The Income Statement

The Trading Account

 The Trading account is the first final account to be prepared. It

contains the summarised form of activities pertaining to goods
bought for resale.

The Importance of a Trading Account

 It provides information about gross profit. The current gross profit

figure can be compared to previous gross profit figuresto find
variations.
 Trading account also providesinformation used to calculate the
gross profit to salesratio.
 It shows the actual value of sales generated in that year.
 It gives the cost of sales.

Contents of the Trading Account

1. Sales–refers to the goods and services sold for cash or credit.

2. Sales returns –This is the value of products that customers have

given back to the seller for a refund.Sales returns reduces the
seller’s revenue.

3. Net sales or turnover - Net sales is calculated by deducting sales

returns from sales.

4. Cost of goods sold

 These are the costs incurred in acquiring goods and in changing

their location.
 The cost of goods sold includes:
a. Purchases– This is the cost of all the goods bought for resale
during the year.

b. Purchases Returns (returns outwards) – this is the value of goods

returned to the supplier. It reduces total purchases to give net
purchases.

c. Carriage/railage inwards: these are expenses incurred in

bringing the goods to the place of sale. Carriage inwards increases
the cost of goods purchased.

d. Duty: customs and exercise duties levied on goods bought form

part of the cost of goods sold. Duty increases the purchases price
thereby increasing cost of goods sold.

e. Opening Stock:
 Opening stock refers to goods that remained unsold from the
previous accounting period.
 The value of opening stock increases the value of cost of goods
sold.

f. Closing stock:
 Refers to goods remaining unsold at the end of financial year.
 Closing stock is ascertained through a stock take.

5. Gross profit/loss
 Gross profit is attained when turnover is greater than cost of sales.
 Gross profit is calculated as Net sales minus the cost of goods sold.
 In abnormal circumstances, the difference is a gross loss.
 Gross loss occurs when turnover is less than cost of goods sold.
  The incident of a gross loss therefore calls for an urgent
investigation to establish its causes.

Reasons why a gross loss may occur could be:

1. Stock was regularly sold at prices below its cost.
2. A considerable amount of stock was wasted and lost.
3. Serious errors could have occurred in stocktaking and in the
valuation of stock.
4. Stock destroyed or stolen.
Double Entry for Trading Account Items

The trading account contains the following entries on the debit side:

1. Opening stock
2. Purchases
3. Purchases returns as a deduction from purchases to find net
purchases.
4. Carriage inwards
5. Closing stock as a deduction to enable the calculation of the
important figure of the cost of sales.

The trading account contains the following entries on the credit

side:

1. Total sales for the period.

2. Sales returns as deduction from sales to find net sales.
3. Any amount of loss arising from damage or theft.

 After posting all the debit and credit entries to the trading account,
the balance shows the gross profit or loss, which is then transferred
to the profit and loss account.

Journal entries for transferring the gross profit or loss to profit and loss
account
 Gross profit Dr ($) Cr ($)
2015 Trading account (gross profit) 50 000
31 Dec Profit and loss 50 000
Gross loss
2015 Profit and loss 30 000
31 Dec Trading account (Gross loss) 30000
Presentation of the Trading Account

Trading account presented horizontally or vertically.

Horizontal format

Trading account for the year ended 31 December 20-0

$ $ $ $
Opening stock Xxx Sales Xxx
Add: purchases Xxx Less: sales returns xxx
Less: purchases Net Xxx
returns xxx sales/turnover
Net purchases xxx
Add:expenses on cost
of sales
Freight charges xxx
Railage inwards xxx
Carriage inwards xxx
Packaging xxx Xxx
Cost of goods available
for resale Xxx
Less: closing stock
Xxx
Cost of goods sold Xxx
Gross profit c/d Xxx
Xxx Xxx

Vertical Format
Trading account for the year ended 31 December 20-0

Sales Xxx
Less: sales returns Xxx

Net sales/turnover Xxx

Less: cost of goods sold

Opening stock xxx

Add purchases xxx
Less: purchases returns xxx
Add: Carriage inwards/ railage inwards/freight xxx
charges.
Packaging costs xxx

Net purchases xxx

xxx

Less: closing stock xxx

Cost of goods sold Xxx

Gross profit Xxx

Example 1

Trial balance of Zhouas at 31 December 20-0 $ Cr $ Dr

Stock on 1st January 11000
Purchases
Wages 39 000
Carriage inwards 2 800
 Stationery 800
Returns inwards 450
Returns outwards 1 300
Trade expenses 2 000
Motor Vehicles 200
Office Furniture 47 000
Freight charges 10 000
Packages expense 1 000
Cash in hand 2 000
Sales 3 000
Capital 65 000
Creditors 35 050
Debtors 23 500
Totals 7 000
125 550 125 550

Closing stock on 31 December was valued at $4 500.

Required:

Prepare the trading account for the year ended 31 December using both
the horizontal and vertical format.

Answer in Vertical Format

Trading account for the year ended 31 December 20-0

$ $ $
Sales 65 000
Less: Returns inwards 1300
Net sales/turnover 63 700

Less: Cost of goods sold

Opening stock 11 000
Add: purchases 39 000
Less:returns outwards (purchases returns) 2 000
Net purchases 37 000
Add
Freight inwards 1 000
Packaging expenses 2 000
Carriage inwards 2 800 42 800
Cost of goods available for resale 53 800
Less: closing stock 4 500
Cost of goods sold 49 300
Gross profit 14 400

Answer in Horizontal Format

Trading account for the year ended 31 December 20-0

$ $ $ $
Opening stock 11 000 Sales 65 000
Add: purchases 39 000 Less: returns
inwards 1 300
Less:purchases Net sales/turnover 63 700
returns 2 000
Net purchases 37 000
Add:
Freight charges 1 000
Packaging expenses 2 000
Carriage inwards 2 800 42 800
Cost of goods
available for resale 53 800
Less: closing stock 4 500
Cost of goods sold 49 300
Gross profit c/d 14 400
63 700 63 700
Diagrammatic presentation of trading Account

Net sales

Less

Cost of sales

Equals to

Gross profit

Profit and Loss Account

 The profit and loss account is prepared after the trading account.
 A profit and loss account, also called an income statement, reports
on all revenues generated by the business and how the revenues
were spent.
 It also shows the difference between the revenues generated and
the expenses incurred by the business
 The aim of a profit and loss account is to ascertain whether the
business has made a net profit or a net loss in respect of the
accounting period.

Features of profit and loss account

1. This account is prepared on the last day of an accountingyear in

order to determine the net profit of the business.
2. It is the second stage in the preparation of final accounts.
 3. Profit and loss account only shows indirect expenses and indirect
revenues.
4. It starts with the closing balance of the trading account, which is
Gross profit or Gross loss.
5. All items of revenue concerning the current year, whether received
in cash or not, and all items of expenses, whether paid in cash or
not, are considered in this account. No item relating to the past or
the following year is included in it.

Steps in Preparing a Profit and Loss Account

1. Transfer gross profit from the trading account to the profit and loss
account.
2. Close off all indirect revenue accounts and transfer the balances to
the profit and loss account.
3. Close off all indirect expense accounts and transfer the balances to
the profit and loss account.
4. Calculate net profit.

Information recorded on the Income Statement

On the debit side:

1. All expenses incurred in the selling and distribution of the goods, and
in the administration of the business.

Office and Administration expenses

 These are the expenses involving the management of the business

some examples are: salaries of managers, accountant and office
clerks, office rent, office stationery, office electricity charges, general
expenses, stationery and insurance.

Selling and distribution expenses

 These are the expenses, directly or indirectly connected with the sale
of goods. These expenses vary with the sales, they increase or
decrease with the increase or decrease of sale of goods. Examples are
advertisement, carriage outwards, sales men’s salaries,
commission,discount allowed, travelling expenses, bad debts,
warehouse rent and many more.

Financial expenses

Expenses in this category have to do with loans borrowed or finance

related charges. Examples are interest on loan, interest on overdraft and
bank charges.

2. Gross loss
When the amount realised in the trading account is a loss it must be
posted to the debit side of the profit and loss account.

On the credit side enter:

Or The Gross profit

When the amount realised on the sale of goods is more than the
cost of goods, it is gross profit.
3. Net profit

After all the transfers to the profit and loss account have been made, the
difference between the credit and the debit sides of the account is the net
profit or net loss for accounting period.

 If total of credit entries exceed the total of debit entries, the resulting
credit balance represents the net profit for the period.
 If total of debit entries exceed the total of credit entries, the resulting
debit balance represents the net loss for the period.
  Net profit accrues to the owner of the business and therefore increases
the owner’s capital. The net profit increases capital amount of the
owner and net loss decreases the capital.
 In a sole proprietorship, the net profit or loss is transferred to the
proprietor’s capital account.

The journal entry for transferring the gross profit from trading account to
the profit and loss account would appear as follows:

The journal

Dec Trading account 40 000

31/16 Profit and loss account 40 000

Being transfer of gross profit for the

year from the trading account to the
profit and loss account

Dec

31/16 Profit and loss account 40 000

Trading account 40 000

Being transfer of gross loss for the

year from the trading account to the
profit and loss account
Horizontal format of profit and loss
Dr Cr
Gross loss b/d xxx Gross profit b/d Xxx
Expenses
Salaries Xxx
Rent, rates Xxx
Postage and telegrams Xxx
Office electric charges Xxx
Telephone charges Xxx
Printing and stationery xxx
Carriage outward Xxx
Advertisement Xxx
Salesmen’s salaries Xxx
Insurance Xxx
Travelling expenses Xxx
Bad debts Xxx
Depreciation Xxx
Net Profit Xxx Net loss Xxx
x xxx x xxx

Vertical format of the Profit and Loss for the year ended 31 Dec 20xx
$ $
Gross profit (loss) from Trading account xxx (xxx)
Less: Expenses
Salaries xxx
Rent, rates xxx
Postage and telegrams xxx
Office electric charges xxx
Telephone charges xxx
Printing and stationery xxx
Carriage outward xxx
Advertisement xxx
Salesmen’s salaries xxx
Insurance xxx
Travelling expenses xxx
Bad debts xxx
Depreciation xxx
Total expenses Xxx
Net profit or (loss) xxx(xxx)

 The journal entry for the net profit of a sole proprietor is transferred to
capital account and that of a partnership is transferred to appropriation
account.
 The journal entry for transferring the profit and loss to capital account
for sole proprietorship would appear as follows:

The Journal

Date Details Cr $ Dr $
Dec Profit and loss account (profit) 3 000
31/2016 Capital account 3 000
Being transfer of net profit for the year to
the capital account

Dec Capital account 2 000

31/2016 Profit and loss account (loss) 2 000
Being transfer of net loss for the year to the
capital account
Continuous Presentation of the Income Statement

The trading, profit and loss account may be represented continuously,

that is, from trading account up to profit and loss account. The trading,
profit and loss account maybe represented diagrammatically as shown:
The presentation of trading profit and loss account can be presented in T-
account format (horizontal) or vertical format. The modern form of
presentation of this financial statement is the vertical presentation.
Example 2:

The following is a Trial Balance for T. Tonderai Enterprises as at 31

December 2015

Dr $ Cr $
Sales 64 000
Electricity 4 000
Interest paid 600
Admin expenses 3 000
Purchases 24 000
Carriage on purchases 1 200
Advertising 2 000
Postage 500
Salaries 5 000
Stock 01/01/15 9 000
Machinery 34 000
Land and Buildings 10 000
Capital 26 300
Creditors 6 000
Cash 3 000
100 300 100 300

Stock in hand at 31 December 2015 amounted to $7 000.

From the above information (trial balance) and additional information, the
trading profit and loss account appears as follows:

T. Tonderai enterprises Income Statement for the year ended 31

December 2016.
$ $
Sales 64 000

Less: cost of goods sold

Opening stock 9 000
Add: Purchases 24 000
Add: carriage on Purchases 1 200
Cost of goods available for sale 34 200
Less: closing stock 7 000
Cost of goods sold 27 200
Gross profit 36 800

Trading Account
 Profit and
Less: expenses
Electricity 4 000 Loss
Interest paid 600 Account
Delivery expenses 3 000
Advertising 2 000
Postage 500
Salaries 5 000
15 100
Net profit 21 700

The limitations of the Income Statement

1. The Income Statement is a historical view of the business.

2. It does not tell us what will happen in the future although it may help
to identify trends.
3. Business may manipulate accounts in order to reduce their tax
liabilities, or to deter a potential takeover.

The nature of profit or loss relatingto a specific period

 All business organisations carry out their operations with the view of
making profit, growth, survival and customer satisfaction.
 Profit or loss of a business is calculated by preparing the trading profit
and loss account.
 Revenue and expenses relating to a specific period are matched to
ascertain profit or loss for the period.

Definition of terms

 Gross profit–Sales less cost of goods sold for a specific period.

 Cost of sales - refers to the actual cost price of the goods which were
sold during the year plus any cost related to the acquisition of those
goods. This is adjusted with stock of goods from previous period.
 Profit- can be defined as the excess of income over expenditure.
  The following formula is used to calculate profit or loss of a profit
making organisation.
 Loss- the surplus of expenditure over income.

Net profit/loss =gross profit + income from other

sources –total operational expenses

Difference between gross profit and net profit/loss

Gross profit Net profit/loss

 Sales less cost of sales Gross profit less Operating expenses

 Shows profit made on trade
 The gross profit of the same period of
the same organisation is greater than
net profit.
Shows the overall profit/or loss of the
business
Net profit /loss of the same period is
always less than the gross profit.