Optimal stock market investment requires both technical and fundamental analysis. While technical analysis aids in gauging the price movements of a particular stock, fundamental analysis analyses the financial performance and health of the company through its financial statements, like the Trading and Profit & Loss Account.
As the number of demat accounts in India rose to more than 20 crores, a surge primarily led by investors under 30 years of age, clarifying and decoding the concepts of optimal technical and fundamental analysis has become key. Therefore, this blog decoded the Trading and Profit & Loss Account in detail, along with their meaning, constituents, formats and much more.
Let us begin with understanding the trading account.
Introducing Trading Account
A financial statement that reduces the direct costs and expenses from direct income to deliver the gross profit or loss is called a trading account. This statement shows the basic profitability of the primary business of a company.
However, even direct transactions have various aspects that can be explored by understanding the trading account format.
Format of Trading Account
The table below shows the trading account format. A glance at this format, followed by a detailed analysis of each of its constituents, can help solidify the concept of trading accounts.
| Debit | Credit | ||
| Heads | Amount (₹) | Heads | Amount (₹) |
| Opening Stock | xxx | Closing Stock | xxx |
| Purchase | xxx | Sales | xxx |
| Sales Returns | xxx | Purchase Returns | xxx |
| Direct Expenses | xxx | Gross Loss (balancing figure) | xxx |
| Gross Profit (balancing figure) | xxx | ||
| Total | xxx | Total | xxx |
Now, let us decode the constituents of the trading account format.
- Stock: Trading account is made for a particular period, that is, the whole financial year. Therefore, the inventory amount at the beginning and closing of the year helps us to identify the net inventory the company still possesses.
- Purchase and Sales: The cost at which the manufacturer or trader acquired or manufactures his goods is called the purchase cost. Moreover, the income earned, in cash or credit, is constituted as sales.
- Returns: People return deliveries in case of defects or discrepancies. This holds not only for customers but also for suppliers. When the business in question receives defective or problematic supplies from suppliers, it is called purchase returns. Purchase returns reduce the cost of purchase. Therefore, it is either reduced from purchases in the debit side or recorded in the credit side.
For instance, if Mr A purchases items worth ₹15,000 from S. However, he returns goods worth ₹5,000. Therefore, the net purchase will be ₹10,000.
Moreover, when the customers of a business in question return the goods to the business, it is called sales returns. It can either be reduced from sales in the credit side or recorded in the debit side.
For instance, if D returns ₹6,000 of goods worth ₹10,000 sold to him by A, net sales will be ₹4,000.
When purchase returns increase, gross profit can increase. However, when sales returns increase, gross profit can fall.
- Direct Expenses: Expenses that are crucial for the execution of sales are called direct expenses and are recorded in the trading account. For example, factory wages, freight, etc. Imagine a manufacturing business. While such a business can be executed without an advertising cost (a form of indirect expense), it cannot be executed without paying wages to the labourers.
Now that the format and essence of trading accounts are explained, let us take an example to crystallise the understanding.
How to Calculate Gross Profit (with Example)
Discussed below is the example of Verma Ltd., a furniture trader, preparing his trading account to understand gross profit.
| Debit | Credit | ||
| Heads | Amount (₹) | Heads | Amount (₹) |
| Opening Stock | 20,000 | Closing Stock | 25,000 |
| Purchase | 60,000 | Sales | 1,00,000 |
| Sales Returns | 2,000 | Purchase Returns | 3,000 |
| Wage | 10,000 | ||
| Freight | 3000 | ||
| Gross Profit (balancing figure) | 33,000 | ||
| Total | 1,28,000 | Total | 1,28,000 |
Now, after preparing the trading account, businesses prepare the P&L account. Let us understand the profit and loss account.
Introducing Profit and Loss Account
The income statement of a company that aids in computing the net profit or loss after accounting for indirect and other income and expenses is called a profit and loss account. Under this account, businesses reduce indirect expenses and add indirect income to gross profit or loss to compute net profit or loss.
This statement shows the actual overall profitability of the business and helps determine the scale of its operations.
Now, let us take a look at the P&L account format to further understand it.
Format of Profit & Loss Account
The P&L account format is discussed below, along with a detailed explanation of its aspects.
| Debit | Credit | ||
| Particulars | Amount (₹) | Particulars | Amount (₹) |
| Gross Loss | xxx | Gross Profit | xxx |
| Indirect Expenses | xxx | Other Income | xxx |
| Administrative Expenses | xxx | Net Loss (Balancing Figure) | xxx |
| Selling Expenses | xxx | ||
| Financial Expenses | xxx | ||
| Depreciation | xxx | ||
| Net Profit (Balancing Figure) | xxx | ||
| Total | xxx | Total | xxx |
Now, let us decode each aspect of the P&L account format.
- Gross Value: The profit and loss account receives the gross profit or loss that was noted in the trading account. The computation of other income and expenses is made from here to reach the net profit or loss.
- Expenses: The profit and loss account records a variety of expenditures, including indirect, administrative, financial, etc. When these expenses increase, the net profit decreases. The table below shows examples of such expenses.
| Expense | Examples |
| Indirect | Rent, taxes, legal and audit fees, insurance, etc. |
| Administrative | Office salaries of managers, internet charges, etc. |
| Selling | Advertising and sales, freight, commissions, etc. |
| Financial | Interest on loans, foreign exchange loss, etc. |
- Depreciation: A type of non-cash charge on an asset is called depreciation. Since it is a non-cash expense, it finds space in the profit and loss account.
- Other Income: A company can generate revenue from sources outside of its main line of work. These incomes can be of a recurring or non-recurring nature. For instance, bank interest received, discount received, rent received, etc.
To understand how gross profit becomes net profit, let us look at an example.
Gross Profit VS Net Profit: How They Connect
Discussed here is the profit and loss account of Verma Ltd.
| Debit | Credit | ||
| Particulars | Amount (₹) | Particulars | Amount (₹) |
| Salary | 4,000 | Gross Profit b/d | 33,000 |
| Advertising | 3,000 | Other Income | 20,000 |
| Audit Fees | 2,000 | ||
| Tax Paid | 3,000 | ||
| Depreciation | 2,000 | ||
| Net Profit (Balancing Figure) | 39,000 | ||
| Total | 53,000 | Total | 53,000 |
Let us now compare Trading and Profit & Loss Account to uphold their comparative analysis and understand their features.
Key Differences: Trading Account vs P&L Account
Discussed below are the key differences between Trading and Profit & Loss Account.
| Particulars | Trading Account | Profit and Loss Account |
| Finding | It facilitates the calculation of gross profit or loss | It aids in computing the net profit or loss |
| Objective | The goal is to explain the profitability of the core business | The goal is to explain the profitability of the overall business |
| Stage | Prior to the profit and loss account, it is created | It is prepared after the trading account |
| Transfer | The profit and loss account receives the gross profit | The balance sheet receives the net profit |
| Type of Expenses and Income | It includes direct income and expenditure | It includes indirect income and expenditure |
However, while the concept of Trading and Profit & Loss Account is understood individually, in practice, they are combined to form a single income statement or a consolidated Trading and Profit & Loss Account. Let us understand this with an example.
Practical Example: Combined Statement
The table below shows the combined Trading and Profit & Loss Account of Verma Ltd.
| Debit | Credit | ||
| Particulars | Amount (₹) | Particulars | Amount (₹) |
| Opening Stock | 20,000 | Closing Stock | 25,000 |
| Purchase | 60,000 | Sales | 1,00,000 |
| Sales Returns | 2,000 | Purchase Returns | 3,000 |
| Wage | 10,000 | ||
| Freight | 3000 | ||
| Gross Profit (balancing figure) | 33,000 | ||
| Total | 1,28,000 | Total | 1,28,000 |
| Salary | 4,000 | Gross Profit b/d | 33,000 |
| Advertising | 3,000 | Other Income | 20,000 |
| Audit Fees | 2,000 | ||
| Tax Paid | 3,000 | ||
| Depreciation | 2,000 | ||
| Net Profit (Balancing Figure) | 39,000 | ||
| Total | 53,000 | Total | 53,000 |
Now, let us understand the importance of these statements to various stakeholders and taxation needs.
Need for Trading and Profit & Loss Account: Importance
The advantages and requirements for the Trading and Profit & Loss Account are covered below.
- Financial Health: The trading and profit & loss account helps stakeholders, like investors, creditors and others, to understand the financial health of the company. Thus, explore its creditworthiness and investability.
- Operational Efficiency: These statements also indicate how efficiently the business converts its stock into sales. This guarantees the speed and effectiveness of the business.
- Taxation: The financial statements are necessary for tax compliance. Optimal maintenance of records also helps in finding the fair tax due.
- Other Legal Compliance: Various other statutory regulations, during specific events or otherwise, require detailed fiscal records. For example, a company needs to disclose its income statements in the offer documents during the IPO.
FAQs
The trading account discloses the gross profit or loss by deducting the direct expenses from the direct income. This aids in understanding the core profitability of the business. However, a profit and loss account helps in computing the net profit or loss by accounting for the indirect expenses and incomes, as well. This aids in exploring the overall profitability of the business.
The trading account is computed by accounting for both direct income and direct expenses. On the debit side, it starts with the opening inventory and includes purchases, sales returns, direct expenses, etc. The credit side includes sales, purchase returns and closing stock. If the debit side is greater than the credit side, it is a gross loss. If the credit side is greater, it is gross profit.
The opening inventory is the starting point for trading on the debit side, which also includes purchases, sales returns, direct costs, etc. Closing stock, purchase refunds, and sales are all included in the credit side. A gross loss occurs when the debit side total exceeds the credit side total. It is gross profit if the credit side is larger.
The profit and loss account begins with the balance of the trading account, whether a profit or a loss. Other income, in the form of interest from deposits, dividends received, etc., is added on the credit side. While the debit balance includes indirect, administrative, financial and other expenses, like advertising, audit fees, etc. If the total of the credit side is greater than the debit side, it is a net profit. Otherwise, it is a net loss.
Let us take the example of K Ltd. The trading account portion of a combined trading and P&L account starts by deducting the cost of goods sold, say ₹50,000, from sales of ₹1,00,000 to determine the gross profit of ₹50,000. This gross profit is then adjusted by other operating expenses of ₹10,000 and incomes of ₹20,000 to identify the ultimate net profit of ₹60,000 in the P&L section.
Trading and profit and loss statements are created separately to first compute the gross profit from the core trading activity, followed by the net profit after subtracting any other indirect costs. Understanding the difference between overall earnings (net profit) and operational effectiveness (gross profit) requires this distinction. Separate accounts keep the evaluation of fundamental company performance from being skewed by non-operational profits or losses.
The trading and profit & loss account helps investors, creditors, suppliers and other stakeholders judge the financial health of a business. It aids in understanding the creditworthiness, investability, and other measures. Moreover, it is necessary to ensure tax and other statutory compliance. During key events like IPO, disclosure of such income statements is integral.
