1.3 Preparation of a Trading and Profit and Loss Account

When a trading and profit and loss account is shown in details rather than in summary form （as is the case for the published statements of profit or loss of companies）， it contains two accounts． One is called the trading account ．The trading account is prepared in order to arrive at a figure for gross profit ．Below the trading account is shown a summary of another account—the profit and loss account ．It is these two accounts that together comprise the statement of profit or loss．

This profit and loss account should not be confused with the‘statement of profit OR loss’．The profit AND loss account is prepared so as to arrive at the figure for net profit ．It is these two accounts that together comprise the statement of profit or loss． The basic format of the Trading and Profit and Loss account is shown in Exhibit 1.4.The trading account is combined with the profit and loss account． Both the trading account and the profit and loss account are part of the double entry system． At the end of a financial period， they are closed off． They are then summarised and the information they contain is then copied into a statement of profit or loss．

Note：

·The trading account shows the gross profit （ or loss） that the company has made． The gross profit is the difference between the two sides of the trading account and must be brought down to the opposite side of the profit and loss account．

·The profit and loss account shows the net profit （or loss） made．Net profit is the difference between the two sides of the profit and loss account． This is recorded by debiting the profit and loss account and crediting the capital account． The reason is because the profit belongs to the owner and it increases the amount of capital he or she is entitled to withdraw from the business．

·If the debit side of the profit and loss account exceeds the credit side， this is shown as a net loss on the credit side and debited to the capital account．

Before drawing up a statement of profit or loss you should prepare the trial balance． This contains nearly all the information needed （Later on in this book you will see that certain adjustments have to be made， but we will ignore these at this stage）．

We now look at the trial balance of G． John （Exhibit 1.5）， drawn up as on 31 December 20×1 after the completion of his first year in business．

There are goods unsold at the end of the period． However， there is no record in the accounting books of the value of this unsold inventory． The only way that John can find this figure is by checking his inventory at the close of business on 31 December 20×1.

To do this he would have to make a list of all the unsold goods and then find out their value． The value he would normally place on them would be the cost price of the goods， i．e． what he paid for them． Let's assume that this is ￡ 3，000.

Note： To make this easier to follow， we shall assume that purchases consist of goods that are resold without needing any further work． You'll learn later that these are known as‘finished goods’but， for now， we'll simply refer to them as‘goods’．

Firstly， we have to calculate the cost of goods sold as follows：

Based on the sales revenue of ￡ 38，500 the gross profit can be calculated：

Sales－Cost of Goods Sold ＝ Gross Profit

￡ 38，500－￡ 26，000 ＝ ￡ 12，500

We now have the information we need to complete the trading account section of the statements of profit or loss． Next， the following four steps should be followed when preparing the trading account ：

We now close off the trading account in the normal way． In this case， revenues exceed costs so we describe the balance as‘gross profit’． The double entry transactions for the above transfers are shown as follows：

Note：

·The balance shown on the trading account is described as‘gross profit’ rather than being described as a balance．

·The balance （i．e． the gross profit） is not brought down to the next period．

·The entry of the closing inventory on the credit side of the trading account is a deduction from the purchases on the debit side．

·After the trading account has been completed， there are no balances remaining in the sales and purchases accounts． These accounts are now said to be ‘closed off’．

We can now draw up a profit and loss account．The gross profit has been transferred from the trading account to the credit of the profit and loss account． Next， any revenue account balances， other than sales （which have already been dealt with in the trading account）， are transferred to the credit of the profit and loss account． Typical examples are commissions．

To calculate net profit and record it

The double entries needed to transfer the expense accounts to the profit and loss account，and the net profit to the capital account， are as follows：

The profit and loss account will now appear as follows：

The fact that a separate drawings account has been in use can now also be seen to have been in keeping with the policy of avoiding unnecessary detail in the capital account． There will， therefore， only be one figure for drawings entered in the debit side of the capital account— the total of the drawings for the whole of the period．

To increase the capital account and record it

The capital and drawings account will now appear as follows：