firm’s assets are sold, they should not be included in the sale.

2. Closing stock. It is the value of unsold stock in a warehouse or store at the end of the accounting period. Normally the closing stock is shown on the credit side of the trading account in case it is issued outside the trial balance. But if it is given in the trial balance, it will not be shown on the credit side of the trading account but only appears as an asset in the balance sheet. Closing stock value or market price whichever is lower should be valued.

Valuation of closing stock

Determining the value of closing stock requires a complete inventory of all items owned by God. Stock lists are prepared based on physical observation and total stock value is calculated based on unit value. Thus, it is clear that stock-taking involves (i) inventorying, (ii) pricing. Each commodity is priced until the market price falls. It is easier to determine the cost of inventory at cost if the price remains fixed. But prices keep fluctuating; Stocks are therefore valued based on one of several valuation methods.

Preparing a trading account helps to know the relationship between the expenses incurred by the business and the revenue earned and the level of efficiency. The ratio of sales to gross profit is very significant: it reaches:

Gross Profit X 100 / Sales

With the help of GP ratio one can check how efficiently he is running the business the higher the ratio the better the efficiency.

Closing entries related to trading account

To transfer various accounts relating to goods and purchase expenses, the following closing entries are recorded:

(i) For Stock Opening: Debit Trading Account and Credit Stock Account

(ii) For Purchases: Debit Trading Account and Credit Purchase Account, amounting to Et after deducting Purchase Returns.

(iii) For Purchase Returns: Debit Purchase Returns Account and Credit Purchase Account.

(iv) For Inward Returns: Debit Sales Account and Credit Sales Returns Account

(v) For Direct Expenditure: Debit Trading Account and Credit Direct Expenditure Account individually.

(vi) For Sales: Debit Sales Account and Credit Trading Account. We will find that all accounts will be closed except the trading account as mentioned above

(vii) For closing stock: Debit closing stock account and credit trading account After recording the above entries the trading account will be balanced and the difference between the two sides will be determined. If the credit side is higher, the result is gross profit for which the following entry is recorded.

(viii) For Gross Profit: Debit Trading Account and Credit Profit and Loss Account If the result is Gross Loss then the above entry is reversed.

Profit and Loss Account

A profit and loss account is opened by recording the total profit (credit side) or total loss (debit side).

In order to make a net profit, a businessman has to incur many expenses other than direct expenses. Those costs are subtracted from the profit (or added to the total loss), resulting in a net profit or net loss figure.

The expenses recorded in the profit and loss account are ill ‘indirect expenses’. They can be classified as follows:

Selling and distribution expenses.

This includes the following costs:

(a) Salary and Commission of Salesman

(b) Commission to Agents

(c) Freight and Transportation on Sale

(d) Sales Tax

(e) Bad debt

(f) Advertising

(g) Packing costs

(h) Export Duties

Administrative expenses.

It includes:

(a) Office Salaries and Wages

(b) Insurance

(c) Legal Expenses

(d) Trade Expenses

(e) Rates and Taxes

(f) Audit Fees

(g) Insurance

(h) Rent

(i) Printing and Stationery

(j) Postage and telegrams

(k) Bank Charges

financial costs

This includes:

(a) Discount allowed

(b) Interest on capital

(c) Interest on Loans

(d) Discount on bill discount charges

Maintenance, Depreciation and Provisions etc.

This includes the following expenses:

(a) Amendment

(b) Depreciation on assets

(c) Provision or reserve for doubtful debts

(d) Reserve for relief on debtors.

Along with the above indirect expenses, the debit side of the profit and loss account also includes various business losses.

The items recorded on the credit side of the profit and loss account are:

(a) Exempted

(b) Commission received

(c) Rent received

(d) Interest received

(e) Investment income

(f) Gain on sale of property

(g) Recovered bad debts

(h) Dividend received

(i) Apprenticeship premium etc.

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