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Distinction between Trading Account and Profit and Loss Account and between Balance Sheet and Trial Balance


Difference between Trading Account and Profit and Loss Account

Basis

Trading Account

Profit and Loss Account

1. Relation

Trading Account is a part of Profit and Loss Account

Profit and Loss Account is the main account

2. Nature

The Gross Profit or Gross Loss are ascertained from the Trading Account

The Profit and Loss Account is prepared to ascertain the net profit or net loss of the business

3. Transfer of Balance

The balance of the Trading Account is transferred to the Profit and Loss Account

The Balance of the Profit and Loss Account is transferred to the Capital Account of the proprietor.

4. Items

Items shown in the Trading Account are Purchases, Sales, Stock, direct expenses etc.

Items like indirect expenses related to sales, distribution, administration, finance etc. are shown in the Profit and loss Account

 

Explanation regarding Certain Items of Profit and Loss Account
  1. Salary - Salary is an indirect expense. The combined 'Salaries and Wages' account is also treated as an indirect expense and therefore, it is transferred to the Profit and Loss Account. As pointed out earlier, a combined 'Wages and Salaries' Account is treated as a direct expense and transferred to the Trading Account.
  2. Depreciation - Depreciation is a decrease in the value of an asset due to wear and tear, use or lapse of time. It is treated as business expense and is charged to the Profit and Loss Account.
  3. Discount - Discount Allowed Account and Discount Received Account should be shown separately on the debit side and credit side of the Profit and Loss Account respectively.
  4. Loss by fire - Loss of goods by fire is a loss to the business. It is debited to the Profit and Loss Account.
  5. Insurance - Generally, assets are insured to cover the risk of loss. Insurance premium is treated as a business expense and debited to the Profit and Loss Account.
  6. Bad Debts and Bad Debts Recovered - when a customer does not pay the amount due from him when it becomes irrecoverable, it is said to be a bad debt. It is written on the debit side in the Profit and Loss Account. If later the amount is recovered, it is treated as a gain; it is not credited to the party paying it; it is credited to Bad Debts Recovered Account. It is written on the credit side in the Profit and loss Account.

Closing Entries in Respect of the Profit and Loss Account


Entries that are to be recorded in the Journal for preparing the Trading and Profit and Loss Account, that is, for transferring the various accounts to these two accounts, are known as closing entries. To complete the Profit and Loss Account, the under-mentioned three closing entries are necessary.
  1. For items to be debited to the Profit and Loss Account, this account is debited and the various accounts concerned are credited. For example, salaries Account, Rent Account, Interest Account are closed by transferring their balances to the debit side of the Profit and Loss Account. The entry is
    Profit and Loss Account                          Dr.
    To Salaries A/c
    To Rent A/c
    To Interest A/c
  2. Items of income or gain such as Interest Received Account, Miscellaneous Income Account are closed by transferring their balances to the credit side of the Profit and Loss Account. The entry passed are:
    Interest Received A/c                            Dr.
    Miscellaneous Income A/c                      Dr.
    To Profit and Loss A/c
    These two entries close all the nominal accounts.
  3. At this stage the Profit and loss Account shows net profit or net loss. Both are transferred to the capital account. In case of net profit, i.e., when the credit side is bigger than the debit side, the entry is
    Profit and Loss A/c                                 Dr.
    To Capital A/c
  4. In the other case of net loss, the entry will be reverse ie.,
    Capital A/c                                            Dr.
    To Profit and Loss A/c
Distinction between Gross Profit and Net Profit

Gross Profit

Net Profit

1. Gross Profit = Sales - Cost of Goods sold

Net Profit = Gross Profit + All other incomes - indirect expenses and losses

2. It is ascertained from the Trading Account

It is ascertained from the Profit and Loss Account

3. Gross Profit is transferred to Profit and Loss Account

Net Profit is transferred to the Capital Account

4. It does not include any income from other sources

It may include income from other sources

5. It does not depend on the amount of net profit

It depends on the amount of gross profit

6. Amount of Gross Profit depends on the valuation of stock. Increase in the value of stock will increase the gross profit. Similarly, reduction in the value of closing stock will reduce the gross profit

Amount of Net Profit depends on the valuation of assets other than stock. For example, provision for doubtful debts, depreciation etc.

Operating Profit and Net Profit


Profit may be divided into two ie., Operating Profit and Net Profit

Operating Profit is the excess of gross profit over operating expenses. Gross profit is the excess of net sales revenue over cost of goods sold. Operating expenses includes office and administration expenses, selling and distribution expenses, cash discount allowed, interest on bills payable and other short term debts, bad debts and so on. Net sales means cash sales + credit sales - sales return.

Operating Profit  = Net Sales - Operating Cost
                         = Net Sales - (cost of Goods sold+ Administration and Office Expenses + Selling and Distribution Expenses) or

Operating Profit = Net Profit + Non - Operating Expenses - Non - Operating Income.

Net Profit means the excess of revenue (whether operating or non - operating) over expenses and losses (whether operating or non - operating). In other words, net profit is arrived by deducting operating expenses from operating profit as well as non operating profit. Expenses which are incidental or indirect to the main operations of the business are called non-operating expenses. They include interest on loan, charities and donations, loss on sale of fixed assets, extraordinary losses due to theft, and loss by fire and so on. Similarly, non- operating income are added while computing the net profit. Non- operating incomes include, receipt of interest, rent, dividend, profit on sale of fixed assets, etc.

Illustration 4:
Compute Operating Profit and Net Profit from the following particulars:

 

Particulars

Rs.

Particulars

Rs.

Gross Profit

4,40,000

Interest on loan

22,000

Carraige Outwards

4,800

Interest on Investments

2,800

Advertising

12,000

Printing and Stationary

3,600

Salaries

1,78,000

Loss on sale of Furniture

35,000

Rent and Taxes

62,000

General Expenses

1,400

Lighting

15,000

Donation

5,100

Insurance Charges

2,400

Rent Received

6,000

Bad Debts

1,500

Loss by fire

20,000

Audit Fees

2,000

Gain on sale of Machine

50,000

 

Solution:
 

Rs.

Rs.

Gross Profit

 

4,40,000

Less: Selling and Distribution Expenses

   

Carraige Outwards
Advertising
Bad Debts

4,800
12,000
1,500
 

 

18,300

Less Office and Administrative Expenses:
Salaries
Rent and Taxes
Lighting
Insurance Charges
Audit Fees
Printing and Stationery
General Expenses

 


1,78,000
62,000
15,000
2,400
2,000
3,600
1,400

 

 

 




2,64,400    
2,82,700
 

Operating Profit

 

1,57,300

Add: Non - Operating Incomes:
Interest on Investments
Rent Received
Gain on sale of Machine

 


2,800
6,000
50,000

 

 


58,800            2,16,100

Less: Non - Operating Expenses
Interest on Loans
Loss on sale of Furniture
Donation
Loss by fire

Net Profit

 


22,000
35,000
5,100
20,000

 

 

 

82,100         

1,34,000

Balance Sheet

The next step after preparing the Trading and Profit and Loss Account is preparing the Balance. A balance sheet is prepared from Real Accounts and Personal Accounts. The balance sheet may be defined as “A Statement which sets out the Assets and Liabilities if a firm or an institution as at a certain date”. In the words of Francis R. Stead, “A Balance Sheet is a screen picture of the financial position of a going business at a certain moment.” It is a statement which reports the property owned by the enterprise and the claims of the creditors and owners against these properties. It shows the status of the business as at a given moment of time, in so far as accounting figures can show its status.

 

The purpose of preparing the Balance Sheet is to ascertain the financial position of a business ie., to know what the business owes and what it owns on a certain date. This is why the balance sheet has the heading : Balance Sheet as at.... As against the heading of Trading and Profit and Loss Account which usually is for a year.

 

Since even a single transaction will make a difference to some of the assets or liabilities, the Balance Sheet is true only at a particular point of time. That is the significance of the words 'as at'.

 

Need: A Balance Sheet is prepared with a view to measure the true financial position of a business at a particular point of time. It is a device to show the financial position of a business in a systematic and standard form. It is a screen picture of the financial position of the business. Through it the position of the business, at a particular point of time, can be understood at a glance. Just as a doctor will feel the pulse of a person and know whether he is enjoying good health or not, in the same manner by looking at the Balance Sheet one can know whether the firm is solvent or not. If the assets exceed liabilities it is solvent; in the other case, it would be insolvent. It may serve as the basis for determining purchase consideration of the business.

 

Illustration 5:
From the following information, prepare Balance Sheet.

Cash in hand - Rs. 440
Cash at Bank - Rs. 1,000
Capital A/c (Opening Balance Rs. 10,000 + Net Profit Rs. 6,300) = Rs. 16,300
Machinery A/c = Rs. 6,000
Furniture and Fittings A/c - Rs. 1,360
Sundry Debtors - Rs. 8,500
Sundry Creditors - Rs. 3,700
Stock A/c - Rs. 2,700

Balance Sheet
As at March 31, 2008

Liabilities

Rs.

Assets

Rs.

Sundry Creditors

Capital

3,700

16,300

 

 

               
20,000      

Cash in Hand

Cash at Bank
Sundry Debtors
Stock
Furniture and Fixtures
Machinery

 

440

1,000
8,500
2,700
1,300
6,000   
20,000   

The assets are shown on the right hand side and the liabilities and capital on the left hand side.

 

Form of Balance Sheet: The usual items found in the Balance Sheet of a firm are given below:

 

BALANCE SHEET OF As at .......

Liabilities

Rs.

Assets

Rs.

Sundry or Trade Creditors
Bills Payable
Bank Overdraft
Employees Provident Fund
Loans (Cr.)
Mortgage
Reserves or Reserve Fund
Capital
Add: Interest on Capital
       Net Profit
Less: Drawings
        Income Tax
        Interest on Drawings
        Net Loss

 

 

 

 

 

 

 

                 
   

                   

Cash in Hand including Petty Cash
Cash at Bank
Bills Receivable
Sundry Debtors/ Book Debts
Loans (Dr.)
Closing Stock
Loose Tools
Investments
Furniture and Fixtures
Plant and Machinery
Land and Buildings
Freehold/ Leasehold Premises
Patents and Trade marks etc
Good will

 

 

 

 

 

 

 

 

               
 

               

Characteristics


The Balance Sheet has certain characteristics which should be noted. These are:
  1. It is prepared at a particular date, rather on the close of the day and not for a period. It is true only on that date and not later.
  2. The Balance Sheet is prepared after the preparation of the Profit and Loss Account. This is the reason why the Profit and Loss Account (including the Trading Account) and the Balance Sheet together called the 'Final Accounts'.
  3. The Balance Sheet shows the financial position of a business as a going concern.
  4. The Balance Sheet is not an account but only a statement of assets and liabilities. On the left - hand side, the liabilities of the business are shown whereas on the right - hand side the assets of the business appear.
  5. The total of the asset side must be equal to the total of liabilities side. i.e., the two sides of the Balance Sheet must have the same totals. If this is not the case, there is certainly an error somewhere.
Distinction Between Balance Sheet and Trial Balance.

Basis

Balance Sheet

Trial Balance

1. Purpose

The purpose is to portray the financial position.

The purpose is to establish the arithmetical accuracy of the books of account.

2. Information about profits

It provides information as to the profitability and financial position of the firm

No such information is possible from the Trial Balance

3. Necessity

It is essential to prepare the balance Sheet to complete the accounting process

Though desirable, it may be possible to dispense with its preparation

4. Headings

The two sides are headed as assets and liabilities

The two columns are headed as debit and credit.

5. Coverage

Only personal and real accounts appear in the Balance Sheet

In the Trial Balance all accounts must be written; no account can be left out

6. Closing Stock

This Account appears in the Balance Sheet

Normally, a closing stock does not figure in the Trial Balance

7. Period

Normally, it is prepared only at the end of the trading period

A Trial Balance is prepared normally every month, and whenever desired

8. Adjustment

A Balance Sheet cannot be prepared without making adjustments for outstanding and prepaid items and without taking into account all events and transactions of the year

A Trial Balance can be prepared at any stage, without even making adjustments.

Grouping and Marshalling (Arrangement ) of Assets and Liabilities


The assets and liabilities should be shown in a certain order in the Balance Sheet. Therefore, they should be arranged in certain groups and in a particular order. This is called 'Grouping' and 'Marshalling' of the Balance Sheet. Thus, 'Grouping' means putting items of a similar nature under a common heading. The arrangement of assets and liabilities in a particular order in the Balance Sheet is called 'Marshalling'.

Before we discuss the arrangement of assets and liabilities in the Balance Sheet, let us first understand what assets and liabilities mean. The team 'assets' denote the economic resources (property) of the business and includes all current and fixed assets. These are discussed subsequently. The term liabilities denote all claims against the assets of the business and include those of the outsiders (creditors) or those of the owners of the business. Assets and liabilities are shown in the Balance Sheet either in the order of liquidity or in the order of permanence.
  1. In the order of liquidity - Liquidity means the facility with which the assets may be converted into cash; those assets which are most difficult to convert into cash are written last. Liabilities are to be shown first as short - term liabilities and then as long - term liabilities and last of all as capital. According to this arrangement, the form of a Balance Sheet is as follows

BALANCE SHEET OF As at ..............

Liabilities

Rs.

Assets

Rs.

Bills Payable
Sundry Creditors
Bank Overdraft
Loans
Capital
Opening Balance
Add: Net Profit
Less: Drawings

 

 

 

 

 

 

 

                  

                  
 

Cash in hand
Cash at Bank
Bills Receivable
Debtors
Closing Stock
Investment
Furniture
Plant and Machinery
Land and Buildings
Goodwill

 

 

 

 

 

 

 

                 

                   

  1. In order of Permanence - Assets, which are to be used permanently in the business and are not meant to be sold are written first. Assets, which are most liquid such as cash in hand are written last. Liabilities may also be shown according to their performance arrangement. In this method, first show the capital, then long - term liabilities and the last of all short - term liabilities like amounts due to suppliers of goods or bills payable. The form of a Balance Sheet under such an arrangement would be as follows:

BALANCE SHEET OF As at ..............

Liabilities

Rs.

Assets

Rs.

Capital:
Opening Balance
Add: Net Profit
Less: Drawings
Loans
Bank Overdraft
Sundry Creditors
Bills Payable

 

 

 

 

 

                 
                 

Goodwill
Land and Buildings
Plant and Machinery
Furniture
Investment
Closing Stock
Debtors
Bills Receivable
Cash at Bank
Cash in Hand

 

 

 

 

 

                 
                 
 


Some of the assets may be capable of being sold easily like investment in government securities or shares of some companies. They should be treated as liquid or permanent according to the intention of the firm.

 

One should also note that the order in which the assets and liabilities of a company are to be shown in described by the Companies Act.




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