In this article, you will learn the preparation of financial statement- Trading account, profit and loss account, and balance sheet. Here, we also discuss the need and importance of these statements. Further, you will come to know which items are included in which side of the account.
According to J.R. Batliboi, “The trading account shows the results of buying and selling of good. In preparing this account, the general establishment charges are ignored and only the transactions in goods included.”
‘Gross Profit’ is nothing but the excess of sales and closing stock over the opening stock, purchases and direct expenses, whereas ‘Gross Loss’ is the excess of opening stock, purchases and direct expenses over sales and closing stock. It is calculated in trading account.
Need and Importance of Trading Account
Here, you know the importance of this account. Some of them are as follows:
1. It provides information about Gross Profit and Gross Loss
It informs of the gross profit or gross loss as a result of buying and selling the goods during the year. The percentage of Current Year’s gross profit on the amount of sales can be calculated and compared with those of the previous years. Thus, it provides data for comparison, analysis and planning for a future period. It provides information about gross profit and gross loss that helps in preparation of financial statements.
2. It provides information about the direct expenses
All the expenses incurred on the purchase and manufacturing of goods are recorded in the trading account in a summarized form. Percentage of such expenses on sales can be calculated and compared with those of the previous years. In this way, it enables the management to control and rationalize the expenses.
3. Comparison of closing stock with those of the previous years
Closing stock has to be valued and recorded. This stock can be compared with the closing stock of the previous years and if the stock shows an increasing trend, the reasons may be inquired into.
4. It provides safety against possible losses
If the ratio of gross profit has decrease in comparison to the preceding year, the businessman can take effective measures to safeguard himself against future losses. For example, he may increase the sale price of his goods or may proceed to analyze and control the direct expenses.
Preparation of Trading Account
It Account is a Nominal Account and all expenses which relate to either purchase or manufacturing of goods are written on the Dr. side of this account. It helps in better preparation of financial statements.
Items written on the Dr. side of the Trading Account
Items that are shown in on debit side of the account are as:
1. Opening Stock
The stock of goods remaining unsold at the end of the previous year is termed as the opening stock of the current year. In other words, the closing stock of the last year becomes the opening stock of the current year. Opening Stock will include the following:
I. Opening Stock of Raw Material,
II. Opening Stock of Semi-finished goods
III. Opening Stock of Finished goods.
2. Purchases and Purchases Returns
Goods which have been bought for resale are termed as Purchases and goods which are returned to suppliers are termed as purchase returns or returns outwards. Purchase Account will be given on the debit side of the trial balance and Purchase Return Account on the credit side of the trial balance. Purchase returns will be shown as a deduction from Purchases on the debit side of the account. Purchases include cash as well as credit purchases.
3. Direct Expenses
All expenses incurred in purchasing the goods, bringing them to the go down and manufacture of goods are called direct expenses. Direct expenses include the following:
(I) Wages :- Wages are paid to workers who are directly engaged in the loading, unloading and production of goods and as such are debited to the trading account.
(i)If the item ‘Wages and Salaries’ is given in the question it will be shown on the trading account. On the contrary, if ‘Salaries and Wages’ is given it will be shown on the Profit & Loss Account.
(ii) If wages are paid for bringing a new machine or for its installation it will be added to the cost of the machine and hence will not be shown in the trading account.
(2) Carriage or Carriage Inwards or Freight :- These expenses should be debited to the account because these are generally paid for bringing the goods to the factory or place of the business. However, if any carriage or freight is paid on bringing an asset, the amount should be added to the asset account and must not be debited to trading account.
(3) Manufacturing Expenses :- All expenses incurred in the manufacture of goods are shown on the debit side of the trading account such as Coal, Gas, Fuel, Water, Power, Factory Rent, Factory Lighting etc.
(4) Dock Charges :- These are the charges levied on ships and their cargo while entering or leaving docks. If dock charges are paid on import of goods they are shown on the debit side of Trading Account. In the absence of specific instructions, these are debited to Trading Account.
(5) Import Duty or Custom Duty :- Custom duty is paid on import as well as on export of goods. Custom absence duty of when specific paid instructions, on the purchase these of are goods debited to trading account.
(6) Octroi :- This is levied by the municipal committee when the goods enter the city and hence debited to trading account.
(7) Royalty :- this is the amount paid to the owner of a mine patent for using his right or patent. Royalty is usually charged to trading account because it increases the cost of production.
Items written on the Cr. side of the Trading Account
Items that are included on the credit side of the account are as:
Sales of the goods, an organization deals with (whether cash or credit), is shown on the credit side of the trading account. Sales of assets/items, the organization does not deal with, are not included under sales. It is a part of trading account.
2. Sales Returns
‘Sales Returns’ or the ‘Returns Inwards’ include the goods supplied earlier to the customers and subsequently returned by them. The amount of the goods sold returned is deducted from the sales figure. Sales returned account has a debit balance.
3. Closing Stock
The stock of goods remained unsold at the year-end is termed as ‘Closing Stock’. The amount of such stock appears on the credit side of the trading account. Closing stock is not a part of ledger and is out of purview of the trial balance. Generally, the figure of the closing stock is given separately in trading account.
Profit and Loss Account
A financial statement that lists the revenues, expenditures, and expenses incurred over a given time period is called a profit and loss (P&L) statement. The profit and loss account, which is a component of a company’s financial statements, reveals whether the business has made money or not.
It provides a summary of a company’s trade results over a period of time (usually one year), including both income and expenses. It is an important part in preparation of financial statements.
According to Prof. Carter:- “A Profit and Loss Account is an account into which all gains and losses are collected, in order to ascertain the excess of gains over the losses or vice-versa”.
Need and Importance of Profit and Loss Account
The need and importance of this account are as follows:
1. To ascertain the Net Profit or Net Loss
A Trading Account only discloses the Gross Profit earned as a result of trading activities, whereas the Profit & Loss Account discloses the net profit (or net loss) available to the proprietor and credited to his capital account.
2. Comparison with previous years’ profits
The net profit of the current year can be compared with that of the previous years. It enables the businessman to know whether the business is being conducted efficiently or not. For this, preparation of financial statements should be done.
3. Control on Expenses
Preparation of profit and loss account helps in comparing various expenses with the expenses of the previous year. Also the percentage of each individual expenses to net profit is calculated and compared with the similar ratio of previous years. Such comparison will be helpful in taking concrete steps for controlling the unnecessary expenses. There is always control on expenses during preparation of financial statements.
4. Helpful in the preparation of Balance Sheet
A Balance Sheet can only be prepared after ascertaining the Net Profit.
Preparation of Profit and Loss Account
A Profit and Loss Account is started with the amount of gross profit or gross loss brought down from the Trading Account. As such, all those expenses and losses which have not been debited to the Trading Account are now debited to Profit & Loss Account. These expenses include administrative expenses, selling expenses, distribution expenses etc. These are called ‘Indirect Expenses’. Preparation of financial statements should be done carefully. Profit and Loss Account is a Nominal Account and as such, all the expenses and losses are shown on its debit side and all the incomes and gains are shown on its credit side.
Items Written on the Dr. Side of Profit and Loss Account
Items present on the debit side of the account are as:
1. Gross Loss
If trading account discloses Gross Loss, it is shown on the debit side first of all.
2. Office and Administrative Expenses
Such as salary of office employees, office rent, lighting, postage, printing, legal charges, audit fee etc.
3. Selling and Distribution Expenses
Such as advertisement charges, commission, carriage outwards, bad-debts, packing charges etc.
4. Miscellaneous Expenses
Such as interest on loan, interest on capital, repair charges, depreciation, charity etc.
Items written on the Cr. side of Profit and Loss Account
Items shown on credit side of the account are as follows:
1. Gross Profit
The starting point of the Cr. side is the gross profit brought down from the Trading Account.
2. Other Incomes and Gains
All items of incomes and gains are shown on the credit side, such as income from investments, rent received, discount received, commission earned, interest received, dividend received etc.
If the credit side of the profit and loss account exceeds that of debit side, the difference is termed as net profit. On the other hand, the excess of the debit side over the credit side is termed as net loss. Net profit is added to the capital whereas net loss is deducted from the capital in balance sheet.
After ascertaining the net profit or loss of the business enterprise, the businessman would also like to know the exact financial position of his business. For this purpose, a statement is prepared which contains all the Assets and Liabilities of the business enterprise. The statement so prepared is called a Balance Sheet because it is a sheet of balances of ledger accounts which are still open after the transfer of all nominal accounts to the Trading and Profit & Loss Account. Balances of all the personal and real accounts are grouped as assets and liabilities. Liabilities are shown on the left hand side of the Balance Sheet and Assets on the right hand side. Financial position of a company is known after the preparation of financial statements.
According to A. Palmer :-“The Balance Sheet is a statement at a particular date showing on one side the trader’s property and possessions and on the other hand the liabilities.”
According to J.R. Batliboi :-“A Balance Sheet is a statement prepared with a view to measure the exact financial position of a business on a certain fixed date.”
Need and Importance of Balance Sheet
- The main purpose of preparing a Balance Sheet is to ascertain the true financial position of the business at a particular point of time.
- It helps in ascertaining the nature and cost of various assets of the business such as the amount of Closing Stock, amount owing from Debtors, amount or fictitious assets etc.
- It helps in determining the nature and amount of various liabilities of the business.
- It gives information about the exact amount of capital at the end of the year and the addition or deduction made into it in the current year. It is shown clearly by preparation of financial statements.
- It helps in finding out whether the firm is solvent or not. The firm is solvent if the assets exceed the external liabilities. It would be insolvent if opposite is the case.
- It helps in preparing the Opening Entries at the beginning of the next year.
Characteristics of Balance Sheet
- A Balance Sheet is a part of the Final Accounts. This is the reason that the Trading and Profit and Loss Account and the Balance Sheet are together called ‘Final Accounts’. However, the Balance Sheet is a statement and not an account. It has no debit or credit side and as such the words ‘To’ and ‘By’ are not used before the names of the accounts written there in.
- A Balance Sheet is a summary of the Personal and Real Accounts, which are still open and have not been closed by transfer to the Trading and Profit & Loss Account. Debit balances of all Personal and Real Accounts are put on the right hand side known as Assets side, whereas the credit balances are put on the left hand side known as Liabilities side.
- The totals of the two sides of the Balance Sheet must be equal. If the totals are not equal, there will be an error somewhere.
- Balance Sheet is prepared on a particular date and not for a fixed period. As such, it discloses the financial position of a business on a particular date and not for a period. It is True only for the date on which it is prepared because even a single transaction would cause a change in the assets and liabilities.
- It shows the financial position of the business according to the going concern concept.
Classification of Assets
Assets that are shown on the assets side can be classified into further categories which are as follows:
1. Fixed Assets
Fixed Assets are those which are acquired for continuous use and last for many years such as Land and Building, Plant and Machinery, Motor Vehicles, Furniture etc. According to Finney and Miller :- “Fixed Assets are assets of a relatively permanent nature used in the operations of business and not intended for sale”.
2. Current Assets
Current Assets are those which are either in the form of cash or can be easily converted into cash within one year of the date of Balance Sheet. Current Assets include Cash, Bills Receivable, Short Term Investments, Debtors, Prepaid Expenses, Accrued Income, Closing Stock etc. While valuing these assets, Closing Stock is valued at cost or realizable value whichever is less and a reasonable provision for doubtful debts is deducted out of Sundry Debtors …
3. Liquid Assets
Liquid Assets are those which are either in the form of Cash or can be quickly converted into cash, such as Cash, Bills Receivable, Short Term Investments, Debtors, Accrued Income etc. In other words, if Prepaid Expenses and Closing Stock are excluded from Current Assets, the balance will be Liquid Assets.
4. Fictitious or Nominal Assets
These are the Assets which cannot be realized in Cash or no further benefit can be derived from these assets. Such assets include Debit balance of P & L A/c and the expenditure not yet written off such as Advertisement Expenses etc.
5. Wasting Assets
These are the Assets which are exhausted or consumed over a period of time such as mines and oil-wells. Their value reduces through being worked.
6. Tangible and Intangible Assets
Tangible Assets are those which have a physical existence or which can be seen and felt like Plant and Machinery, Building, Furniture, Stock, Cash etc. Intangible Assets are those which do not have any physical existence or which cannot be seen or felt such as the Goodwill, Trade Marks, Patents etc. Intangible Assets are as much valuable as Tangible Assets because they also help the firm in earning profits.
Classification of Liabilities
Liabilities can be classified into three categories.
1. Fixed or Long-term Liabilities
Those liabilities which are to be repaid after one year or more are termed as long-term liabilities. These include Public Deposits, Long-term Loans, Debentures etc.
2. Current or Short-term Liabilities
Those liabilities which are expected to be paid within one year of the date of the Balance Sheet are termed as current or short-term liabilities. These include Bank Overdraft, Creditors, Bills Payable, Outstanding expenses etc.
3. Contingent Liabilities
These are the liabilities which will become payable only on the happening of some specific event, otherwise not in balance sheet. Such as :-
i) Liabilities for bill discounted :- In case a bill discounted from the bank is dishonored by the acceptor on the due date, the firm will become liable to the bank.
ii) Liability in respect of a suit pending in a court of law :- This would become an actual liability if the suit is decided against the firm.
iii) Liability in respect of a guarantee given for another person :- The firm would become liable to pay the amount if the person for whom guarantee is given fails to meet his obligation.