The trading profit and loss account is made up of two separate accounts within the general ledger.
- The trading account
- The profit and loss account
The purpose of the two accounts is to separately identify the gross profit and net profit of the business. The trading account is the top part of the trading profit and loss account and is used to determine the gross profit. The profit and loss account is the lower part of the trading profit and loss account and is used to determine the net profit of the business.
Both the trading account and the profit and loss account form part of the double entry as they are used to close off the temporary accounts at the end of an accounting period.
The trading and profit and loss accounts are discussed in more detail below.
The Trading Account
The trading account is particularly useful for a merchandising business or trading business involved in the buying and selling of finished products. The account allows the merchandiser to easily determine its overall gross profit and gross profit percentage which are important indicators of how efficiently a business is buying and selling its products.
Trading Account Formula
The trading account shows the gross profit which is determined by deducting the cost of goods sold from the net sales revenue of the business.
The gross profit is calculated using the trading account formula.
In the formula net sales is equal to the gross sales of the business less sales returns, allowances, and discounts.
It should be noted that carriage outwards is not included in the trading account. Carriage outwards is an expense included in the profit and loss account discussed below.
The cost of goods sold used in the formula can be expanded using the following formula.
Net purchases is equal to the gross purchases of the business including carriage inwards less any purchase returns, allowances, and discounts.
Preparation of Trading Account
The trading account is prepared by closing the temporary revenue and purchases accounts and adjusting the inventory accounts using a closing journal entry as shown in the example below.
| Account | Debit | Credit |
|---|---|---|
| Sales | 105,000 | |
| Sales returns | 5,000 | |
| Purchases | 49,000 | |
| Purchase returns | 3,000 | |
| Beginning inventory | 8,000 | |
| Ending inventory | 9,000 | |
| Trading Account | 55,000 | |
| Total | 117,000 | 117,000 |
Each account is closed and transferred to the trading account. The credit entry to the trading account of 55,000 represents the gross profit for the period.
Trading Account Example
After the closing journal entry has been posted the trading account would take the format shown in the example below.
| Trading Account | ||||
|---|---|---|---|---|
| Debit | Credit | |||
| Sales returns | 5,000 | Sales | 105,000 | |
| Purchases | 49,000 | Purchase returns | 3,000 | |
| Beginning inventory | 8,000 | Ending inventory | 9,000 | |
| Balance c/d | 55,000 | |||
| Total | 117,000 | Total | 117,000 | |
| Balance b/d | 55,000 | |||
For clarity, in this example each line item is posted to the general ledger trading account leaving a credit balance brought down of 55,000 which represents the gross profit of the business.
In the example above the trading account has a net credit balance of 55,000 which indicates sales are greater than the cost of goods sold and the business has made a gross profit. If the trading account had a net debit balance brought down it would indicate (unusually) that sales were less than the cost of goods sold and the business had made a gross loss.
Trading Account in Final Accounts
In the final accounts the trading account is usually presented in a more readable format. Assuming the figures relate to the month ended 31 December an example of a trading account might appear as follows.
| Net sales | 100,000 | |
| Net purchases | 46,000 | |
| Beginning inventory | 8,000 | |
| Ending inventory | -9,000 | |
| Cost of goods sold | 45,000 | |
| Gross profit | 55,000 |
Again the trading account shows the gross profit of 55,000 the business made on the products it buys and sells.
In addition since the trading account shows the net sales the gross profit percentage can be easily calculated as follows.
Gross profit % = Gross profit / Net sales Gross profit % = 55,000 / 100,000 = 55%
The Profit and Loss Account
The profit and loss account is used to determine the net profit of the business. The starting point for the profit and loss account is the balance carried down from the trading account which is the gross profit of the business.
Profit and Loss Account Formula
The profit and loss account shows the net profit which is the determined by deducting the expenses of the business from the trading account gross profit and adding other income.
The net profit is calculated using the profit and loss account formula.
In the above formula expenses refers to all the costs of the business which are not included in cost of goods sold in the trading account such as wages and salaries, rents, insurance, bank charges etc.
Other income refers to any income other than that included in sales revenue such as interest received.
Preparation of Profit and Loss Account
The profit and loss account is prepared by closing the trading account, expense accounts and other income accounts using a closing journal entry.
| Account | Debit | Credit |
|---|---|---|
| Trading Account | 55,000 | |
| Expense accounts | 48,000 | |
| Other income | 5,000 | |
| Profit and Loss Account | 12,000 | |
| Total | 60,000 | 60,000 |
Each account is closed and transferred to the profit and loss account in the general ledger. The credit entry to the profit and loss account of 12,000 represents the net profit for the period.
Profit and Loss Account Example
After the closing journal entry has been posted the profit and loss account would take the format shown in the example below.
| Profit and loss account | ||||
|---|---|---|---|---|
| Debit | Credit | |||
| Gross profit b/d | 55,000 | |||
| Expenses | 48,000 | Other income | 5,000 | |
| Balance c/d | 12,000 | |||
| Total | 60,000 | Total | 60,000 | |
| Balance b/d | 12,000 | |||
Again for clarity, in this example each line item is posted to the general ledger profit and loss account leaving a credit balance brought down of 12,000 representing the net profit of the business.
In the example above the profit and loss account has a net credit balance of 12,000 which indicates sales and other income are greater than the cost of goods sold and expenses and the business has made a net profit. If the profit and loss account had a net debit balance brought down it would indicate that sales and other income were less than the cost of goods sold and expenses and the business had therefore made a net loss for the accounting period.
Profit and Loss Account in the Final Accounts
The profit and loss account starting with gross profit is not usually shown as a separate statement and is normally combined with the trading account and shown as a combined trading profit and loss account format shown later in this post.
For the sake of completeness, assuming the figures relate to the month ended 31 December, a separate profit and loss account starting with gross profit might appear as follows.
| Gross profit | 55,000 | |
| Expenses | 48,000 | |
| Other income | 5,000 | |
| Net profit | 12,000 |
Again the profit and loss account shows the net profit of 12,000 the business has made for the accounting period.
Using the net sales from the trading account the business can quickly calculate the net profit percentage as follows.
Net profit % = Net profit / Net sales Net profit % = 12,000 / 100,000 = 12%
Trading Profit and Loss Account Format
The trading account and the profit and loss account can be combined into a single summary known as a trading profit and loss account.
An example trading profit and loss account format is shown below.
| Net sales | 100,000 | |
| Net purchases | 46,000 | |
| Beginning inventory | 8,000 | |
| Ending inventory | -9,000 | |
| Cost of goods sold | 45,000 | |
| Gross profit | 55,000 | |
| Expenses | 48,000 | |
| Other income | 5,000 | |
| Net profit | 12,000 |
By using the trading profit and loss account the merchandising business can clearly see both the gross and net profit of the business and can quickly calculate the gross and net profit percentages based on net sales.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.