Trading, profit and loss account

Meaning of trading, profit and loss account

The account through which annual net profit or loss of a business is ascertained, is called profit and loss account. Gross profit or loss of a business is ascertained through trading account and net profit is determined by deducting all indirect expenses (business operating expenses) from the gross profit through profit and loss account. Thus profit and loss account starts with the result provided by trading account.

The particulars required for the preparation of profit and loss account are available from the trial balance. Only indirect expenses and indirect revenues are considered in it. This account starts from the result of trading account (gross profit or gross loss). Gross profit is shown on the credit side of the profit and loss account and gross loss is shown on the debit side of this account. All indirect expenses are transferred on the debit side of this account and all indirect revenues on credit side.  If the total of the credit side exceeds the debit side, the result is “net profit” and if the total of the debit side exceeds the total of the credit side, the result is net loss.

Purpose of trading, profit and loss account

The purpose of the profit and loss account is to:

• Show whether a business has made a PROFIT or LOSS over a financial year.
• Describe how the profit or loss arose – e.g. categorising costs between “cost of sales” and operating costs.

A profit and loss account starts with the TRADING ACCOUNT and then takes into account all the other expenses associated with the business.

Trading account

The trading account shows the income from sales and the direct costs of making those sales. It includes the balance of stocks at the start and end of the year.

An example of the trading account of a business would look this:

Trading account for XYZ Ltd for the year ended 31 March 20X5:

Note that the closing stock figure would appear in the balance sheet under Stock.

Profit and loss account

The trading account now has all the other expenses now deducted.

It would look like the table below:

Trading, profit and loss account for XYZ Ltd for the year ended 31 March 20X5

Notes on the items in the profit and loss account:

Sales: the amount of money generated by sales

Cost of sales: the cost of making the goods or buying them

Gross profit: sales less direct costs of sales

Overheads and expenses: Costs not directly involved in the production process (indirect costs)

e.g.

Cost of premises e.g. rent, insurance, repairs

Office costs e.g. stationery, postage, computer maintenance, staff salaries and wages

Sales and marketing costs e.g. salaries of salesmen, advertising

Finance costs e.g. bank charges, interest on bank loans

Rules for constructing profit and loss account

1. Debit any temporary revenue accounts by the full amount of money in the account. Credit “Income Summary” by the total amount of all the revenue accounts. This closes out all the profit accounts.
2. Debit “Income Summary” by the total amount of all the expense accounts. Credit any temporary expense accounts by the full amount of money in the account. This closes out all the expense accounts.
3. Debit “Unrealized Loss on Trading Securities” and credit the “Trading Securities” account if the market value of the trading security decreased. For example, if a company owns 100 shares of stock that decreased in value by $5 a share, then debit “Unrealized Loss on Trading Securities” by $500 and credit the “Trading Securities” account by $500.
4. Debit the “Trading Securities” account and credit “Unrealized Gain on Trading Securities” if the market value of the trading security increased. For example, if a company owns 100 shares of stock that increased in value by $5 a share, then debit the “Trading Securities” account by $500 and credit “Unrealized Gain on Trading Securities” by $500.

Assessment

• Briefly define Trading and profit and loss account
• State the rules for constructing profit and loss account