Trading and Profit and Loss Account*
This will be a complete briefing on this topic, it might gets harder to digest for people who doesn’t quite understand Principles of Accounting.
Trading and Profit and Loss Account is opened up by business nature of sole-proprietorship, partnership, company and manufacturing company.
Purposes of Trading and Profit and Loss Account
1) To calculate the profits or losses of a business.
2) To prepare reports for stakeholders, *stakeholders are people who are interested in your business, it could be creditors or investors.
3) To calculate tax required by government policies.
Understand Gross Profit
Understand what is Gross Profit! Students doesn’t know what is the meaning of gross profit, they only know it’s profit! It’s the same thing as knowing nothing.
GROSS PROFIT is profit resulting from your sales over cost of goods sold.
Imagine you yourself selling one DVD movie to one customer at $4. This is your sale, $4.
The cost of your empty DVD disc is $0.50. This is your cost of goods sold. * Students tend to be confused with the term goods. Goods are a term used to refer to a lot of things, and in this case, it means lots of empty DVDs. But for illustration purposes. I only used one DVD as an example.
Go back to the definition of Gross Profit,
We can rewrite it as
Gross Profit = Sales – Cost of Goods Sold
= 4 – 0.50
Understand Cost of Goods Sold
Now, I wonder if you had realized that the phrase ‘cost of goods sold’ does seems tricky.
Cost of Goods Sold can be further broken down into it’s part,
Opening Stock + Purchases – Closing Stock = Cost of Goods Sold
You can skip the explanation if you want, but for some reason, I think learning it can actually enforce your memory. There are cases where students sometimes couldn’t recall memory due to last minute revising. And this will be the time you apply your understanding.
At the beginning of the year, you have 200 empty DVDs at hand. And during the year, you have purchased 400 empty DVDs. At the end of the year, you are left with 100 empty DVDs. Assume the price of Empty DVDs at $0.50.
If you really concentrate on the word Cost Of Goods Sold, you will see that it means the original cost of empty DVDs that have been sold. Now, this 100 empty DVDs left are unsold. Therefore, there are not included in the calculation of Cost of Goods Sold.
If you go back to the definition of Cost of Goods Sold, you will see the relation of subtracting closing stock.
Now, back to Opening Stock and Purchases. Why do we have to add it up?
Imagine your shop is selling DVDs, if you doesn’t buy empty DVDs, how can you sell your final DVDs to customer? Now if you already have 200 empty DVDs at hand, you need to buy more in order to sell enough for your customers. This is the reason why Opening Stock needs to add up with Purchases.
By combining all of this explanation, therefore we arrived at the same formula given earlier of:
Cost Of Goods Sold = Opening Stock + Purchases – Closing Stock
Now we are all done, this is how we can start to draw Trading Account.
Trading Account was simply a calculation of Gross Profit. You will get to see it later. But for now, just know this,
Gross Profit = Sales – Cost of Goods Sold
Gross Profit = Sales – (Opening Stock + Purchases – Closing Stock)
In Trading Account, different countries used different formats to draw such account, either a vertical or horizontal Trading Account. Now, students always think that Trading Account was easy, but for some reasons, failure to draw the format correctly will give you a wrong answer at the end, and for this reason, I wanted students to UNDERSTAND every single terms.
Points to remember:
1) Mark is awarded to title.
2) Use Net Sales instead of Sales*
3) Use Net Purchase instead of Purchase*
*If applicable, I will further explain it later on.
Now, my notes intend to prepare students for O Level Examination, and for this reason, my notes will be complete to that standard. Trading Account wouldn’t be that simple in Cambridge Examination.
Net Sales / Turnover
Sales needs to be net, that is to say, after any deduction on sales. Say for example, you have been selling 400 DVDs to customers, they are bound to be some customers which would come after you claiming bad DVDs. And in this case, say 30 DVDs were returned to you. This is called Sales Return or Return Inward. You need to memorize both of the terms. Assuming the selling price was at $4. Now we try to compute the Net Sales.
Net Sales / Turnover = Sales – Sales Return / Return Inwards
Net Sales = (400 – 30) x 4
= 370 x 4
In exam, sales return was sometimes used instead of return inwards,or otherwise. Therefore, it is important to remember their terms.
Just like Net Sales, Net Purchases were simply any addition or deduction made to the original purchases. In this case, imagine you purchase 600 empty DVDs. The cost of this purchases may include cost of insurance, freight cost or transportation cost or carriage inwards, purchase return or return outwards and etc. As long as anything that you paid in order to get that 600 DVDs into your shop, you add it. Whilst anything you return back to your suppliers, you deduct it from your original purchases.
Net Purchases = Purchases + Any Cost That You Paid – Return Inward
* The reason that I put ‘any cost that you paid’ is because there are too much additions that can be done, students should remember the general rule of ‘anything that you paid to get the DVDs into your shop.’
Profit And Loss Account
To simply show you what is inside Profit And Loss Account,
Net Profit = Gross Profit + Revenues/Gain – Expenses
= A positive amount is called Net Profit
= A negative amount is called Net Loss
In most examination, the answers will always be Net Profit. Unless you are in A Level, then a loss is also possible.
Revenues or Gains are any amount of money that profits a business. For instance, discount received from purchasing the empty DVDs.
Position on Vertical format, below Gross Profit, above Expenses.
Position on Horizontal format, Credit side.
Expenses are any amount that do not profits a business but are necessary to keep the business operating. Example of expenses include rent, wages, salaries, electricity, depreciation, discount allowed and etc.
Position on Vertical Format, below Revenues, above Net Profit.
Position on Horizontal Format, Debit side.
Combining Trading and Profit and Loss Account – Horizontal Format
Will re-update this soon.Combining Trading and Profit and Loss Account – Vertical Format.
Last updated on 07/02/2017.