CHAPTER 05 TRADING AND PROFIT AND LOSS ACCOUNT- BALANCE SHEET

MOST students will already have familiarized themselves to a greater or lesser degree with the nature of the items appearing in the Trading and Profit and Loss Account and the Balance Sheet. The following pages are devoted to the principles and difficulties of this topic: problems of an advanced nature will be dealt with as they arise in connection with Partnerships and Limited Companies in the chapters on those subjects.

DEFINITIONS

Gross Profit and Gross Loss. Gross profit is the excess of the sales (less returns) over the cost of the goods sold including the expenses directly attributable to putting the goods in a saleable condition. The cost of the goods sold is the amount of the opening stock plus purchases (less returns), less the amount of the closing stock-not merely the amount of goods purchased. A gross loss is the converse of a gross profit:

Net Profit and Net Loss. Net profit is the surplus remaining after charging against gross profit all the expenses, including depreciation and other necessary provisions, properly attributable to the normal activities of the particular business. A net loss is the converse of a net profit.

FUNCTIONS OF THE FINAL ACCOUNTS'

The final accounts consist of (a) Trading Account, (b) Profit and Loss Account, (c) Profit and Loss Appropriation Account and (d) Balance Sheet.

The aim of the Trading Account is to ascertain the gross profit or gross loss for a certain period, that of the Profit and Loss Account is to ascertain the net profit or net loss for the same period. The traditional two-sided form of Trading and Profit and Loss Account is nowadays largely being replaced by the vertical or columnar form. It is considered generally that the vertical or columnar form of presentation of such accounts is under- stood more readily by the persons for whom they are primarily intended, viz. business persons in the case of sole traders and partnerships, and shareholders in the case of limited companies. Such persons can under- stand accounts more easily when balances or figures are arrived at by means of comprehensibly narrated additions and subtractions than they can when balances are carried down from one side of an account to the other, and debits and credits are shown with little indication of the reasons.

In this chapter the vertical or columnar form, and in some instances the two-sided form, will be used unless the Trading and Profit and Loss For the present, attention is confined to Trading and Profit and Loss Accounts, so that all references to other methods of showing business activities, eg. Manufacturing Accounts, are excluded Accounts are shown as they would appear in the ledger, in which case the The aim of the Profit and Loss Appropriation Account is to show all dispositions, divisions and appropriations of the net profit. Thus, whereas all expenses incurred in the gaining of the net profit, such as loan interest, depreciation, rent, ratės, wages and the like, are chargeable to the Profit and Loss Account, the Appropriation Account will be debited with such items as Manager's commission (where intended to be a division of profits), interest on capital of a partner, dividends to shareholders of a limited company, etc. Similarly all income properly attributable to the ordinary business activ ities will be credited to the Profit and Loss Ac count, and not to the Appropriation Account. normal debit and credit form will be used.

The vital distinction between the Profit and Loss Account and the Appropriation Account is particularly applicable to the accounts of limited companies and the topic receives attention in Chapter 23.

The Appropriation Account is not usually used in the accounts of a sole trader, non-business expenses, such as drawings, being debited direct to Capital Account, or, where it is desired to keep the capital figure intact, to a Current Account to which also the net profit is credited. The aim of the Balance Sheet is to show in summary form the financial state of the concern as disclosed by the books, and to that end will be scheduled the assets, liabilities, reserves and capital as they exist upon a given date.

The Trading and Profit and Loss Account is (as its name implies) an ACCOUNT and its construction conforms to the rules of double-entry, whereas the Balance Sheet is quite definitely not an account, but a mere SUMMARY OF ACCOUNTS APPEARING IN THE LEDGER AFTER ADJUSTMENT OF THE PROFIT AND LOSS ACCOUNT. It will therefore be comprised of all items that are not transferred to the Trading and Profit and Loss Account, including the closing stock as introduced into the books. Hence, as the Trading and Profit and Loss Account absorbs, as it were, Nominal items, the Balance Sheet will be made up only of assets and liabilities, including closing stock and Capital.

Its form-that is, reverse to the actual side of the Ledger on which the particular item appears-should cause no difficulty so long as the student treats every item consistently. In accordance with British custom, assets are sometimes shown on the right hand of the Balance Sheet and liabilities and capital on the left hand. The modern trend, however, is, as in the case of Trading and Profit and Loss Accounts, to present Balance Sheets in vertical or columnar form.

Finally, as the Trading and Profit and Loss Account contains the results of operations over a period, the heading should be 'Trading and Profit and Loss Account FOR THE YEAR (or other period) ENDED...; the Balance stated date and hence should be headed 'BALANCE SHEET AS AT (or ON) (or AT)...... For example, if final accounts are drawn up as a result of operations for the half-year to 30th April 19... the Trading and Profit and Loss Account will be headed:

TRADING, PROFIT, LOSS ACCOUNT-BALANCE SHEET 0503 TRADING AND PROFIT AND Loss ACCOUNT FOR THE HALF YEAR ENDED 30TH APRI 19 The Balance Sheet at the close of the period will be headed:

BALANCE SHEET AS AT 30TH APRIL 19...

RULES FOR CONSTRUCTION OF FINAL ACCOUNTS

1. Trading Section of the Trading and Profit and Loss Account.

The ients usually appearing in this account in the ledger are:

(a) DEBIT SIDE.

(b) CREDIT SIDE.

Opening Stock. Purchases.

Carriage Inwards,

Wages.

Sales.

Closing Stock.

The Trial Balance will include opening, but not closing, stock; stock at the end of the period must therefore be 'taken' and valued and be , incorporated in the accounts by means of the following Journal entry:

Stock

To Trading Account

Dr.

When this entry is posted, the closing stock will appear on the debit side of the Stock Account and on the credit of the Trading and Profit and Loss Account.

Where the vertical or columnar form of presentation is used, the items could be shown as follows:

Sales

Less Cost of Goods Sold: Purchases

£x

Add Opening Stock*

Deduct Closing Stock*

£x

Carriage Inwards. Wages

Trading Profit (or Loss)

£x

It is more common to show one amount only in respect of the stock adjustment. Thus where the value of closing stock exceeds that of opening stock the form of presentation is:

Purchases

Deduct Increase in value

of stock

ACCOUNTANCY

Where the value of opening stock exceeds that of closing stock:

Purchases

Add Decrease in value

of stock

With a little thought it will be apparent that the net effect of each of the above adjustments is

the same as the respective double adjustment.

As many students experience great difficulty in dealing with the Stock entries, the following is given by way of illustration. The Trial Balance at 31st December 19.2, contains an item Stock (1st January 19.2) £1,000, and on taking stock at 31st December 19.2, the stock on hand is valued at £1,500. The opening stock (£1,000) will have been incorporated into the books at 31st December 19.1, and have been shown in the Balance Sheet at that date as an asset, and will accordingly be a debit balance in the books throughout 19.2. At 31st December 19.2, it will be transferred to the Trading Account by debiting that account and crediting Stock. The closing stock (£1,500) will be introduced into the books by debiting Stock and crediting Trading Account. The new stock will thus appear as an asset in the Balance Sheet and will remain as a debit balance throughout 19.3. The Stock Account will appear thus:

STOCK

19.2

1,000 Dec. 31 Trading A/c [19.2]

19.1

Dec. 31 Trading A/c [19.1]

19.2

Dec. 31 Trading A/c [19.2]

21,500

1,000

An asset in the Balance Sheet at 31st December 19.1. An asset in the Balance Sheet at 31st December 19.2.

If, as occasionally happens in examination questions, the closing stock is given as part of the Trial Balance, the presumption is that the Trading Account has already been prepared prior to the extraction of the Trial Balance; that is, the opening stock, purchases and sales and the necessary double-entry for the inclusion of the closing stock, have already been disposed of in the Trading Account. Reference to the Trial Balance will normally confirm this supposition, in that it will include gross profit as a separate balance. In these circumstances the closing stock will be shown in the Balance Sheet as an asset without adjustment.

The Profit and Loss Account only will be shown; the commencing figure will be the Trading Profit or Loss as shown in the Trial Balance, subject to certain adjustments if required.

2. Profit and Loss Section. The expenses incurred in carrying on the affairs of a concern will vary in accordance with circumstances. The following is a list of the usual expenses:

Wages and Salaries. Rent and Rates. Insurance.

Discounts Allowed.

Stationery.

Postages.

Advertising.

Carriage Outwards. Depreciation.

Bad Debts.

Loan Interest.

Heating and Lighting. Repairs and Renewals. Telephone.

Accountancy and Legal Expenses.

Motor Expenses.

Bank Charges.

Travelling Expenses.

Distributing Expenses generally. Royalties.

Selling Commission.

Expenses of a special nature (e.g. those peculiar to Limited Companies, such as Directors' Fees. Debenture Interest) are not included here, but will receive mention in their appropriate place.

Certain items representing gains will be credited to the Profit and Loss Account. Such are:

Discounts Received. Bank Interest.

Selling Bonuses.

Profit on the Sale of Assets.

Recoveries or Part Recoveries. Income from Investments.

of Bad Debts.

The Profit and Loss balance, being Net Profit or Loss will be carried to Capital or Current Account (or Appropriation Account where applicable).

3. Balance Sheet. The balances remaining in the books, comprised of Assets, Liabilities and Capital, will be extracted to form the schedule or statement known as the Balance Sheet. They are not 'transferred' but merely extracted in the form of a statement and comprise the opening entries for the succeeding period.

The Balance Sheet may be looked upon as the 'Trial Balance' after the transfer into one combined account of Purchases, Sales and Expenses, including the incorporation of the closing Stock and the transfer to Capital Account of the net profit or loss for the period.

It is important to observe that the amount shown in Drawings Account is transferred to Capital Account (and NOT to Profit and Loss Account) so that the Capital Account will in normal circumstances be made up of (1) Capital at the commencement of the period, (2) less Drawings, (3) plus net Profit (or less net Loss) for the period.

The general rules are shown by the following illustration.

Illustration 1

The following balances have been extracted from the books of H. Jones, retail merchant, at 31st December 19... and a TRADING and PROFIT and LOSS ACCOUNT and a BALANCE SHEET have been prepared from them. The closing stock at 31st December 19.. was £450. The Ledger accounts are appended in detail to amplify and clarify the processes called for in the preparation of final accounts.

The balances remaining in the books agree with the items set out in the Balance Sheet below-except that in the Ledger accounts the assets are 'debits' and liabilities and capital are 'credits.'

(A) Trading Account

1. Sales

Debit Sales.

2. Purchases

Debit Trading.

3. Opening Stock

Debit Trading.

Credit Trading.

Credit Purchases.

Credit Stock.

4. Closing Stock (which is not in the Trial Balance)

Debit Stock.

Credit Trading.

The Closing Stock so introduced will now appear as a balance in the Ledger and therefore as an Asset in the Balance Sheet.

5. Expenses (Trading)

Debit Trading.

Credit Expenses.

Notice that in the vertical or columnar form of account the principle of debit and credit is still maintained and the rules here stated in journal form are still appropriate.

TRADING, PROFIT, LOSS ACCOUNT-BALANCE SHEET 0509

6. The balance of Trading is the opening figure for the Profit and Loss Account. Normally this will be a credit balance; if, however, it should be a debit balance as a result of Cost of Goods Sold exceeding Sales then this will be indicated by prefixing the resulting balance thus (Dr.)

(B) Profit and Loss Account

1. As already stated there will be a balance, being either Trading (or Gross) Profit (credit) or Trading (or Gross) Loss (debit) from Trading.

2. Expenses (Profit and Loss)

Debit Profit and Loss.

Credit Expenses.

3. Sundry income (e.g. Discounts received).

Debit the appropriate account (e.g. Discounts Received).

Credit Profit and Loss.

4. The balance of Profit and Loss will be transferred to Capital Ac- count. The Journal Entries would be:

(a) If a Profit.

Debit Profit and Loss.

(b) If a Loss.