Lesson-8. Income Statements. To understand the meaning of profit and loss account To understand the method of preparing the profit and loss account

Transcription

1 Lesson-8 Income Statements Learning Objectives To understand the meaning of profit and loss account To understand the method of preparing the profit and loss account Introduction After the agreement of trial balance, a trader closes ledger accounts with a view to ascertain the following aspects: Gross profit Net profit Financial position of the firm The gross profit on purchase and sale of goods is ascertained from the goods account. This is because the goods account has stock of goods at commencement and purchases during the period on the debit side and total sales and stock of goods at the end on the credit side. The difference between the total of the two sides represents either gross profit or gross loss of the trader during a given period. In practice, however, an account under the heading of goods account is not opened. For detailed information, the trader sub-divides the transactions relating to the movements of goods and maintains separate accounts of the following: Cash and credit purchases under the heading purchase account Cash and credit sales under the heading sales account A separate stock account If there is a movement of goods to and from the trader, separate ledger accounts are opened under the headings of returns inwards account and returns outwards account respectively. The balances of these separate accounts at the end of the period appear in the trial balance (instead of the balance of goods account). Thus, the goods account is split up and separate accounts are opened as follows: Opening stock account, i.e. stock at commencement Purchase account including both cash and credit purchases Sales account including both cash and credit sales Returns inwards account, i.e. total goods returned by customers Returns outwards account, i.e. total goods returned to vendors Closing stock account, i.e. stock of goods at the end These separate accounts, in total, are ultimately transferred to a common heading called trading account. 72

2 The format of trading account is as follows: Specimen Dr. Trading A/c Cr. To (Opening) Stock To Purchases Less-- Returns outward To Carriage/Freight inward To Clearing Charges To Octroi charges To Wages To Direct Expenses * To Gross Profit (Balancing Figure) Total By Sales Less-- Returns inward By (Closing) Stock Total In order to find out the gross profit or gross loss of a business, a trading account is prepared. This account gives the overall profit of the business relating to an accounting period which is subject to deduction of general administrative, selling and other expenses. Gross profit is the difference between sale proceeds of a particular period and the cost of the goods actually sold during that period. Profit and Loss Account Profit and loss account is prepared with a view to ascertain the profit or loss on account of business activity during an accounting period. Profit and loss account is also an account like other accounts in the ledger which discloses the net effect in the form of profit or loss resulting from settling off the expenses incurred against the revenue earned during the accounting period. The profit and loss account measures net income by matching revenues and expenses as per the accepted accounting principles. The difference between total revenue and total expenses represents net income or net loss according to whether the difference is positive or negative. In this regard, it is pertinent to note that all the expenses incurred for the period are to be debited to this account, whether paid or not. Likewise, all revenue earned, whether received or not, are to be credited to this account. The balance of a trading account showing gross profit or gross loss becomes the opening transfer entry of this account on the credit or debit side respectively. All the revenue expenses appear on the debit side including those expenses which do not find a place in the trading account. The losses on sale of capital asset or any abnormal loss also appear on the debit side. The credit side of the account shows the revenue earned including the non-trading income like interest on bank deposit or securities, dividend on shares, rent of let-out property, profit arising from sale of fixed assets etc. after transfer of all the nominal accounts from the trial balance to the profit and loss account. The net result of the profit and loss account is ascertained by balancing it. If the credit side is more than the debit side, it indicates net profit for the period. Conversely, if the debit side is more than the credit side, it indicates net loss for the period. 73

3 1. Specimen Profit and Loss Account Dr. For the year ended on... Cr. To Gross Loss To Salaries To Office Rent To Office Expenses/General Expenses/Administrative Expenses/Sundry Expenses To Telephone Charges/Rent To Rates and Taxes To Insurance To Printing and Stationery To Audit Fees To Postage and Telegram To Interest Paid To Bank Charges To Commission Paid To Discount Allowed To Advertisement To Bad Debts To Carriage outward To Depreciation on Building Furniture Equipment * To Net Profit transferred to Capital A/c By Gross Profit By Interest Received By Discount Received By Commission Received By Bad Debts Recovered * By Net Loss transferred to Capital A/c 2. Method of preparing the Profit and Loss Account a) Transfer the gross profit or gross loss from the trading account to the profit and loss account. b) Transfer all debit balances of nominal accounts in the trial balance (not counting those put in the trading account) to the debit side of profit and loss account. c) Transfer all credit balances of nominal accounts in the trial balance (not counting those taken to trading account) to the credit side of profit and loss account. d) Transfer the balance in the profit and loss account (which represents net profit or net loss) to the proprietor s capital account. e) Income or gains under each appropriate heading earned during the period (whether actually received or not) are credited. f) Any expense paid or incurred during the period pertaining to a subsequent period is excluded. g) Any income received during the period not yet earned but received in advance (expected to be earned during a subsequent period) is excluded. In fact, the aim of profit and loss account of a given period is that it should show the net result of that period only. For this, it should be debited with expenses of the period and credited with all incomes of the period only. If any account of expenses is debited with 74

4 an item of expense which properly belongs to a preceding period (paid in arrears) or subsequent period (paid in advance), it is evident that such item should be transferred to some other account so that the nominal account concerned may remain debited with the expense of the current period only. In the same way, if an income account is credited with an income of a preceding period (received in arrears) or a subsequent period (received in advance), it should also be excluded from the income account by a transfer entry to leave the income account concerned with the income pertaining to the current period only. From a given trial balance, all items of expenses and income which have not been transferred to the trading account should be taken to the profit and loss account. The items of expenses debited in the ledger should be transferred to the debit side of the profit and loss account. The items of expenses showing credit balances are credited to the profit and loss account by passing the necessary closing entries through the journal. The net profit or net loss as shown by the profit and loss account is then transferred to the capital account. The profit and loss account will thus close. Problem Following are some of the items extracted from the books of Mr. Ambar on December 31, Prepare a trading account for the year ending on December 31, 1998 and also pass closing and adjustment entries. Particulars Particulars 2. Carriage on Purchases 1,050 14,700 6,650 10, Stock as on (a) Raw materials (b) Work in progress (c) Finished goods 3. Purchases of Raw Materials 5. Lighting 7. Direct Wages 9. Rent 59, ,100 4, Plant and Machinery 6. Sales 8. Repairs to Plant 10. Sale of Scrap 49,000 1,17, ,750 Adjustments 1. Stock on includes raw materials 11,340, work in progress 5,460 and finished goods 12, Direct wages are outstanding at Machinery is to be depreciated by 10%. 4. Office premises occupied 1/5 th of the total area. 5. Lighting is to be charged as to 2/3 for factory and 1/3 for office. Dr. Trading Account Cr. 75

5 To (Opening) Stock (a) Raw Materials (b) Work in Progress (c) Finished Goods To Purchases 14,700 6,650 10,850 59,600 By Sales By Sale of Scrap By (Closing) Stock (a) Raw Materials (b) Work in Progress (c) Finished Goods 1,17,040 1,750 11,340 5,460 12,670 To Lighting To Direct Wages# To Carriage on Purchases To Rent To Repairs to Plant To Gross Profit 630 9,730 1, Total Total Note-- # Direct Wages outstanding 630 Direct Wages