Lesson-8

Income Statements
Learning Objectives

To understand the meaning of profit and loss account

To understand the method of preparing the profit and loss account

Introduction
After the agreement of trial balance, a trader closes ledger accounts with a view to
ascertain the following aspects:

Gross profit
Net profit
Financial position of the firm

The gross profit on purchase and sale of goods is ascertained from the goods account.
This is because the goods account has stock of goods at commencement and purchases
during the period on the debit side and total sales and stock of goods at the end on the
credit side. The difference between the total of the two sides represents either gross profit
or gross loss of the trader during a given period.
In practice, however, an account under the heading of goods account is not opened. For
detailed information, the trader sub-divides the transactions relating to the movements of
goods and maintains separate accounts of the following:

Cash and credit purchases under the heading purchase account

Cash and credit sales under the heading sales account
A separate stock account

If there is a movement of goods to and from the trader, separate ledger accounts are
opened under the headings of returns inwards account and returns outwards account
respectively. The balances of these separate accounts at the end of the period appear in
the trial balance (instead of the balance of goods account). Thus, the goods account is
split up and separate accounts are opened as follows:

Opening stock account, i.e. stock at commencement

Purchase account including both cash and credit purchases
Sales account including both cash and credit sales
Returns inwards account, i.e. total goods returned by customers
Returns outwards account, i.e. total goods returned to vendors
Closing stock account, i.e. stock of goods at the end

These separate accounts, in total, are ultimately transferred to a common heading called
trading account.

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The format of trading account is as follows:

Specimen
Dr.
To (Opening) Stock
To Purchases
Less-- Returns outward
To Carriage/Freight inward
To Clearing Charges
To Octroi charges
To Wages
To Direct Expenses
* To Gross Profit
(Balancing Figure)
Total

Trading A/c
Rs.
By Sales
Less-- Returns inward
By (Closing) Stock

Cr.
Rs.

Total

In order to find out the gross profit or gross loss of a business, a trading account is
prepared. This account gives the overall profit of the business relating to an accounting
period which is subject to deduction of general administrative, selling and other
expenses. Gross profit is the difference between sale proceeds of a particular period and
the cost of the goods actually sold during that period.
Profit and Loss Account
Profit and loss account is prepared with a view to ascertain the profit or loss on account
of business activity during an accounting period. Profit and loss account is also an
account like other accounts in the ledger which discloses the net effect in the form of
profit or loss resulting from settling off the expenses incurred against the revenue earned
during the accounting period. The profit and loss account measures net income by
matching revenues and expenses as per the accepted accounting principles. The
difference between total revenue and total expenses represents net income or net loss
according to whether the difference is positive or negative. In this regard, it is pertinent
to note that all the expenses incurred for the period are to be debited to this account,
whether paid or not. Likewise, all revenue earned, whether received or not, are to be
credited to this account.
The balance of a trading account showing gross profit or gross loss becomes the opening
transfer entry of this account on the credit or debit side respectively. All the revenue
expenses appear on the debit side including those expenses which do not find a place in
the trading account. The losses on sale of capital asset or any abnormal loss also appear
on the debit side. The credit side of the account shows the revenue earned including the
non-trading income like interest on bank deposit or securities, dividend on shares, rent of
let-out property, profit arising from sale of fixed assets etc. after transfer of all the
nominal accounts from the trial balance to the profit and loss account. The net result of
the profit and loss account is ascertained by balancing it. If the credit side is more than
the debit side, it indicates net profit for the period. Conversely, if the debit side is more
than the credit side, it indicates net loss for the period.

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1. Specimen
Profit and Loss Account
Dr.
For the year ended on .....
By Gross Profit
To Gross Loss
By Interest Received
To Salaries
By Discount Received
To Office Rent
By Commission Received
To Office Expenses/General
By Bad Debts Recovered
Expenses/Administrative
* By Net Loss transferred to
Expenses/Sundry Expenses
Capital A/c
To Telephone Charges/Rent
To Rates and Taxes
To Insurance
To Printing and Stationery
To Audit Fees
To Postage and Telegram
To Interest Paid
To Bank Charges
To Commission Paid
To Discount Allowed
To Advertisement
To Bad Debts
To Carriage outward
To Depreciation on
Building
Furniture
Equipment
* To Net Profit transferred to
Capital A/c

Cr.

2. Method of preparing the Profit and Loss Account

a) Transfer the gross profit or gross loss from the trading account to the profit and
loss account.
b) Transfer all debit balances of nominal accounts in the trial balance (not counting
those put in the trading account) to the debit side of profit and loss account.
c) Transfer all credit balances of nominal accounts in the trial balance (not counting
those taken to trading account) to the credit side of profit and loss account.
d) Transfer the balance in the profit and loss account (which represents net profit or
net loss) to the proprietors capital account.
e) Income or gains under each appropriate heading earned during the period
(whether actually received or not) are credited.
f) Any expense paid or incurred during the period pertaining to a subsequent period
is excluded.
g) Any income received during the period not yet earned but received in advance
(expected to be earned during a subsequent period) is excluded.
In fact, the aim of profit and loss account of a given period is that it should show the net
result of that period only. For this, it should be debited with expenses of the period and
credited with all incomes of the period only. If any account of expenses is debited with

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an item of expense which properly belongs to a preceding period (paid in arrears) or

subsequent period (paid in advance), it is evident that such item should be transferred to
some other account so that the nominal account concerned may remain debited with the
expense of the current period only. In the same way, if an income account is credited
with an income of a preceding period (received in arrears) or a subsequent period
(received in advance), it should also be excluded from the income account by a transfer
entry to leave the income account concerned with the income pertaining to the current
period only.
From a given trial balance, all items of expenses and income which have not been
transferred to the trading account should be taken to the profit and loss account. The
items of expenses debited in the ledger should be transferred to the debit side of the
profit and loss account. The items of expenses showing credit balances are credited to the
profit and loss account by passing the necessary closing entries through the journal.
The net profit or net loss as shown by the profit and loss account is then transferred to
the capital account. The profit and loss account will thus close.
Problem
Following are some of the items extracted from the books of Mr. Ambar on December
31, 1998. Prepare a trading account for the year ending on December 31, 1998 and also
pass closing and adjustment entries.
Particulars
1. Stock as on 1.1.98
(a) Raw materials
(b) Work in progress
(c) Finished goods
3. Purchases of Raw
Materials
5. Lighting
7. Direct Wages
9. Rent

Rs.

Particulars
2. Carriage on Purchases

Rs.
1,050

14,700
6,650
10,850
4. Plant and Machinery
59,600
945 6. Sales
9,100 8. Repairs to Plant
4,200 10. Sale of Scrap

49,000
1,17,040
770
1,750

Adjustments
1.

Stock on 31.12.98 includes raw materials 11,340, work in progress Rs. 5,460 and
finished goods Rs. 12,670.
Direct wages are outstanding at Rs. 630.
Machinery is to be depreciated by 10%.
Office premises occupied 1/5th of the total area.
Lighting is to be charged as to 2/3 for factory and 1/3 for office.

2.
3.
4.
5.
Dr.

Trading Account
Rs.

Cr.
Rs.

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To (Opening) Stock
(a) Raw Materials
(b) Work in Progress
(c) Finished Goods

14,700
6,650
10,850

To Purchases

59,600

To Lighting
To Direct Wages#
To Carriage on Purchases
To Rent
To Repairs to Plant
To Gross Profit

630
9,730
1,050
3360
770
40920

Total
Note-- # Direct Wages
+ outstanding
Direct Wages

By Sales
By Sale of Scrap
By (Closing) Stock
(a) Raw Materials
(b) Work in Progress
(c) Finished Goods

148260 Total

1,17,040
1,750
11,340
5,460
12,670

148260

9100
630
9730

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