Trading Account:

1. Define and explain a trading account.
2. What are the benefits of preparing a trading account?

Definition and Explanation:

1. It is the first stage of final accounts of a trading concern.
2. It is prepared on the last day of an accounting period.
3. Only direct revenue and direct expenses are considered in it.
4. Direct expenses are recorded on its debit side and direct revenue on its credit side.
5. All items of direct expenses and direct revenue concerning current year are taken into account but no item relating to past or next year is considered in it.
6. If its credit side exceeds it represents gross profit and if debit side exceeds it shows gross loss.

Purpose of Preparing Trading Account:

1. Gross profit of a business is very important data, since all business expenses are met out of it. So the amount of gross profit should be adequate to meet the indirect expenses of a business concern.
2. The amount of net sales can be determined through this account. Gross sales can be ascertained from sales account in the ledger, but net sales cannot be so obtained. The true sales of a business is net sales - not gross sales. Net sales are determined by deducting sales returns from gross sales in trading account.
3. The success or failure of a business can be ascertained by comparing net sales of the current year with that of the last year. It should be noted that an increase in the amount of net sales of the current year over the last year may not be regarded as a sign of success, since sales may increase because of rise in price level.
4. Percentage of gross profit on net sales (gross profit ratio) can be easily determined from trading account. This percentage is very important yardstick for measuring the success or failure of a business. Compared to last year, if the rate increases, it indicates success; on the other hand if the rate decreases, it is an indication of failure.
5. Percentage of different items of buying expenses (direct expenses) on gross profit can be easily determined and by comparing the percentage of the current year with that of the previous year the variations can be ascertained. An analysis of variances will disclose their cause which will help in controlling the amount of expenses.
6. Inventory or stock turnover ratio can be determined from trading account. The success or failure of a business can be measured by this rate. Higher rate indicates a favorable sign i.e. goods are sold soon after their purchase. On the other hand, low rate signifies deterioration, i.e. goods are sold long after their purchase.

Method of Preparation of Trading Account:

Example:

Solution:

Profit and Loss Account:

Learning Objectives:

1. Define and explain a profit and loss account.
2. What are the benefits of preparing a profit and loss account?

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Definition and Explanation:

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. As the net profit or net loss of a certain accounting period is determined through profit and loss account, so its heading is:

Name of Business
Profit and Loss Account for the year ended 31.12.2005(if accounting period ends on 31.12.2005)

Sequence of Expenses in Profit and Loss Account:

There is no hard and fast rule as to the order in which the items of expenses are shown in profit and loss account. Generally, the items of expenses are shown in the following sequence:

Office and Administration Expenses:

These are the expenses with the management of the business e.g. salaries of manager, accountant and office clerks, office rent, office stationary, office electric charges, office telephone etc.

Selling and Distribution Expenses:

These are the expenses which are directly or indirectly connected with the sale of goods. These expenses vary with the sales i.e. they increase or decrease with the increase or decrease of sale of goods. Examples are advertisements, carriage outward, salesmen's salaries and commission, discount allowed, traveling expenses, bad debts, packaging expenses, warehouse rent etc.

Financial and Other Expenses:

All other expenses excepting those mentioned above are considered under this class.

Features of Profit and Loss Account:

1. This account is prepared on the last day of an account year in order to determine the net result of the business.
2. It is second stage of the final accounts.
3. Only indirect expenses and indirect revenues are shown in this account.
4. It starts with the closing balance of the trading account i.e. gross profit or gross loss.
5. All items of revenue concerning current year - whether received in cash or not - and all items of expenses - whether paid in cash or not - are considered in this account. But no item relating to past or next year is included in it.

The following is a specimen of profit and loss account

Name of Business
Profit and Loss Account for the year ended .....

	$			$
Trading A/C			Trading A/C
Gross profit (transferred)	-----		Gross profit (transferred)	-----
Office and Administration Expenses:	-----		Interest received	-----
Salaries	-----		Rent received	-----
Rent, rates, taxes	-----		Discount received	-----
Postage & telegrams	-----		Dividend received	-----
Office electric charges	-----		Bad debts recovered	-----
Telephone charges	-----		Provision for discount on creditors	-----
Printing and stationary	-----		Miscellaneous revenue	-----
Selling and Distribution Expenses:			Net loss - transferred to capital A/C	-----
Carriage outward	-----
Advertisement	-----
Salesmen's salaries	-----
Commission	-----
Insurance	-----
Traveling expenses	-----
Bad debts	-----
Packing expenses	-----
Financial and Other Expenses:
Depreciation	-----
Repair	-----
Audit fee	-----
Interest paid	-----
Commission paid	-----
Bank charges	-----
Legal charges	-----
Net profit - transferred to capital A/C	-----
If credit side exceeds the debit side = Net profit If debit side exceeds the credit side = Net loss

Example:

The following is the trial balance of XYZ company on 31st December 2005.

		Dr.	Cr.
		$	$
1	Opening stock	64,000
2	Purchases	460,000
3	Returns inwards	50,000
4	Carriage inwards	16,000
5	Salaries	96,000
6	Carriage outwards	10,000
7	Rent	72,000
8	Discount allowed	8,000
9	Sundry debtors	240,000
10	Plant and Machinery	360,000
11	Furniture	60,000
12	Drawings	18,000
13	Sundry creditors		350,000
14	Returns outwards		36,000
15	Sales		740,000
16	Capital		328,000
		1,454,000	1,454,000

The closing stock is valued at $126,000.

Required:

Prepare a profit and loss account for the year ended 31st December 2005.

Solution:

As we have already discussed that profit and loss account starts with the gross profit or gross loss figure produced by trading account, we have to determine the gross profit or gross loss by preparing trading account of XYZ company first.

XYZ co.
Trading Account for the year ended 31.12.2005

		$				$
Stock 1.1.2005		64,000		Sales	740,000
Purchases	4,60,000			Less returns	50,000	470000
Less returns	36,000	424,000
				Stock (closing)		126,000
Carriage inward		16,000
Gross profit (transf. to P&L A/C)		312,000
		816,000				816,000

XYZ co.
Profit and Loss Account for the year ended 31.12.2005

	$			$
Office and Administration Expenses:			Gross profit (transferred from	312,000
Salaries	96,000
Rent, rates, taxes	72,000
Selling and Distribution Expenses:
Carriage outwards	10,000
Discount allowed	8,000
Net profit - transferred to capital A/C	126,000
	312,000			312,000

Balance Sheet 

Learning Objectives:

1. Define and explain balance sheet.
2. What are its features?
3. How assets and liabilities are classified.
4. What are different methods of preparing balance sheet?

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Contents:

• Definition and Explanation
• Features of Balance Sheet
• Method of Preparation of Balance Sheet
• Classification of Assets
• Classification of Liabilities
• Grouping and Marshaling of Assets and Liabilities in Balance Sheet

Definition and Explanation:

Balance sheet is a list of the accounts having debit balance or credit balance in the ledger. On one side it shows the accounts that have a debit balance and on the other side the accounts that have a credit balance. The purpose of a balance sheet is to show a true and fair financial position of a business at a particular date. Every business prepares a balance sheet at the end of the account year. A balance sheet may be defined as:

1. "It is a statement of assets, liabilities and owner's equity (capital) on a particular date".
2. "It is a statement of what a business concern owns and what it owes on a particular date".  What is owns are called assets and what it owes are called liabilities.
3. "It is a statement which discloses total assets, total liabilities and total capital (owner's equity) of a concern on a particular date".
4. "It is a statement where all the ledger account balances which remain open after the preparation of trading and profit and loss account, find place".

Balance sheet is so called because it is prepared with the closing balance of ledger accounts at the end of the year. It has two sides - assets side or left hand side and liabilities side or right hand side. The accounts have a debit balance are shown on the asset side and those have a credit balance are shown on the liabilities side and the total of the two sides will agree.

Assets means all the things and properties under the ownership of the business i.e. building, plant, furniture, machinery, stock, cash etc. Assets also include anything against which money or service will be received i.e. creditors accrued income, prepaid expenses etc.

Liabilities means our dues to others or anything against which we are to pay money or render service, i.e. creditors, outstanding expenses, amount payable to the owner of the business (capital) etc.

Asset side of the balance sheet indicates the different types of assets owned by a concern, while liabilities side discloses the various sources through which funds have been obtained in order to acquire those assets. Balance sheet reveals the financial position of the firm on a particular date at a point of time, so it is also called "position statement". It is prepared on the last day of the accounting year and discloses concern for the whole year cannot be determined through the balance sheet because financial position is ever changing. The is why the heading of the balance sheet is given as under:

Balance Sheet as at 31st December, 2005(If accounting year ends on 31 Dec. 2005)

Features of Balance Sheet:

Balance sheet has the following features:

1. It is the last stage of final accounts
2. It is prepared on the last day of an accounting year.
3. It is not an account under the double entry system - it is a statement only.
4. It has two sides - left hand side known as asset side and right hand side known as liabilities side.
5. The total of both sides are always equal.
6. The balances of all asset accounts and liability accounts are shown in it. No expense accounts and revenue accounts are shown here.
7. It discloses the financial position and solvency of the business.
8. It is prepared after the preparation of trading and profit and loss account because the net profit or net loss of a concern is included in it through capital account.

Method of Preparation of Balance Sheet:

All the information necessary for the preparation of balance sheet is available from trial balance and from some other ledger accounts. After transferring accounts relating to expenses and revenues to trading and profit and loss account, the trail balance contains only the accounts of assets, liabilities, and capital. All assets have debit balances and all liabilities and capital have credit balances. The asses are shown on the asset side of the balance sheet and liabilities and capital are shown on the liabilities side of the balance sheet after arranging them properly.

As the balance sheet is prepared on the last day of an accounting year, so its heading and format will  be:

Balance Sheet
as at 31st December, 2005

Asset	$	Liabilities and Capital	$.

Classification of Assets:

Assets may be classified as follows:

Real Assets:

Assets which have some market value are called real assets, e.g. building, machinery, stock, debtors, cash, goodwill, etc. Real assets are further divided into two types according to their permanence:

Fixed Assets: Assets which have long life and which are bought for use for a long period of time are called "fixed assets". These are not bought for selling purposes, e.g. land, building, plant, machinery, furniture etc. Fixed assets are again sub-divided into two:

1. Tangible Assets: Assets which have physical existence and which can be seen, touched and felt are called "tangible assets", e.g. building, plant, machinery, furniture etc.
2. Intangible Assets: Assets which have no physical existence and which cannot be seen, touched or felt are called "intangible assets", e.g. goodwill, patent right, trade mark etc.

Current Assets: Assets which are short-lived and which can be converted into cash quickly to meet short term liabilities are called "current assets", e.g. stock debtors, cash etc. Such assets change their form repeatedly and so, they are also known as circulating or floating assets. For example, on purchase of goods cash is converted into stock and on sale of goods, stock is converted into debtors, on collection from debtors, debtors take the form of cash etc.

Out of current assets those which can be converted into cash very quickly or which are already in the form of cash are called liquid or quick assets e.g. debtors, cash in hand, cash at bank etc.

Fictitious Assets: Assets which have no market value are called fictitious assets. examples of fictitious assets include preliminary expenses, loss on issue of shares etc. They are also known as nominal assets.

Besides these, there is another type of assets whose value gradually reduce on account of use and finally exhaust completely. This type of assets is called wasting assets e.g. mine, forest etc.

Classification of Liabilities:

Internal Liabilities:

The total amount of debts payable by a business to its owner is called internal liability e.g. Owner's equity (capital), reserve etc. From practical view point internal liabilities should not be regarded as liabilities, since there is no question of meeting such liabilities al long as the business continues.

External Liabilities:

All debts payable by a business to the outsiders (other than the owner) are called external liabilities e.g. creditors, debentures, bills payable, bank overdraft, etc. External liabilities are further divided into two.

Fixed or Long Tern Liabilities: The liabilities which are payable after a long period of time are called fixed or long term liabilities e.g. debentures, loan on mortgage etc.

Current or Short Term Liabilities: The debts which are repayable within a short period of time are called current or short-term liabilities e.g. creditors, bills payable, bank overdraft etc. Current liabilities may again be divided into two:

1. Deferred Liabilities: Debts which are repayable in the course of less than one year but more than one month are called deferred liabilities e.g. Short term loan etc.
2. Liquid or Quick Liabilities: Debts are repayable in the course of a month are called liquid or quick liabilities e.g. bank overdraft, outstanding expenses, creditors etc.

Besides the above, there is another type of liability which is known as contingent liability. It is one which is not a liability at present, but which may or may not become a liability in in future. It depends upon certain future event. For example, suppose, the buyer of goods filed a suit in the court against the seller claiming damage of $10,000 for breach of contract. This will be regarded as a contingent liability to the seller until the receipt of the court's order. To the buyer, this is a contingent asset. Both contingent liability and contingent asset are not recorded in the balance sheet. They are generally mentioned in the balance sheet as a note.

Grouping and Marshaling of Assets and Liabilities in Balance Sheet:

As we have discussed that the main purpose of balance sheet is to disclose a true and fair financial position of a business on a particular date. So, the assets and liabilities must be shown in such a manner that the financial position of the business can be assessed through it easily and quickly. Thus an arrangement is made in which assets and liabilities are shown in the balance sheet. Such an arrangement is called marshaling of assets and liabilities. There are three methods of marshaling:

1. Permanency Preference Method
2. Liquidity Preference Method
3. Mixed Method

These methods of preparing a balance sheet are briefly explained below:

Permanency Preference Method:

Under this method, the assets and liabilities are shown in balance sheet in the order of their permanence. In other words, the more permanent the assets and liabilities, the earlier are they shown. This method is adopted by joint stock companies and under this method the balance sheet will take the following form:

Balance Sheet as at.....

Assets	$	Liabilities	$
Fixed Assets:     Good will      Patent      Land      Building      Plant & Machinery      Furniture & Fixtures Current Assets:      Investment      Stock      Sundry debtors      Bills receivable      Prepaid expenses Liquid Assets:      Cash at bank      Cash in hand		Fixed Liabilities:     Capital      Reserves      Long term loans Current Liabilities:      Sundry creditors      Bills payable      Bank overdraft      Outstanding expenses

Liquidity Preference Method:

Under this method, assets and liabilities are shown in order of their liquidity. The more liquid the assets, the earlier are they shown. The sooner the liabilities are to be paid off, the earlier are they shown. This method is adopted by sole proprietorship and partner ship business. Under this method the form of balance sheet is:

Balance Sheet as at.....

Assets	$	Liabilities	$
Liquid Assets:     Cash at bank      Cash in hand Current Assets:      Investment      Stock      Sundry debtors      Bills receivable      Prepaid expenses Fixed Assets:      Good will      Patent      Land      Building      Plant & Machinery      Furniture & Fixtures		Current Liabilities:     Sundry creditors      Bills payable      Bank overdraft      Outstanding expenses Fixed Liabilities:      Capital      Reserves      Long term loans

(Liquidity preference method is exactly reverse of the first method)

Mixed Method:

Under this method, assets are shown in the order of permanence and liabilities are shown in order of liquidity. This method is adopted by banks and insurance companies etc.