Understanding Trading and Profit and Loss Account Format, Definition Types And Their Differences
Final accounts represent both the financial position of a business and also shows the profitability of the concern. The final Account is used by both the external and internal parties for various purposes. The Trading Account, Profit and Loss Account, and Balance Sheet all together are known as the final accounts.
The trading account is the first part of this final account, and this is used to determine the gross profit which is earned by the business. The profit and loss account is the second part of the final account that is used to determine the net profit of the business concern.
What is a Trading and Profit and Loss Account?
Trading Account:
A trading account can be called an investment account which contains securities and cash. Generally, a trading account refers to a trader’s main account. The investors tend to buy and sell the assets frequently, thus their accounts are subject to special regulation for this. The assets which are held in a trading account are separated from others which may be part of a long-term buy and hold strategy.
Profit and Loss Account:
The profit and loss abbreviated as the P&L statement is a financial statement that summarizes the revenues, the costs, and the expenses that are being incurred during a specified period, usually in a fiscal year. The P&L statement aligns with the income statement, which records information about a company's ability or its inability to generate profit by increasing the sales revenue, by reducing costs, or both. The P&L statement is also referred to as a statement of profit and loss, income statement, statement of operations, etc.
Types of expenses that can be included in a Profit and Loss Account:
Sales Tax
Maintenance
Depreciation
Administrative Expenses
Selling and Distribution Expenses
Provisions
Freight and Carriage on Sales
Wages and Salaries
Types of Profit and Loss Accounts
There are mainly two types of Profit and Loss Accounts in trading:
Gross Profit and Loss Account: This part focuses on the direct trading activities of the business, like buying and selling goods. It calculates the profit or loss made after deducting the cost of goods sold from the sales revenue.
Net Profit and Loss Account: This includes all other expenses and incomes, such as office expenses, salaries, and other operational costs. It shows the final profit or loss after considering these additional factors.
Trading and Profit and Loss Account and Balance Sheet
A balance sheet is the last drawn financial statement which reports a company's assets, liabilities, and the shareholders' equity at a particular year in time, and provides a basis for computing the rates of return and evaluating the capital structure of the company. The financial statement provides a view of what a company owns and owes to its debtors, as well as the amount that is invested by the shareholders.
How to Calculate Gross Profit in a Trading Account
In order to calculate the gross profit, it is necessary to know the cost of goods which are sold and its sales figures.
Gross Profit = Sales – COGS (Sales + Closing Stock) – (Stock in the beginning + Purchases + Direct Expenses)
Items that are included on the debit side and on the credit side give the resultant figure which is either gross profit or the gross loss.
Every business wants to know how much money they made and how much money they spent during a certain period, usually at the end of the year.
A Profit & Loss Statement/Account shows how much money a business made or lost over a month or a year.
Companies use the Profit & Loss Statement, while other people use the "T Account" for these reasons. There are two main reasons why a Profit & Loss Statement/Account is made.
To find out how much money was invested or incurred by a business
To follow and maintain the Statutory requirements
Traditionally, determining profit/loss required two steps. It referred to the process of preparing:
Trading Account
Profit and Loss Account
The trade account reflects the business's gross profit or loss. The Profit & Loss Account displays the company's net profit or loss.
Trading and Profit and Loss Account Format and Calculations
There is no prescribed structure for profit and loss accounts for sole traders and partnership enterprises. They can create the profit and loss account in any format. However, it should separately display gross and net profit.
Typically, these entities prefer a "T-shaped form" for compiling their profit and loss statements.
A T-shape profit and loss account has two sides - debit and credit. Usually, a trading account is created, followed by a profit and loss statement and it has two sides - Debit and Credit.
Hence, Calculation of Profit and Loss Account would be:
Add up all revenue earned over the accounting period.
Add up all expenditures made throughout the accounting period.
Subtract total expenses from total revenue to find the difference.
If the value is positive, it represents profit; if it is negative, it represents a loss.
Format of P&L Account for Companies
Companies are required to submit profit and loss accounts under Schedule III of the Companies Act, 2013.
Balance Sheet
A balance sheet examination can reveal a wealth of information about a business's performance.
It is a critical instrument for investors, creditors, and other stakeholders as it helps in ascertaining an entity's financial health.
It enables stakeholders to comprehend the entity's business performance and liquidity status.
It is a report sheet that requires total assets to match total liabilities + shareholder capital.
Hence, the Calculation would be:
Assets = Liability + Capital
Assets - An asset is a resource that an entity owns and uses to generate positive economic value.
Liabilities - This is a list of obligations owed to others by an entity.
The money contributed by the shareholders is referred to as capital or equity.
There are various different balance sheet styles to choose from, however the most common of them includes horizontal and vertical.
Horizontal Format
Difference Between Trading Account and Profit and Loss Account
The Trading and Profit and Loss Account is a crucial tool for understanding a business's financial performance. While the trading account focuses on the gross profit or loss from core trading activities, the profit and loss account provides a complete picture by including all other incomes and expenses. Together, these statements help businesses make informed decisions, track their profitability, and plan for growth. Understanding these accounts is essential for any business owner.
FAQs on Trading and Profit & Loss Account: Structure and Use
1. What is the primary purpose of preparing a Trading and Profit & Loss Account?
The primary purpose is to determine the financial performance of a business over a specific accounting period, typically a year. It is prepared in two stages:
- The Trading Account is created first to calculate the Gross Profit or Gross Loss, which shows the profitability of the core buying and selling activities.
- The Profit & Loss Account is prepared next to find the Net Profit or Net Loss, which reflects the overall operational efficiency of the business after considering all other operating and non-operating incomes and expenses.
2. What is the standard T-shaped format of a Trading Account as per the NCERT syllabus?
A Trading Account follows a 'T-shape' format with two sides: Debit (Dr.) and Credit (Cr.).
- Debit Side (Dr.): This side records all direct expenses. It includes items like Opening Stock, Net Purchases (Purchases - Purchase Returns), and Direct Expenses (e.g., Wages, Carriage Inwards, Freight).
- Credit Side (Cr.): This side records direct revenues and the value of unsold goods. It includes Net Sales (Sales - Sales Returns) and Closing Stock.
3. What items are included in the format of a Profit and Loss Account?
A Profit and Loss (P&L) Account also uses a T-shaped format and begins with the result from the Trading Account.
- Debit Side (Dr.): This side lists all indirect expenses incurred during the accounting period. Examples include Salaries, Rent, Printing & Stationery, Depreciation, Interest on Loan, and Selling & Distribution expenses.
- Credit Side (Cr.): This side lists all indirect incomes. It starts with the Gross Profit transferred from the Trading Account and includes other incomes like Rent Received, Commission Earned, and Discount Received.
4. Why are expenses debited and incomes credited in the Profit and Loss Account?
This is based on the 'Nominal Account' rule from the golden rules of accounting, which states: "Debit all expenses and losses; Credit all incomes and gains." The Profit and Loss Account is a nominal account. Therefore, all expenses (like salaries, rent, depreciation) are debited as they represent costs incurred by the business. Conversely, all incomes (like commission received, interest earned) are credited as they represent financial gains.
5. What is the key difference between a Trading Account and a Profit and Loss Account?
The key difference lies in their scope and purpose. The Trading Account focuses only on direct revenues and direct costs associated with the buying and manufacturing of goods to calculate Gross Profit. In contrast, the Profit and Loss Account has a broader scope; it considers all other business expenses (indirect costs) and incomes to determine the final Net Profit or Net Loss.
6. How does the result of the Trading Account affect the Profit and Loss Account?
The Trading Account and the Profit and Loss Account are prepared sequentially and are directly linked. The result of the Trading Account, which is either Gross Profit or Gross Loss, becomes the starting point for the Profit and Loss Account. If there is a Gross Profit, it is transferred to the credit side of the P&L Account as an income. If there is a Gross Loss, it is transferred to the debit side as a loss.
7. Can you provide examples of direct expenses versus indirect expenses?
Yes, the distinction is crucial for placing items in the correct account:
- Direct Expenses (for Trading Account): These are costs directly related to purchasing or manufacturing goods. Examples include Wages (paid to factory workers), Carriage Inwards (cost of bringing goods to the factory), Factory Rent, and Power & Fuel.
- Indirect Expenses (for P&L Account): These are operational costs not directly tied to production. Examples include Salaries (paid to office staff), Carriage Outwards (cost of delivering goods to customers), Office Rent, and Depreciation on office equipment.
8. If a business sells an old piece of furniture for a profit, where is this transaction recorded?
The profit from selling an old piece of furniture is not shown in the Trading Account because selling furniture is not the main trading activity of the business. This is considered a non-operating gain. Therefore, the profit on the sale of the asset would be credited to the Profit and Loss Account as an indirect income. The Trading Account is exclusively for revenue from the sale of goods the business normally deals in.
9. What do Gross Profit and Net Profit signify about a business's performance?
Gross Profit signifies the efficiency of a business's core trading operations—specifically, how well it manages the costs of purchasing or producing goods relative to its sales revenue. A high Gross Profit margin indicates good pricing or cost control. Net Profit provides a comprehensive view of the overall profitability after all operating and non-operating expenses are paid. It is the ultimate measure of a company's success during an accounting period.
10. Why is the Profit and Loss Account prepared before the Balance Sheet?
The final accounts are prepared in a specific sequence because they are interconnected. The Profit and Loss Account is prepared before the Balance Sheet to determine the Net Profit or Net Loss for the period. This resulting Net Profit (or Loss) is then transferred to the Capital Account on the Liabilities side of the Balance Sheet. Without knowing the net profit or loss, the Capital Account cannot be correctly updated, and the Balance Sheet will not balance.
