After studying this unit, you will be able to:-
1.1 INTRODUCTION:- Non-manufacturing entities are the trading entities, which are engaged in the purchase and sale of goods at profit without changing the form of the goods. In other words, non-manufacturing entities do not process the goods purchased and sell them in its original form. Meanwhile it indulges in some liabilities, makes some assets and also incurs some expenses like salaries, stationery expenses, advertisement, rent etc. to run the business. At the end of the accounting year, the entity must be interested in knowing the results of the business. To ascertain the final outcome of the business i.e., the income and financial position, they prepare financial statements at the end of the year.
Financial Statements are the systematically organized summary of all the ledger account heads presented in such a manner that it gives detailed information about the financial position and the performance of the enterprise. As seen above, through categorization of Financial Statements into Income & Position Statement, the profit is measured at two levels:
(a) Gross Profit
(b) Net Profit
The profit of the enterprise is obtained through the preparation of Income Statement i.e Trading and Profit & Loss A/c.
The financial position of the business enterprise is judged by measuring the assets, liabilities and capital of the enterprise and the same is communicated to the users of financial statements. Financial position of the enterprise can be known through the preparation of the Position Statement i.e Balance Sheet.
Comparison between Income Statement and Position Statement
|Income Statement||Position statement|
|Profit or loss is disclosed in the Income Statement prepared at the close of the financial year||It exhibits assets and liabilities of the business as at the close of the financial year.|
|Income Statement is sub-divided into following two parts for a non-manufacturing concern:|
(i) Trading account; and
(ii) Profit and Loss account
|Apart from balance sheet, to judge financial position of the business, sometimes additional statements are also prepared like cash flow statement, value added statement etc. which is not mandatory for noncorporate entities. These additional statements are prepared for the better understanding of the financial position of the business.|
|Income Statement discloses net profit of the business after adjusting from the income earned during the year, all the expenditures of the business incurred in that year.||Position statement discloses the assets and liabilities position as on a particular date.|
1.2 PREPARATION OF FINAL ACCOUNTS:- The principal function of final accounts (Trading Account, Profit and Loss Account and the Balance Sheet) is to exhibit truly and fairly the profitability and the financial position of the business to which they relate. In order that these may be properly drawn up, it is essential that a proper record of transactions entered into by the business during a particular accounting period should be maintained. The BASIC PRINCIPLES in regard to accumulation of accounting period data are:
(i) a distinction should be made between capital and revenue receipts and payments;
(ii) also income and expenses relating to a period of account should be separated from those of another period.
(iii) different items of income and expenditure should be accumulated under significant heads so as to disclose the sources from which capital has been procured and the nature of liabilities, which are outstanding for payment.
Having regard to these basic principles, the various matters to which attention should be paid for determining the different aspects of transactions, a record of which should be kept, and the different heads of account under which various items of income and expenditure should be accumulated, are stated below:
(a) Distinction between personal and business income:- Since the final statements of account are intended to show the profitability of the business and not that of its proprietors, it is essential that all personal income and expenditure should be separated from business income and expenditure.
(b) Distinction between capital and revenue expenditure:- A distinction should be made between capital and revenue, both receipts and expenditure. Different types of income and expenditure should be classified under separate heads. Assets should be included in the Balance Sheet by following accounting principles and accounting standards. Likewise, a provision for income and expenses which have accrued but not paid, should be made by estimation or otherwise on the same basis as in the previous year.
(c) All material information to be disclosed:- Every information, considered material for judging the profitability of the business or its financial position, should be disclosed. For example, when the labour charges have increased on account of bonus having been paid to workmen, the amount of bonus paid should be disclosed. Similarly, if some of the items of inventory are not readily saleable, these should be valued at their approximate net realisable value and the basis of valuation and value of such inventory should be shown separately.
(d) Record only current period transactions:- Though the record of transactions should be maintained continuously, at the end of each accounting period, the transactions of the closing accounting period should be cut off from those of the succeeding period.
(e) Only transactions completed before close of accounts should be given effect:- It should be seen that only the effect of transactions, which were concluded before the close of period of account, has been adjusted in the accounts of the year. For example, when a sale of goods is to take place only after the goods have been inspected by the purchaser and the inspection had not been made before the close of the year, it would be incorrect to treat the goods as a sale in the accounts of the year.
Inter-relationship of the two statements:- One of the points to be remembered is that of total expenditure incurred some type of expenditure appears in the Profit and Loss Account and some in the Balance Sheet. Consider few examples,
1. Salaries paid is shown on the Dr. side of Profit and Loss Account but outstanding salaries is shown on liabilities side of Balance Sheet and is added to Salaries.
2. When a machine is purchased, that part of it which is attributable to the year considered as depreciation is debited to the Profit and Loss Account and the balance is shown in the Balance Sheet as an asset.
Profit & Loss A/c
These illustrations show that the two statements, the Profit and Loss Account and the Balance Sheet, are thoroughly inter-related. The assets shown in the Balance Sheet are mostly only the remainder of the expenditure incurred after a suitable amount has been charged to the Profit and Loss Account or the Trading Account. For preparing the two statements properly, it is of the greatest importance that the amounts to be charged to the Profit and Loss Account should be properly determined as otherwise both statements will show an incorrect position. The principle that governs this is called the Matching Principle.
Matching Principle:- This principle demands that expenses incurred to earn the revenue should be properly matched. This means the following:
(a) If a certain revenue and income is entered in the Trading / Profit and Loss Account all the expenses relating to it, whether or not payment has been actually made, should be debited to the Trading / Profit and Loss Account. This is why at the end of the year an entry is passed to bring into account the outstanding expenses. That is also the reason why the opening inventory of goods is debited to the Trading Account since the relevant sale is credited in the same account.
(b) If some expense has been incurred but against it sale will take place in the next year or income will be received next year, the expense should not be debited to the current year’s Profit and Loss Account but should be carried forward as an asset and shown in the Balance Sheet. It will be debited to the Profit and Loss Account only when the relevant income will also be credited. The same reason applies to depreciation of assets also. The part of the cost which is used to earn current year revenue is debited in same year.
(c) If an income or revenue is received in the current year but the work against it has to be done and the cost in respect of it has to be incurred next year, i.e. income received in advance the income or the revenue is considered to be of next year. It should be shown in the Balance Sheet on the liabilities side as “income received in advance” and should be credited to the Profit and Loss Account of the next year. E.g. Newspapers or magazines usually receive subscriptions in advance for a year. The part of subscription that covers copies to be supplied in the next year is treated as income received in advance.
An exception:- There appears to be one exception to the rule that only such costs as have yielded or is expected to yield revenue should only be debited to Profit and Loss Account. For example, if a fire has occurred and has damaged the firm’s property the loss must be debited to the Profit and Loss Account to the extent it is not covered by insurance. A loss, resulting from the fall of selling price below the cost or from some debts turning bad, must similarly be debited to the Profit and Loss Account. If this is not done the profit will be over-stated.
(NOTE:- The relevant entries and adjustments regarding the above three items are discussed in detail later in this unit.)
1.3 TRADING ACCOUNT:- At the end of the year, as has been seen above, it is necessary to ascertain the net profit or the net loss. For this purpose, it is first necessary to know the gross profit or gross loss. Gross Profit is the difference between the selling price and the cost of the goods sold. For a trading firm, the cost of goods sold can be ascertained by adjusting the cost of goods still on hand at the end of the year against the purchases. It is done as follow:-
Suppose, in the first year, the net purchases (that is after deducting returns) total ₹1,00,000 and that ₹15,000 worth of goods (at cost) were not sold at the end of the year. The cost of the goods sold will then be ₹85,000. If in the next year purchases are ₹1,50,000 and the cost of goods sold is ₹1,45,000 the closing stock will be ₹20,000 calculated as follows:
Gross profit is usually ascertained by preparing a Trading account. The format of Trading Account can be shown as below:-
To Gross Profit c/d*
*Only one will appear
If in the above example net sales, i.e., after adjustment for sales returns, is ₹2,00,000 then the gross profit will be ₹55,000, i.e., ₹2,00,000 – ₹1,45,000. This profit is called gross profit since from it indirect expenses have still to be deducted for knowing the net profit. Now, for the same example Trading account will appear as follows:-
Trading Account for the year ending
Points to Remember:-
Trading Account Items:- In a trading firm like a wholesaler, the main business consists of buying and selling the same goods. In addition to the amount of the opening inventory, the trading account will also be debited with all expenses incurred in bringing the goods to the godown of the firm and in making them ready for sale.
For example, freight paid on purchases, cartage, octroi, etc. will all be debited to the Trading Account. The rule is that this account will be debited with all expenses incurred in bringing the goods to their present location and condition.
We shall now consider individual items:
(1) Opening Inventory: Since this was closing inventory of the last year, it must have been entered in the opening inventory account, through the opening entry. Therefore, it will be found in the trial balance. This item is usually put as the first item on the debit side of the Trading Account. Of course, in the first year of a business there will be no opening inventory.
Trading A/c Dr.
To Opening Stock A/c
(2) Purchases and Purchase Returns: The purchases account will have debit balance, showing the gross amount of purchases made of the materials. The purchase returns account will have credit balance showing the return of materials to the supplier. On the debit side of the trading account the net amount is shown as indicated (with assumed figures):
It happens sometimes that goods are received but the relevant invoice is not received from the supplier. On the date of the closing of the account, an entry must be passed to debit the purchases account and credit the supplier with the cost of goods.
(3) Carriage or Freight Inwards/Freight: This item should also be debited to the Trading Account, as it is incurred to bring the materials to the firm’s godown and make them available for use. However, if any freight or cartage is paid on any asset, like machinery, it should be added to the cost of the asset and not debited to the Trading Account.
(4) Wages: Wages paid to workers in the godown/stores, should be debited to the Trading Account. If any amount is outstanding, it must be brought into books so that full wages for the period concerned are charged to the Trading Account. However, if wages are paid for installation of a fixed asset, it should be added to the cost of the asset.
(5) Sales and Sales Returns: The sales account will have a credit balance indicating the total sales made during the year. The sales return account will have a debit balance, showing the total amount of goods returned by customer The net of the two amounts is entered on the credit side of the Trading Account.
Sometimes, goods are sold on approval basis that is when the the customer has the right to return the goods with in stipulated period in that case the sale entry should be reversed. It is discussed later in detail.
(6) Closing Inventory and its valuation: Usually there is no account to show the value of goods lying in the godown at the end of the year. However, to correctly ascertain the gross profit, the closing Inventories must be properly taken and valued.
The effect of this entry is to reduce the debit in the Purchases Account. The closing inventory is also shown in balance sheet on Assets side.
If Closing Stock appears in the Trial balance:-
The closing inventory is then not entered in the trading account, it is shown only in the balance sheet. This is because it has already been adjusted to arrive at Cost of Goods Sold.
To ascertain value of the closing inventory, it is necessary to make a complete inventory or list of all the items in the godown together with quantities. Of course, damaged or obsolete items are separately listed. To the list of finished goods, one should also add the goods lying with agents sent to them on consignment basis and also the goods sent on approval to customer .
The valuation principle is cost or net realisable value whichever is lower.
Taking inventory is quite a lengthy process. Strictly, immediately at the end of the year the taking of inventory should be completed. Sometimes, however this is done either a few weeks before or a few weeks after the closing. In such a case the value of the inventory thus taken must be adjusted to relate it to the closing date. The adjustment will be necessary because, in the meantime, purchases and sales must have been made. The main point to remember is that in respect of sales their cost has been established. Cost will be sales less gross profit.
ILLUSTRATION 1:- Trial Balance for financial the year (FY) ended 31st March 2017 of M/s Deepakshi shows following details:
Additional Information: Creditors balance as on 1st April, 2016 is ₹3,00,000.
You are required to calculate cost of goods sold and amount paid to creditors during the year.
i) Calculation of Cost of Goods sold:-
So, we can see purchases have already been reduced by the amount of unsold stock, therefore no more adjustment needs to be made on account of closing stock for computing Cost of goods sold (COGS).
ii) Calculation of amount paid to creditors:-
Note: 1) Purchases made during the year can be computed as:
Students may note that in case Closing Stock is not mentioned in Trial Balance, then it means Opening Stock and Purchases appearing in Trial Balance include the value of unsold stock. Since, we prepare our financial statements using matching concept such unsold stock should not form part of cost and therefore is deducted. Therefore, in this case to compute Cost of goods sold (COGS) we will have to use:
COGS= Opening Stock + Purchases - Closing Stock - Purchase Returns
CLOSING ENTRIES IN RESPECT OF TRADING ACCOUNT:-
The following entries will be required:
(i) For opening Inventory: Debit Trading Account and Credit inventory Account.
(ii) For purchases returns: Debit Returns Outward Account and Credit Purchases Account. For returns inward: Debit Sales Account and Credit Returns Inwards Account. (In the trading account information is usually given both in respect of gross sales; and purchases and the respective returns).
(iii) For purchases account: Debit Trading Account and Credit Purchases Account, the amount being the net amount after return.
(iv) For expenses to be debited to the Trading Account, for example wages etc. Debit Trading Account and credit the concerned expenses accounts individually.
(v) For sales: Debit Sales Account with the net amount after returns, and Credit Trading Account. The student will see that all the accounts mentioned above will be closed except for the Trading Account.
(vi) For closing Inventory: Debit Inventory Account and Credit Trading Account. The inventory Account will be carried forward to the next year.
Except entries mentioned in (ii) above, the other entries are usually summarised as follows:
At this stage Trading Account will reveal the gross profit, if the credit side is more, or gross loss if the credit side is less. The gross profit will be transferred to the Profit and Loss Account by the entry:
Required:- From the above information, prepare a Trading Account of M/s. ABC Traders for the year ended 31st March, 2017 and Pass necessary closing entries in the journal proper of M/s. ABC Traders
In the books of M/s. ABC Traders Trading Account for the year ended 31st March, 2016
Journal Proper in the Books of M/s. ABC Traders
1.4 PROFIT AND LOSS ACCOUNT:- The Profit and Loss Account starts with gross profit on the credit side. If there is gross loss, it will be written on the debit side. After that all those expenses and losses, which have not been entered in the Trading Account, will be written on the debit side of Profit and Loss Account. Incomes and gains, other than sales, will be written on the credit side. If we understand word ‘expenses’ properly, there should be no diffculty in distinguishing between items that will be debited to the Profit and Loss Account and those that will be shown as Assets in the balance sheet. Further, it may be noted that the expenses which are personal in nature will not be charged to Profit and Loss A/c. Only those revenue expenses and losses which are related to the current year, are debited to Profit and Loss Account.
It is desirable, according to modern thinking that the Profit and Loss Account should be prepared in such a manner as will enable the reader to form a correct idea about the profit earned or loss suffered by the from during the period together with the significant factor. Too many details will prevent a person from knowing properly the factors leading to the profit earned. Therefore, items should be according to the various functions, such as administrations, selling and financing. The profit/loss A/c appears as follows:-
Note:- (i) Gross loss appears in the debit side of the Profit and Loss Account at the top; while Gross Profit on the credit side.
(ii) Net loss appears in the credit side of the Profit and Loss Account; while Net profit on debit side as balancing figures.
It will be good idea to either show these expenses in a separate schedule or to indicate the total of these prominently in the Profit and Loss Account. This rule should be followed wherever the number of items is rather large.
On the income side of the Profit and Loss Account, besides the gross profit, there may be interest received, discount received, rent from subletting of premises, miscellaneous incomes such as from sale of junk material etc., It would be desirable to show the totals only under each of the main categories of income. However, interest on fixed deposits, interests or income from investments and other interest should be shown separately. Similarly, items which have to be debited/credited to the proprietor should be segregated from other items. Examples would be interest charged on drawings, interest allowed on capital and charges for services rendered by the firm to the proprietor personally.
We shall now consider a few items individually:
(i) Drawings: Drawings are not expenses for the firm but reduction of capital and therefore should not be debited to the Profit and Loss Account but to Capital account of the proprietor.
If the proprietor has enjoyed some benefit personally, like use of the firm’s car, a suitable amount should be treated as drawing and to that extent the charge to the Profit and Loss Account will be reduced, Drawings are debited to the proprietor’s capital account.
(ii) Income Tax: In case of companies, the income tax payable is treated like other expenses. But in the case of sole proprietorship, income tax is treated as a personal expense. It is debited to the Capital Account and not to the Profit and Loss Account.
This is because the amount of the tax will depend on the total income of the partners or proprietor besides the profit of the firm. In case of partnership business, firm’s tax liability is to be debited to profit and loss account of the firm but partners’ tax liability are not to be borne by the firm. Therefore if the firm pays income tax on behalf of partners, such payment of personal income tax should be treated as drawings.
(iii) Discount received and allowed: We have already seen that discount is of two types. Trade discount and Cash discount. Trade discount is allowed when the order for goods is not below a certain figure. It is deducted from the invoice. Only the net amount of invoice is entered in books. There is no further treatment of the trade discount. Cash discount is allowed to a customer if he makes the payment before a certain date. It is allowance made to him for prompt payment and is recorded in the books. Therefore, Trade discount is not debited to P/L account, but cash discount is.
Discount received is really in the nature of interest received and similarly, discount allowed really means interest paid. Discount received is a gain and is credited to the Profit and Loss Account while discount allowed is debited.
(iv) Rebate: It is the allowance given to a customer when his purchases during a period, say one year, total upto a certain figure. Suppose a firm allows a rebate of 4% to those customers whose purchases during the year are at least ₹5,000. One Customer’s purchases are ₹4,500, he will not get any rebate. Another customer’s purchases total ₹5,100, he will get a rebate of ₹204. The entry for rebate is made only at the end of the year. The Rebate Account is debited and is later written in the profit and Loss Account on the debit side. Various customers who have earned the rebate are credited.
(iv) Bad Debts: When a customer does not pay the amount due from him and all hopes of recovering the amount are lost, it is said to be a bad debt. It is a loss to the firm. Therefore, the bad debts account is debited, which is later on written in the Profit and Loss Account on the debit side. Since it is no use showing the amount due still as an asset, the account of the customer concerned is closed by being credited. The entry
In case of Provision for Bad debts has already been prepared then bad debts should be written off first from it. Entry for it will be:
If later on, the amount is recovered, it should be treated as a gain. It should not be credited to the party paying it. It should be credited to Bad Debts Recovered Account. It will be entered in the Profit and Loss Account on the credit side.