Preparation of Trading and Profit and Loss account (a/c)

The "Trading and Profit & Loss a/c" is a ledger account. Like all ledger accounts, the postings in this ledger account also flow from the journal. "No Journal No Ledger".

• Transactions making up the Trading and Profit & Loss a/c

The transactions relating to the journal entries that would go into the "Trading and Profit & Loss a/c" are not ones that are take place in the ordinary course of business. These are transactions that are specifically meant to create this "Trading and Profit & Loss a/c". Consider the above formula for ascertaining the profit or loss,
Profit = Sum of balances in Nominal accounts with a Credit Balance
− Sum of balances in Nominal accounts with a Debit Balance .

» For Ascertaining the sum of balances in Nominal Accounts with a Debit Balance

This is done by transferring the balances in the nominal accounts with a debit balance, to an account by name "Trading and Profit & Loss a/c".

Transferring a debit balance from one account to a second results in the second account being debited and the first account being credited.

Therefore the Journal Entry would be

Journal in the books of M/s __ for the period from ____ to _____
Date	V/R No.	Particulars		L/F	Debit Amount (in Rs)	Credit Amount (in Rs)
March 31st	–	Trading and Profit & Loss a/c       To Nominal a/c [with a debit balance]	Dr	– –	xxxx	xxxx
		[For the debit balances in the nominal accounts transferred to the "Trading and Profit & Loss a/c" for the purpose of ascertaining the profits on the last day of the accounting period ]

» For Ascertaining the sum of balances in Nominal Accounts with a Credit Balance

This is done by transferring the balances in the nominal accounts with a credit balance to an account by name "Trading and Profit & Loss a/c".

Transferring a credit balance from one account to a second results in the second account being credited and the first account being debited.

Therefore the Journal Entry would be

Journal in the books of M/s __ for the period from ____ to _____
Date	V/R No.	Particulars		L/F	Debit Amount (in Rs)	Credit Amount (in Rs)
March 31st	–	Nominal a/c [with a credit balance]       To Trading and Profit & Loss a/c	Dr	– –	xxxx	xxxx
		[For the credit balances in the nominal accounts transferred on the last day of the accounting period to the "Trading and Profit & Loss a/c" for the purpose of ascertaining the profits.]

• Trading and Profit and Loss Account (a/c)

Thus the "Trading and Profit & Loss a/c" would appear as follows

Dr

Trading and Profit & Loss a/c

Cr

Date	Particulars	J/F	Amount (in Rs)	Date	Particulars	J/F	Amount (in Rs)
31/03/06 31/03/06 31/03/06 31/03/06 31/03/06	To Nominal a/c 1 [Dr] To Nominal a/c 2 [Dr] To Nominal a/c 3 [Dr] ... ...	– – – – –	xxx xxx xxx xx xxx	31/03/06 31/03/06 31/03/06 31/03/06 31/03/06	By Nominal a/c 1 [Cr] By Nominal a/c 2 [Cr] ... ...	–	xxx xxx xxx xxx xxx
	sub-total		3,24,000		sub-total		5,80,000
31/03/06	To Bal (Profit)	–	2,56,000
	Total		5,80,000		Total		5,80,000

Thus the "Trading and Profit & Loss a/c", is nothing but a consolidated account formed by transferring the balances in the nominal accounts.

Ascertaining the how much of Profit/Loss

• Profit = Total (Incomes + Gains) − Total (Expenses + Losses)

Using this relation, a positive profit figure indicates a profit and a negative profit figure indicates a loss.

• Math of Ascertainment of Profit/Loss

Nominal accounts are related to incomes/gains and expenses/losses. Thus the information relating to the aspects that would define the profit or loss made by the organisation is contained in the Nominal accounts.

» Nominal Accounts with Debit balances

Those ledger accounts which have a debit balance in them represent expenses or losses The total (sum) of balances in all the nominal (ledger) accounts with a debit balance indicates the total (expense + losses).

» Nominal Accounts with Credit balances

Those ledger accounts which have a credit balance in them represent incomes or gains. The total (sum) of balances in all the nominal (ledger) accounts with a credit balance indicates the total (incomes + gains).

If the total of (expense + losses) and (incomes + gains) are set off, we would be able to arrive at the profit or loss made.
Thus the relation to ascertain the profit or loss can be written as

Profit = Sum of balances in Nominal accounts with a Credit Balance
− Sum of balances in Nominal accounts with a Debit Balance .

Accounting Period

Accounting Period is that period for which the organisation ascertains the profit or loss. If the organisation is trying to ascertain the profits made over a year, then the accounting period is a year. If it is trying to ascertain the profits made over a six months period, then the accounting period is six-months.
There are two aspects relating to an accounting period. The length of the period as well as the being/end dates of the period. These can be ascertained from the way the accounting period is stated.
For example, where the accounting period of an organisation is stated as

• From 1st July to 31st December,
  This implies that the length of the accounting period is 6 months.
• One year and starts on 1st January every year.
  This implies that the accounting period is from 1st January to 31st December and is one year long.

• What Accounting Period to Follow?

What accounting period an organisation follows is dependent on the informational as well as statutory needs of the organisation. The most common period followed all over the world is a period of 1 year which starts from either 1st January or 1st April.

» Statutory Requirements

The need of the organisation to comply with the various laws that it has to adhere to would also influence the decision relating to the accounting period. Say in India, the Income Tax Act, needs organisations to calculate and present their business profits for the period from 1st April to the following 31st March. Therefore, the organisations would follow the same accounting period so that their accounting would serve their informational needs as well as enable them to easily present the information that has to be presented to the Income Tax Department.

When is the information relating to profits & position collected/derived

Information needs vary from organisation to organisation. Even the information relating to profits and position would also be derived for such periods and on such dates respectively depending on the organisations need or this information.

» Period for which profits are ascertained

The information relating to profits is something that is needed by the organisation periodically. For what period do we try to ascertain profits. Do we think of profits made every day or over a week or over a month or over a six month period or over a year? This is dependent on the information needs of the organisation.
Though theoretically it is possible to derive this information's for any time period, conventionally it is derived for a year. That is in most cases, information relating to profits is derived over a year. We think of profits made over a year.

» Day on which position is ascertained

The information relating to the position may be needed by the organisation at many points of time. Theoretically this is also capable of being derived at any point of time we need it. However, conventionally it is derived at a point which indicates the end of the period for which the profits are ascertained. Say if we think of profits made for the period from 1st April 2005 to 31st March 2006, we think of deriving the position as on 31st March 2006.

Debtors (Assets) and Creditors (Liabilities)

• Assets

Real accounts and Personal accounts are capable of being called assets. Any element (account) that is capable of being liquidated (that is capable of being converted to cash by giving it away) indicates an asset. Machinery, Furniture, Cash, etc are real accounts that can be called assets.

» Debtors represent Assets

Debtors represent the persons and organisation who owe to the organisation. They would clear their dues by paying out either in cash or in some other form. Thus Debtors get liquidated and as such can be called assets.

• Liabilities

All elements representing liabilities are Personal accounts. An element that is capable of being cleared by paying out indicates a liability.

» Creditors represent Liabilities

Creditors represent the persons and organisation to whom the organisation owes. The organisation would clear its due by paying them either in cash or in some other form. Thus creditors are cleared by paying out and as such can be called liabilities.

How is the Additional Information obtained?

• Information relating to Profits

The ledger accounts relating to the organisation are classified into three types. Personal, Real and Nominal.

» Nominal Accounts

Nominal accounts are related to expenses, losses, incomes and gains.

Since ascertaining profits or losses involves dealing with incomes, gains, expenses and losses we can conclude that all the nominal accounts together would give us the information relating to the profits or losses made by the organisation.

» Trading and Profit and Loss Accounts

To derive the information relating to profits from these nominal accounts a ledger account by name "Trading and Profit & Loss a/c" is prepared.

Almost in all cases, we use two separate ledger accounts "Trading a/c" and "Profit and Loss a/c" to derive information relating to profits with a greater detail. [The more the information we need, the more the accounting heads we need to maintain].

Preparation of these ledger accounts requires us to think beyond just transferring the information in the nominal accounts into these accounts.

• The Position of the organisation

The ledger accounts maintained within an organisational accounting system are classified into three as Personal, Real and Nominal.

» Real Accounts

Real accounts are related to tangible aspects. In general we can identify that all asset accounts are real accounts.

» Personal Accounts

Personal accounts are related to persons and organisations. These are persons/organisation which owe the organisation or to whom the organisation owes. In effect they either form creditors (liabilities) or debtors (assets).

Since all the nominal accounts have been dealt with in deriving the information relating to profits and we are left with only the real and personal accounts which represent either assets or liabilities we can conclude that all the real and personal accounts together give us the information relating to the position of the organisation.

» Balance Sheet

To derive the information relating to the position of the organisation from these real and personal accounts a statement by name "Balance Sheet" is prepared. However preparing the Balance sheet need us to think a bit beyond just listing out the information relating to the personal and real accounts in the statement.

Additional Information Needed by the Organisation

Apart from the information relating to the various elements (ledger accounts) that an organisation collects, there is other information that is needed by the organisation. In general, in accounting we can identify two important pieces of information that the organisation needs.
The ledger accounts collect information relating to each element. All the elements (account heads) are classified into three types. Personal accounts (relating to persons and organisations), Real accounts (relating to tangible aspects) and Nominal accounts (relating to incomes/gains and expenses/losses).

• Profits made by the organisation

As and when an element is effected by a transaction, the ledger account is posted to with the information. This keeps on happening continuously. The information thus collected in the form of ledger accounts does not say anything about the profits made by the organisation. The organisation periodically would be interested in knowing the amount of profit that it has made over the period.

» Involvement of a Period

When it comes to thinking about profits there is a period involved in the thought. We think of profits made over a period and not at a particular instance. For example, We think of Profits made

• From 1st April to 31st April or
• During April or
• During the 6 months ending 30th June
• For the year from 1st April, 2005 to 31st March 2006.

• Position of the Organisation

The ledger accounts are periodically balanced to obtain the balances in the accounts. The act of balancing is done at such periods as is needed by the organisation. For example, where the organisation needs the information relating to cash balance daily, therefore Cash a/c is balanced daily.

» Assets and Liabilities indicate a persons Position

What is it that comes to our mind when we think of a persons position? It is the value of his/her property and the liabilities he/she has. Even in accounting, in trying to ascertain the position of a business entity, this is what we think of. The position of a business is indicated by the value of its assets and liabilities.
The organisation at times would be interested in knowing its position as at a particular point of time.

» Position at an instance

When it comes to thinking about the position there is an instance involved in the thought. We think of the position as at a point of time and not a period. For example, We think of the position

• As on 24th June or
• As at the end of a period i.e. on the last day of the period