Table of Contents
The final accounts or financial statements consists of:
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Trading and profit and loss account or income statement, which is prepared to know the profit earned or loss suffered by the business during a specific period.
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Balance sheet, which is prepared to know the financial position of the business on a particular date.
These two items or statements are collectively known as “final accounts or financial statements”
Trading Account
Trading account is prepared for calculating the gross profit or gross loss arising or incurred as a result of the trading activities of a business. In other words, it is prepared to show the result of manufacturing, buying and selling of goods. If the amount of sales exceeds the amount of purchases and the expenses directly connected with such purchases, the difference is termed as gross profit. On the contrary, if the purchases, and direct expenses exceed the sales, the difference is called gross loss. A Trading Account records the number of purchases of goods and also the expenses which are incurred in bringing that commodity to a saleable state. In other words, all expenses which relate to either purchase of raw material for manufacturing of goods are recorded in the Trading Account. All such expenses are called ‘Direct Expenses’. According to J.R. Batliboi, “The Trading Account shows the results of buying and selling of goods. In preparing this account, the general establishment charges are ignored and only the transaction in goods are included.”
Sometimes, a Trading Account is also called ‘Good A/c’ because all the transaction relating to goods are recorded in it. Such as (i) Opening Stock, (ii) Purchases, (iii) Purchases Returns, (iv) Sales, (v) Sales Returns, (vi) Closing Stock, (vii) Expenses incurred on manufacturing of goods, and (viii) Expenses incurred on purchasing and bringing the goods to the trading place. All such expenses are summarised and recorded in the Trading Account at the end of the year.
Need and Importance of Trading Account
Preparation of Trading Account serves the following objectives:
- It provides information about Gross Profit and Gross Loss: It informs of the gross profit or gross loss as a result of buying and selling the goods during the year. The percentage of Current Year’s gross profit on the amount of sales can be calculated and compared with those of the previous years. Thus, it provides data for comparison, analysis and planning for a future period.
- It provides information about the direct expenses: All the expenses incurred on the purchase and manufacturing of goods are recorded in the trading account in a summarised form. Percentage of such expenses on sales can be calculated and compared with those of the previous years. In this way it enables the management to control and rationalise the expenses.
- Comparison of closing stock with those of the previous years: closing stock has to be valued and recorded in a trading account. This stock can be compared with the closing stock of the previous years and if the stock shows an increasing trend, the reasons may be inquired into.
- It provides safety against possible losses: If the ratio of gross profit has decreased in comparison to the preceding year, the businessman can take effective measures to safeguard himself against future losses. For example, he may increase the sale price of his gods or may proceed to analyse and control the direct expenses.
Profit And Loss Account
Trading account only discloses the gross profit earned as a result of buying and selling of goods. However, a businessman has to incur a number of expenses which are not taken to trading account. Hence, a businessman is more interested in knowing the net profit earned or net loss incurred during the year. As such, a Profit & Loss Account is prepared which contains all the items of losses and gains pertaining to the accounting period. According to Prof. Carter, “A Profit & Loss Account is an account into which all gains and losses are collected, in order to ascertain the excess gains over the losses or vice-versa”.
Need and Importance of Profit & Loss A/c
- To Ascertain the Net Profit or Net Loss: A Trading Account only discloses the Gross Profit earned as a result of trading activities, whereas the Profit & Loss Account discloses the net profit (or net loss) available to the proprietor and credited to his capital account.
- Comparison with previous years’ profit: The net profit of the current year can be compared with that of the previous years. It enables the businessman to know whether the business is being conducted efficiently or no.
- Control on Expenses: Profit & Loss Account helps in comparing various expenses with the expenses of the previous year. Also the percentage of each individual expenses to net profit is calculated and compared with the similar ratio of previous years. Such comparison will be helpful in taking concrete steps for controlling the unnecessary expenses.
- Helpful in the preparation of Balance Sheet: A Balance Sheet can only be prepared after ascertaining the Net Profit through the preparation of Profit and Loss Account.
Balance Sheet
After ascertaining the net profit or loss of the business enterprise, the businessman would also like to know the exact financial position of his business. For this purpose a statement is prepared which contains all the Assets and Liabilities of the business enterprise. The statement so prepared is called a Balance Sheet because it is a sheet of balances of ledger accounts which are still open after the transfer of all nominal accounts to the Trading and Profit & Loss Account. Balances of all the personal and real accounts are grouped as assets and liabilities. Liabilities are shown on the left hand side o the Balance Sheet and assets on the right hand side.
Definitions: A Balance Sheet has been defined as follows:
In the words of Karlson, “A business form showing what is owed and what the proprietor is worth, is called a Balance Sheet.”
According to A. Palmer, “The Balance Sheet is a statement at a particular date showing on one side the trader’s property and possessions and on the other hand the liabilities.”
According to J.R. Batliboi, “A Balance Sheet is a statement prepared with a view to measure the exact financial position of a business on a certain fixed date.”
Need and Importance of Preparing a Balance Sheet
The purposes of preparing a Balance Sheet are as follows:
- The main purpose of preparing a Balance Sheet is to ascertain the true financial position of the business at a particular point of time.
- It helps in ascertaining the nature and cost of various assets o the business such as the amount of Closing Stock, amount owing from Debtors, amount of fictitious assets etc.
- It helps in determining the nature and amount of various liabilities of the business.
- It gives information about the exact amount of capital at the end of the year and the addition or deduction made into it in the current year.
- It helps in finding out whether the firm is solvent or not. The firm is solvent if the assets exceed the external liabilities. It would be insolvent if opposite is the case.
- It helps in preparing the Opening Entries at the beginning of the next year.