Trading and Profit and Loss Account (Sole Proprietorship)

Trading And Profit And Loss Account

The primary objective of any business is to earn profit. To ascertain the profitability of the business for a specific accounting period (usually a financial year), the Trading and Profit and Loss Account is prepared. This statement summarises all the revenues and expenses of the business related to its operations during the period. It is prepared at the end of the accounting year after all ledger accounts have been balanced.

For a sole proprietorship, the Trading and Profit and Loss Account is a single combined statement, often presented in a vertical format or a horizontal 'T' format. It is a nominal account as it deals with incomes, expenses, gains, and losses.

Relevant Items In Trading And Profit And Loss Account

The Trading and Profit and Loss Account includes various items of revenue and expense. These are segregated into two parts: the Trading Account and the Profit and Loss Account.

Items in the Trading Account (To determine Gross Profit/Loss):

Debit Side:
- Opening Stock: Value of unsold goods at the beginning of the accounting period.
- Purchases: Total credit and cash purchases of goods during the period.
- Less: Purchases Returns (Return Outwards): Value of goods returned to suppliers. (Net Purchases = Purchases - Purchases Returns).
- Direct Expenses: Expenses directly related to the purchase of goods or bringing them to a saleable condition. E.g., Wages (for production labour), Carriage Inwards, Freight Inwards, Factory Rent, Factory Lighting, Octroi, Import Duty.
Credit Side:
- Sales: Total credit and cash sales of goods during the period.
- Less: Sales Returns (Return Inwards): Value of goods returned by customers. (Net Sales = Sales - Sales Returns).
- Closing Stock: Value of unsold goods at the end of the accounting period.

Items in the Profit and Loss Account (To determine Net Profit/Loss):

Debit Side (Expenses and Losses): All Indirect Expenses (expenses incurred for the general administration, selling, and distribution of the business, not directly related to purchasing/producing goods). E.g., Salaries, Rent, Lighting (Office/Showroom), Printing and Stationery, Postage and Telegrams, Telephone Expenses, Advertising, Bad Debts, Discount Allowed, Depreciation, Repairs and Maintenance, Insurance, Interest Paid, Audit Fees, Legal Expenses, Loss on Sale of Assets.
Credit Side (Incomes and Gains): All Indirect Incomes (incomes earned from sources other than the main sales of goods/services). E.g., Rent Received, Discount Received, Commission Received, Interest Received, Dividend Received, Profit on Sale of Assets.

Closing Entries

At the end of the accounting period, all nominal accounts (revenues, expenses, gains, losses) are closed by transferring their balances to the Trading Account or Profit and Loss Account. The journal entries passed for this purpose are called Closing Entries.

Purpose of Closing Entries:

To transfer the balances of nominal accounts to the Trading and Profit and Loss Account.
To close all nominal accounts, making them ready for the next accounting period (they start with a zero balance).

Common Closing Entries:

1. To close accounts with Debit Balances (Expenses and Losses, Opening Stock, Purchases):

Date	Particulars	Debit (₹)	Credit (₹)
(Last Day of Year)	Trading A/c Dr.	[Total]
	To Opening Stock A/c		[Balance]
	To Purchases A/c		[Net Purchases]
	To Direct Expenses A/c (Individually)		[Balance]
	(Being transfer of debit balances to Trading A/c)

Similarly, all indirect expenses and losses are transferred to the Profit and Loss Account:

Date	Particulars	Debit (₹)	Credit (₹)
(Last Day of Year)	Profit and Loss A/c Dr.	[Total]
	To Individual Expense/Loss A/c		[Balance]
	(...and so on for all indirect expenses/losses)
	(Being transfer of indirect expenses/losses to P&L A/c)

2. To close accounts with Credit Balances (Revenues and Gains, Sales):

Date	Particulars	Debit (₹)	Credit (₹)
(Last Day of Year)	Sales A/c Dr.	[Net Sales]
	To Trading A/c		[Net Sales]
	(Being net sales transferred to Trading A/c)

Similarly, all indirect incomes and gains are transferred to the Profit and Loss Account:

Date	Particulars	Debit (₹)	Credit (₹)
(Last Day of Year)	Individual Income/Gain A/c Dr.	[Balance]
	(...and so on for all indirect incomes/gains)
	To Profit and Loss A/c		[Total]
	(Being transfer of indirect incomes/gains to P&L A/c)

3. For Closing Stock:

Closing Stock is an Asset at the end of the period. It is not a nominal account and hence not closed like other items. It is brought into the Trading Account to determine COGS. The entry is:

Date	Particulars	Debit (₹)	Credit (₹)
(Last Day of Year)	Closing Stock A/c Dr.	[Value of Closing Stock]
	To Trading A/c		[Value of Closing Stock]
	(Being closing stock brought into Trading A/c)

(Closing Stock A/c is a Real Account, it appears in the Balance Sheet).

4. To transfer Gross Profit or Gross Loss:

The balance of the Trading Account represents the Gross Profit or Gross Loss. This balance is transferred to the Profit and Loss Account.

If Gross Profit: Trading A/c (Credit side total > Debit side total) has a Credit balance. Transferring requires debiting Trading A/c.

Date	Particulars	Debit (₹)	Credit (₹)
(Last Day of Year)	Trading A/c Dr.	[Gross Profit Amount]
	To Profit and Loss A/c		[Gross Profit Amount]
	(Being Gross Profit transferred to P&L A/c)

If Gross Loss: Trading A/c (Debit side total > Credit side total) has a Debit balance. Transferring requires crediting Trading A/c.

Date	Particulars	Debit (₹)	Credit (₹)
(Last Day of Year)	Profit and Loss A/c Dr.	[Gross Loss Amount]
	To Trading A/c		[Gross Loss Amount]
	(Being Gross Loss transferred to P&L A/c)

5. To transfer Net Profit or Net Loss:

The balance of the Profit and Loss Account represents the Net Profit or Net Loss. This balance is transferred to the Owner's Capital Account (for a sole proprietorship).

If Net Profit: Profit and Loss A/c (Credit side total > Debit side total) has a Credit balance. Transferring requires debiting P&L A/c.

Date	Particulars	Debit (₹)	Credit (₹)
(Last Day of Year)	Profit and Loss A/c Dr.	[Net Profit Amount]
	To Capital A/c		[Net Profit Amount]
	(Being Net Profit transferred to Capital A/c)

If Net Loss: Profit and Loss A/c (Debit side total > Credit side total) has a Debit balance. Transferring requires crediting P&L A/c.

Date	Particulars	Debit (₹)	Credit (₹)
(Last Day of Year)	Capital A/c Dr.	[Net Loss Amount]
	To Profit and Loss A/c		[Net Loss Amount]
	(Being Net Loss transferred to Capital A/c)

After passing all closing entries, the balances of all nominal accounts become zero, and the balances of Real and Personal Accounts are ready to be carried forward to the Balance Sheet.

Concept Of Gross Profit And Net Profit

Gross Profit (or Gross Loss) is the difference between Net Sales and the Cost of Goods Sold during an accounting period. It reflects the profitability of buying (or manufacturing) and selling the core products or services of the business before considering other operating expenses.

A high gross profit margin indicates efficient purchasing, production, and pricing strategies relative to the cost of goods.
A low gross profit margin suggests issues with cost of goods, selling prices, or efficiency in the core business activity.

Net Profit (or Net Loss) is the final profit or loss figure remaining after deducting all operating expenses (direct and indirect), non-operating expenses, and losses, and adding all other incomes and gains to the Gross Profit. It represents the overall profitability of the business after accounting for all activities.

Net profit is the amount that increases the owner's capital (or decreases in case of net loss).
It is the figure most often used to assess the overall performance and efficiency of the business.

Gross Profit is a stepping stone to Net Profit. The Profit and Loss Account essentially explains how the Gross Profit turned into Net Profit by detailing all other revenues and expenses.

Cost Of Goods Sold And Closing Stock–Trading Account Revisited

The Trading Account is prepared to find the Gross Profit or Loss. Its structure is based on the calculation of the Cost of Goods Sold (COGS).

Cost of Goods Sold (COGS) = Opening Stock + Net Purchases + Direct Expenses - Closing Stock

Opening Stock: Represents the value of goods on hand at the beginning of the period. These are goods that were purchased or produced in the previous period but not sold. They are the first goods available for sale in the current period. It is shown on the Debit side of the Trading Account.

Net Purchases: Represents the total cost of goods purchased during the period specifically for resale, minus any goods returned to suppliers (Purchases Returns). Shown on the Debit side of the Trading Account.

Direct Expenses: Costs directly attributable to bringing the goods to the point of sale or converting raw materials into finished goods (for manufacturing businesses). Examples include carriage inwards, wages, factory expenses. Shown on the Debit side of the Trading Account.

Closing Stock: Represents the value of unsold goods on hand at the end of the accounting period. These are goods purchased or produced during the current period but not sold. They are part of the COGS calculation but are deducted because they were not sold in the current period and will be carried over to the next period as Opening Stock. Closing Stock is shown on the Credit side of the Trading Account and as an Asset in the Balance Sheet.

Trading Account for the period ended [Date]

Debit (₹)		Credit (₹)
To Opening Stock	[Amount]	By Sales	[Amount]
To Purchases	[Amount]	Less: Sales Returns	[Amount]
Less: Purchases Returns	[Amount]
Net Purchases	[Amount]	Net Sales	[Amount]
To Direct Expenses (Individually listed)	[Amount]	By Closing Stock	[Amount]
...		...
To Gross Profit (transferred to P&L A/c)	[Amount]
		By Gross Loss (transferred to P&L A/c)	[Amount]
Total	[Sum of Debit side]	Total	[Sum of Credit side]

The balance (difference between credit total and debit total) is either Gross Profit (if Credit > Debit) or Gross Loss (if Debit > Credit), which is then transferred to the Profit and Loss Account.

Operating Profit (Ebit)

Operating Profit, also known as Earnings Before Interest and Tax (EBIT), is a measure of a business's profitability from its core operating activities. It is calculated by deducting all operating expenses (both direct and indirect) from the operating revenues, but before deducting interest and taxes.

Operating Profit focuses on the efficiency of the main business operations, excluding financing costs (interest), non-operating incomes/expenses, and income tax.

Calculation of Operating Profit:

Operating profit can be calculated from Gross Profit or from Net Profit.

Operating Profit = Gross Profit + Other Operating Incomes - Other Operating Expenses

In the context of a simple Trading and P&L A/c, "Other Operating Incomes" might include items like commission received or discount received if they are part of the normal operating activities, but it generally excludes purely financial income like interest received or profit on sale of asset. "Other Operating Expenses" include all indirect expenses that are related to operations (e.g., salaries, rent, advertising, depreciation, bad debts), but exclude non-operating expenses like interest paid or loss on sale of assets.

A more direct calculation from P&L items:

Operating Profit = Net Profit + Non-operating Expenses + Interest Paid - Non-operating Incomes - Interest Received

Non-operating expenses/incomes are those not related to the main business activity (e.g., loss/profit on sale of asset, interest received/paid on loans).

Example 6.

From the following, calculate Operating Profit:

Gross Profit: ₹5,00,000

Salaries: ₹1,50,000

Rent: ₹50,000

Advertising: ₹30,000

Depreciation: ₹20,000

Bad Debts: ₹10,000

Interest Received (on Investments): ₹5,000

Profit on Sale of Asset: ₹15,000

Interest Paid (on Bank Loan): ₹8,000

Answer:

Operating Expenses = Salaries + Rent + Advertising + Depreciation + Bad Debts

Operating Expenses = ₹1,50,000 + ₹50,000 + ₹30,000 + ₹20,000 + ₹10,000 = ₹2,60,000

Operating Profit = Gross Profit - Operating Expenses

Operating Profit = ₹5,00,000 - ₹2,60,000 = ₹2,40,000

Alternatively, first calculate Net Profit:

Net Profit = Gross Profit - Operating Expenses + Other Incomes - Other Expenses

Net Profit = ₹5,00,000 - ₹2,60,000 + Interest Received (₹5,000) + Profit on Sale (₹15,000) - Interest Paid (₹8,000)

Net Profit = ₹5,00,000 - ₹2,60,000 + ₹20,000 - ₹8,000 = ₹2,52,000 - ₹8,000 = ₹2,44,000

Operating Profit = Net Profit + Interest Paid - Interest Received - Profit on Sale of Asset

Operating Profit = ₹2,44,000 + ₹8,000 - ₹5,000 - ₹15,000

Operating Profit = ₹2,52,000 - ₹20,000 = ₹2,32,000

Correction: The first method is correct here. Non-operating items were interest received/paid and profit on sale of asset. Let's re-calculate using the second formula and identifying operating vs non-operating carefully.

Net Profit = Gross Profit ₹5,00,000 - Operating Exp ₹2,60,000 + Non-operating Incomes (Interest Received ₹5,000 + Profit on Sale ₹15,000) - Non-operating Expenses (Interest Paid ₹8,000)

Net Profit = ₹5,00,000 - ₹2,60,000 + ₹20,000 - ₹8,000 = ₹2,52,000

Operating Profit = Net Profit + Non-operating Expenses + Interest Paid - Non-operating Incomes - Interest Received

Operating Profit = ₹2,52,000 + ₹8,000 - ₹5,000 - ₹15,000 = ₹2,40,000

Both methods give the same result, ₹2,40,000.

Operating Profit (EBIT) = ₹2,40,000.

Significance of Operating Profit:

Shows the profitability of the core business activities, unaffected by how the business is financed (interest) or taxed.
Useful for comparing the operating performance of different companies or the same company over different periods, as financing and tax structures can vary.
It is often used by analysts to assess operational efficiency.

Operating profit is a key performance indicator that provides a clear view of the earning power of the business's main operations.