The Trading Account and Profit and Loss Account are two essential components of financial statements of any concern. While Trading Account shows gross results from trading activities only, the Profit and Loss Account shows the net results of a business from all of its operations. In this blog, we have highlighted the differences between these two.
Final accounts or financial statements are the end products of the accounting process. They involve determining the net profit earned or loss suffered by a business during an accounting period as well as assessing its financial position at the end of that period.
To determine the profit or loss, a statement called “Trading and Profit & Loss Account” (Income Statement) is prepared by incorporating all items of income and expenditure relating to a given period.
And to show the financial position on the last date of the accounting period, another statement known as “Balance Sheet” (Position Statement) is prepared to show all assets, liabilities, and capital of the business.
The Income Statement is broken down into two parts: 1) Trading Account and 2) Profit and Loss Account.
Trading Account and its features
Trading Account is the first component of the income statement that is prepared to determine the gross profit or gross loss for a specific accounting period. It is prepared prior to the preparation of the Profit and Loss Account.
The main features of a Trading Account are as under:
- It reflects the outcome of trading activities associated with the purchase and sale of goods and services.
- Trading Account is made to show separately the profit from sale & purchase transactions only.
- The profit/loss so determined is known as gross profit or gross loss because many other expenses of a business like administration, selling & distribution, repair, maintenance charges, etc. are not deducted.
- Only the direct expenses which are incurred to bring the product/goods into their saleable condition such as freight, carriage inwards, insurance, fuel, power, royalties on production, consumption of materials & stores, etc. are taken into consideration for computing the gross profit or gross loss.
- Gross Profit is given by: Net Sales – Cost of the Goods Sold; Net Sales = Total Sales – Sales Returns (Returns Inward); Cost of goods sold = Opening Stock of Goods + Net Purchases – Closing Stock of Goods at the end + All direct expenses; and Net Purchases = Total Purchases – Purchases Returns (Returns Outward)
- In case the total of the debit side of the Trading Account exceeds its credit side, the resultant figure will be Gross Loss. Hence, Gross Loss = Cost of the Goods Sold – Net Sales
- Stock in hand on the last day of the accounting year should be adjusted to account for purchases that have been recorded but the goods have not yet been received, sales that have been made but the goods have not yet been delivered, and possible items that may be out of the premises due to consignment, goods delivered on sale or return basis, etc.
- The gross profit/loss shown by Trading Account gets transferred to the Profit and Loss Account.
Profit and Loss Account and its features
A profit and loss account is a component of financial statements that takes into account operating as well as non-operating income and expenses incurred during an accounting period. It determines the net profit or loss made by a business. The objective is to show the overall efficiency and profitability of business operations during a particular year.
The main features of the Profit and Loss Account are as under:
- The Profit and Loss Account is prepared to compute the net profit earned or loss incurred by a business during a given accounting period.
- It not only accounts for profit/loss made from trading activities (i.e., sale and purchase of goods); rather it shows the results of entire operations of the business carried out during a particular period.
- The starting point of the preparation of this account is gross profit/gross loss which is transferred from Trading Account.
- Gross Profit is transferred to the credit side of the Profit & Loss Account and gross loss to the debit. Thereafter, all those expenses and losses that have not been already debited to Trading Account are debited here.
- Similarly, other incomes and gains besides sales revenue such as interest earned or commission received, etc. are credited to the Profit and Loss Account.
- The difference between income and expenses gives a net profit or a net loss. Such net profit/loss is then transferred to the Capital Account of proprietors/partners or to the Profit & Loss Appropriation Account in the case of partnership firms. Net profit increases the capital while net loss decreases the capital.
- Net profit = Total Revenues – Total Expenses and Net Loss = Total Expenses – Total Revenues
Trading Account and Profit and Loss Account Format (Specimen)
The differences between Trading Account and Profit and Loss Account are given as under:
|Basis||Trading Account||Profit and Loss Account|
|Outcome||Trading Account is prepared to compute gross profit or gross loss.||The Profit and Loss Account is prepared to arrive at the net profit or loss for a given period.|
|Items||Sales revenue, cost of goods sold, and direct expenses are entered here.||Here, indirect expenses such as salaries, rent, depreciation, selling expenses, etc. are charged against gross profit and other incomes.|
|Closing stock||Closing stock is shown on the credit side. It is shown at cost price or net realizable market value whichever is lower.||Stock is not shown.|
|Balance||The balance of this account is transferred to the Profit and Loss Account.||The balance of this account is transferred to the capital accounts of proprietors/partners. Thus, it will be shown in the Balance Sheet.|
|Purpose||The purpose of preparing a Trading Account is to determine the amount of profit made from the purchase and sale of goods/services.||The purpose of the Profit and Loss Account is to show the net result & profitability of all business operations.|
|Nature of results||Complete results of a business cannot be ascertained using this account. It shows only partial results.||The true and complete results of a business can be known from this account.|
|Nature of expenses||Only expenses directly relatable to the purchase and sale of goods are recorded in this account.||All indirect expenses such as administration, selling, and marketing costs are recorded here.|
|Nature of income||Sales are recorded on the credit side of this account.||All other incomes such as interest and dividend received, commission, etc. are recorded in this account on the credit side.|
|Formula||Gross Profit = Net Sales – Cost of the Goods Sold||Net profit = Total Revenues – Total Expenses|
|Starting point||The starting point for preparing Trading Account is sales. But it doesn’t start with any balance.||The starting point for preparing the Profit and Loss Account is gross profit or gross loss carried over from Trading Account.|
|Dependency||Trading Account is prepared first.||One cannot prepare the Profit and Loss Account before preparing Trading Account.|
|Influence||The outcome of the Trading Account affects the Profit and Loss Account.||The outcome of the Profit and Loss Account affects the liabilities side of the Balance Sheet.|
Fundamental principles for the preparation of Trading and Profit and Loss Account
Some points must be taken care of while preparing the Trading and Profit and Loss Account. Only revenue items must be entered. Capital receipts and capital expenditures form part of the Balance Sheet and shouldn’t be entered here.
Another fundamental principle must be applied called the “matching principle”. It must be observed that final accounts are prepared by matching cost with revenue. This means that expenses and incomes for the full trading period whether or not they have been paid or received must be included and no expenditure or income which does not pertain to the accounting period for which final accounts are being prepared should be included.
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