13 Preparation of Profit and Loss Accounts

S.S Narta

epgp books

 

 

Introduction:

 

The determination of Gross Profit or Gross Loss is done by preparation of Trading Account. But it does not reveal the Net Profit or Net Loss of a concern during the particular period. This is the second part of the income statement and is called as Profit and Loss Account. Profit and loss account starts with gross profit brought down from trading account on the credit side. (If gross loss, on the debit side). All the indirect expenses such as office and administrative expenses, selling and distribution expenses and non operating expenses are debited and all the revenue incomes are credited to the profit and loss account and then net profit or loss is calculated. If incomes or credit is more, than the expenses or debit, the difference is net profit. On the other hand, if the expenses or debit side is more, the difference is net loss. This Net Profit or Net Loss is transferred to the Capital Account of Balance Sheet. Profit and loss account is prepared to ascertain the net profit of the business concern for an accounting period. In the words of Prof. Carter “Profit and loss account is an account into which all gains and losses are collected in order to ascertain the excess of gains over the losses or vice versa.”

 

It shows that only Indirect expenses are taken to Profit & Loss account and deducted from Gross Profit. Such expenses are of the following types:

 

(i) Administrative expenses or Office expenses: It includes office salary and wages, Insurance, Rent, Printing, Postage, Audit fee, law charges, repairs etc.

(ii) Selling and distribution expenses: It includes Salesman’s salaries, travelling expenses, advertising, discount allowed, bad debts, warehouse expenses etc.

(iii) Financial expenses: These expenses which are incurred for acquiring necessary finances for the business are called financial expenses. These include: Interest on capital, Cash discount allowed, bank charges etc.

(iv) Maintenance and depreciation expenses: It includes repair to building, furniture, machinery, depreciation to building, furniture etc.

(v) General expenses and Losses: It includes loss on the sale of fixed assets, loss by fire, theft, etc. Fines, Charity, donation and Gifts, Trade expenses etc.

(vi) Miscellaneous income: It includes discount received, commission received, dividend received, bad debts recovered and income from investments.

 

DEBIT SIDE

 

Expenses shown on the debit side of profit and loss account are classified into two categories.

  • Operating expenses and
  • Non-operating expenses

 

Operating expenses: These expenses are incurred to operate the business efficiently. They are incurred in running the organization. Operating expenses include administration, selling, distribution, finance, depreciation and maintenance expenses.

 

Non-operating expenses: These expenses are not directly associate with day to day operations of the business concern. They include loss on sale of assets, extraordinary losses, writing off fictitious assets such as preliminary expenses, underwriting commission etc.

 

CREDIT SIDE

 

Gross profit is the first item appearing on the credit side of profit and loss account. Other revenue incomes also appear on the credit side of profit and to account. The other incomes are classified as operating incomes and non-operating incomes.

 

Operating incomes: These incomes are incidental to business and earned from usual business carried on by the concern. Examples: discount received, commission earned, interest received etc.

 

Non-operating incomes: These incomes are not related to the business carried on by the firm.Examples are profit on sale of fixed assets, refund of tax etc.

 

CLOSING ENTRIES FOR PROFIT AND LOSS ACCOUNT 1. For transferring expenses to profit and loss account:

Note: In case of partnership, the profit or loss is divided between partners in their profit sharing ratio and credited or debited to the individual partners. In case of limited companies, Net profit or loss is transferred to the P&L Appropriation A/c for disposal.

 

THE SPECIMEN OF PROFIT AND LOSS ACCOUNT IS SHOWN BELOW Profit and Loss Account for the year ended 31st March 2015

 

 

Note: *Either net profit or net loss is the balancing figure in P & L A/c

 

1. The purpose and importance of preparing profit and loss account.

2. To determine the future line of action

3. To know the net profit or loss of business

4. To calculate different ratios

5. To compare the actual performance of the business with the desired one.

 

Purpose and Importance:

 

The purpose and the importance of preparing profit and loss account is as under:

 

1. Knowledge of net profit or net loss: The purpose of preparing profit and loss account is to ascertain the amount of net profit or loss. This is the actual profit available to the proprietor and credited to his capital account.

2. Ascertain ratio between net profit and sales: After getting net profit from profit and loss account. It is matched with the net sale to calculate net profit ratio. This ratio is compared with the desired net profit ratio and if there is any short coming, that will be removed. This ratio can also be compared with the ratio of previous years and effective future line of action can be taken.

3. Calculation of expenses ratio to sale: This ratio can be calculated by compare it with desired expenses ratio and with the ratio of previous years. It will always be in the interest of the firm that the expenses ratio should be the minimum.

4. Comparison: The actual performance of the business is available with the profit and loss account as regards net profit, individual expenses and individual income. We compare our actual performance with our planned and desired performance, identify weakness and try to remove them.

5. Maintaining provision and reserves: Certain reserves and provisions are to be maintained to meet the future uncertainties. The amount of provisions, reserves and funds to be maintained depends upon net profit earned by the firm. It is necessary to prepare profit and loss account to determine the net profit, so that effective provision for uncertain future could be maintained.

6. Determining future line of action: The organization can adopt future line of action on the basis of the information available from profit and loss account regarding net profit and other expenses.

 

PRINCIPLES :

 

There are certain principles which need to be followed while preparing Profit & Loss Account

  • Receipts and expenses of revenue nature should be entered
  • Expenses and incomes relating only to the period for which the accounts are being prepared should be considered if the expense has not yet been paid in cash or the income has not yet been received in cash.
  • All private expenses of the owner and partners must be debited to the capital or drawings accounts and must not be debited to the profit and loss account.
  • Similarly, any income has been earned from the private assets of the proprietor which is received by firm, it must be credited to the capital.

 

Explanation of Important items used in Profit & Loss A/c:

 

1. Salaries: Salaries are paid to employees of the firm working in the office. Salaries paid to workers of the factory, work manager, production engineer is direct expense so debited to Trading Account. Salaries and wages means indirect expenditure whereas wages and salary is a trading item.

2. Rent: Rent of the office, shop, show room etc is an indirect expenses and posted to the debit side of Profit & loss account. Rent of the factory building shall be, however, charged to the Trading A/c. the rent received is an income which should be credited to the profit & loss account.

3. Interest: Interest on loan, bank overdraft, capital etc., is an expense of indirect nature and debited to profit and loss account. Interest on fixed deposits, investments and loan advancement by the firm is an income and as such shall be credited to the profit & Loss account. Interest on proprietor’s drawings should be treated as a separate item.

4. Commission: Commission paid to the selling agents are indirect expenses. It is selling and distribution expense so it will be debited to profit & loss account. Commission paid to agents on the purchase of goods is direct expense and posted to the debit side of trading account.

5. Insurance premium: The firm has to pay insurance premium against fire, marine and other policies. It is an indirect expense; hence it will be debited to the Profit & Loss account.

6. Apprentice Premium: Some firms undertake to train men in various trade, for which they charge certain fees being called apprentice premium.

7. Life insurance premium: If the insurance premium is paid on the Life policy of the proprietor of the business, the amount will be treated as his drawings and is shown by way of deduction from the capital account. It should not be taken to Profit & loss Account.

8. Income Tax: Income tax paid appearing in trial balance of a sole trader is to be treated as an item of personnel expenses of the proprietor, so it is deducted from capital at the liability side of balance sheet. It is not debited or credited to Profit & Loss account.

9. Discount: It can be of two types:

(i) Trade discount: It is allowed at the time of selling goods. It is known as off season discount, new year’s discount, bumper sale and festival discount etc. the amount of this discount is deducted from sale.(No Special entry is required to be passed)

(ii) Cash discount: It is allowed at the time of making or receiving payments. If the payment is made immediately or at an early date company may allow its debtors certain discount.

10.Loss or gain on sale of assets: There may be loss on the sale of assets, so all losses should be debited to profit and loss account. It should be noted that loss on sale of asset is not operating loss. Profit or gain of assets is an income, so it will be credited to profit and loss account. In case of calculating operating net profit company shall excludes profit on sale of assets from the credit side of profit and loss account.

11.Trade Expenses: These expenses are also known as sundry expenses, miscellaneous expenses and office expenses. These expenses are of nominal value, so it is not necessary to open a separate account for such small expenses, which are generally considered as petty expenses.

12.Any other loss: Losses are the unwanted burden which the firm may be forced to bear. These losses may be loss by fire or loss by accident or bad debts etc. These losses will be shown at the debit side of profit and loss account.

 

Example

 

From the following Trial balance of Mr. Rameshwar Swami prepare profit and loss account for the year ended 31-3-2015.

 

 

Gross Profit transferred from the Trading A/c Rs. 25,000

 

SOLUTION

 

Profit and Loss Account of Mr. Rameshwar Swami for the year ended 31-3-2015

 

 

Example

 

From the following Trial balance of Mr. Gandhi prepare profit and loss account for the year ended 31-3-2015.

 

SOLUTION

 

Profit and Loss Account of Mr. Gandhi for the year ended 31-3-2015

Example

 

From the following balance given below, prepare P&L A/c of M/s. Diviya Ltd. for the year ending 31.12.2015.

 

SOLUTION:

 

Profit & Loss of M/s Diviya Ltd. for the year ending 31.12.2015

 

Example

 

From the following balance extracted at the close of the year ended 31-03-2015. Prepare Profit and Loss account of Mr. Santha Kumar as at that date:

 

SOLUTION

 

Profit & Loss Account of Mr. Santha Kumar for the year ending 31-03-2015

 

Summary:

 

Net results of an organization can be known by preparing profit and loss account. All the revenue expenses related to the year whatever it is paid or not and all revenue income related to the current year, whatever it is received are not must be take into consideration in order to know the exact net result.

  • The profit and loss account is opened in order to ascertain the Net Profit or Loss.
  • After the Trading Account is prepared, all other balances on Nominal Accounts remaining in the Trial Balance are transferred to the Profit & loss account.
  • The first item on the Profit and Loss account is a credit by way of transfer of Gross profit from the Trading Account.
  • The transfers of Nominal account balance on Profit & Loss account are made through the Journal and the entries are called closing entries.
  • Closing entries are so called because they serve to close all nominal accounts in the ledger.
  • The profit & loss account is finally closed by transferring to net profit or loss to the capital account of the proprietor.
  • The credit balance of Profit and Loss account represents Net profit, and as profit adds to the capital balance. It is carried to the Credit of the capital account.
  • The debit balance represents Net loss, and as loss reduces the capital, the same is carried to the debit of the capital account.
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Suggested Readings:

  • Shashi K Gupta,R.K,Sharma(2005), “Management Accounting”, Kalyani Publishers, New Delhi
  • Tulsian . P.C (2014) “Financial Accounting” Pearson Education India.
  • Lal, Jawahar  and  Seema  Srivastava  (2004)  “Financial  Accounting”  S.Chand  (G/L)  & Company Ltd.
  • Goyal, V.K. and Ruchi Goyal (2012) “Financial Accounting” PHI.
  • Maheshwari, S.N., Suneel K Maheshwari and Sharad K Maheshwari(2012) “Financial Accounting” Vikas Publishing House Pvt Ltd.
  • Monga, J.R. “Avanced Financial Accounting” Mayoor Paperbacks.
  • Bhattacharyya Asish K., (2012)” Essentials of Financial Accounting” PHI.
  • A Students Guide to IFRS (2012), Kaplan Publishing.