The trading account and profit and loss account

The revenue accounts are a pair of ledger accounts called the trading account and the profit and loss account. They are much like any other ledger account except that they are not ongoing (except for limited companies, dealt with later). Also, they are needed by more people outside the firm for example:

• the Inland Revenue to assess tax liability
• shareholders to see how the business is doing
• prospective purchasers to value the business
• prospective lenders to assess the risk of lending to the business, and its ability to pay interest.

But we adapt these accounts to a more easy-to-read version. Instead of two main columns we have only one (though we also use subsidiary columns for calculations). The two sides of the accounts are then represented in progressive stages of addition and subtraction. So the revenue accounts forwarded to interested parties don’t look like ledger accounts at all.

The trading account

This shows the gross profit, and how it is worked out:

sales – cost of goods sold = gross profit

To work out the cost of goods sold (i.e. cost of sales):

purchases + opening stock + carriage inwards, packaging and ware-house costs – closing stock = cost of sales

When transferring the balances to the trading acount, deduct sales returns from sales, before posting in the trading account. After all, they are merely ‘un-sales’ so to speak. The same goes for purchase returns: there is no place for any returns in the trading account.

Contribution to overheads

Gross profit is not the same things as net profit. Gross profit is first and foremost a contribution to overheads. It is only when they are paid for that any net profit may, or may not be available for shareholders.

The profit and loss account

The profit and loss account sets out the calculation of net profit like this:

gross profit + other income – expenses = net profit

We know that there must be two sides to every ledger posting: as you post each item in the revenue accounts, make an opposite side posting in the original ledger account from where your balance came. Against such postings just write ‘trading account’ or ‘profit and loss’ account. You are now closing down the revenue and expense ledger accounts, ready for a fresh start in the next accounting period.