Introduction to Final Accounts and Accounting Treatment

Table of Contents

1. Introduction

2. Basic Principles Governing Final Accounts

3. Trading Account

4. Profit & Loss Account

5. Balance Sheet

1. Introduction to Final Accounts

The primary function of accounting includes computing the net result of operations of the business for the current period. To meet out this purpose, Income statement and Balance sheet are prepared. These two documents are popularly called as Final Accounts. It is the last phase of Accounting Process.

The components of final accounts depend upon the type of entity. In case of non-manufacturing entities, the business operations include purchase and sale of goods. That is why Trading Account is prepared to calculate Gross Profit. But a manufacturing entity is interested in computation of total cost of manufacturing the finished products. For this purpose, separate account is prepared as Manufacturing Account. The following table shows the components of final accounts for manufacturing and non-manufacturing firms:

The process of final accounts starts after preparation of trial balance. It is mainly divided into following two parts:

1. Income Statement: It is prepared to find out the net result of the operations. It is sub-divided into two parts:

a. Trading Account

b. Profit and Loss Account

2. Position Statement: It includes Balance Sheet showing the status of assets and liabilities as at a particular point of time.

2. Basic Principles Governing Final Accounts

There final account are required to be prepared in such a manner so that the income statement and Balance sheet show true and fair view of profitability and financial position of the business. The following are also considered in this regard:

1. 1. In the preparation of final accounts, proper distinction is required between capital and revenue items. If a capital expenditure is wrongly charged as revenue, then it will lead to undervaluation of profits.
   2. The profitability of the firm can be known if and only if all personal incomes and expenditure are separately treated from the business income and expenditures.
   3. Any such item or information, disclosure of which is material to judge the profitability, should be disclosed appropriately.
   4. The matching principle should be applied strictly which requires that expenses incurred to earn the revenue should be properly matched. For example if during the year 1,000 units have been purchased but 850 units have been sold, then cost of goods sold should be calculated in respect of 850 units and this cost should be compared with the corresponding sale proceeds.
   5. When revenue nature expenses have been incurred but the amount is heavy and the benefits are expected to be received in future also. Then a portion is charged in current period and remaining should be deferred for to be charged in future periods.

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3. Trading Account

In the process of preparation of final accounts, the first step is to calculate the amount of gross profit earned or gross loss incurred. The gross profit is the excess of sales over cost of goods sold. It is the first stage in the preparation of final accounts of a trading concern and the result of this account is transferred to Profit and Loss Account.

The Trading Account is prepared in T shape format. The items to be debited include the following:

1. Opening Stock:
It refers to the closing inventory of the last year entered in the books through the opening entry. Therefore, it always appears in the trial balance. It is important to note that in the first year of its operations, there will be no opening stock.

2. Purchases and purchases returns:
The Purchases account will have debit balance and it shows the gross amount of purchase of goods and materials for the purpose of resale or to be used in production. It includes both cash and credit purchases. On the other hand, Purchases returns account will have credit balance. The net purchases are debited to Trading Account. Besides purchases returns, following are also deducted from purchases:

(a) Goods given as Charity

(b) Goods given as sample

(c) Goods taken by the proprietor for personal use.

3. Direct Expenses:
These expenses are incurred on goods purchased, till they are brought to the place of business for sale. In addition, expenses incurred on production such as wages, power and fuel, factory rent, etc. are also treated as direct expenses. The following are some of the important direct expenses:

(a) Carriage or freight or cartage inwards:
It refers to the cost of bringing materials to the godown of the firm and making them available for use. It is important to note that if such expenses are in connection with the purchase of fixed asset, then the same are capitalised and not taken to Trading account.

(b) Manufacturing Wages:
Wages paid to workers in the godown/stores, should be debited to the trading account. If any amount is outstanding, it must be brought into books so that full wages for the period concerned are charged to the trading account. However, if wages are paid for installation of an asset, it should be added to the cost of the asset.

3.1 The Trading Account is credited with the following:

1. Sale and sales returns:
It reflects the total sale of goods by the firm during the period. It includes both cash as well as credit sales. The amount does not include sales tax or Value Added Tax. There may be sales returns also. So, net sales are to be disclosed to the credit of Trading Account.

2. Closing Stock:
It refers to the unsold goods lying in the godown of the firm at the end of the period. As per the convention of conservatism, this stock is always valued at lower of cost and net realizable value. It is usually given outside the trial balance as an adjustment and is recorded in the books through the following adjustment entry:

3.2 Balancing of Trading Account

After having entered, the items to the relevant sides of Trading Account, the totals of debit side and credit side are compared. If the total of the credit side is more than that of the debit side, the excess is Gross Profit.

3.3 Closing entries in respect of Trading Account

The following are the relevant closing entries:

3.4 Format of Trading Account

The format of Trading Account is as follows:

Illustration 1

Manu Enterprises has provided you the following information for the year ending 31st March, 2019. Prepare Trading Account.

Solution

In the books of Manu Enterprises

Trading account

For the year ended 31st March, 2019

4. Profit & Loss Account

It is prepared to calculate the net profit earned or net loss incurred by the firm in a particular accounting period. This account starts with the amount of gross profit (or loss) reflected by Trading Account. The gross profit appears to the credit side and gross loss to the debit side. All indirect expenses are transferred to the debit side of Profit and Loss Account. The administrative expenses include salaries, printing and stationery, postage, audit fees, rent and rates, etc. The expenses are also debited to Profit and Loss Account. These expenses are salesmen’s salaries, packing charges, advertisement expenses, export duties, bad debts, commission to agents, etc. There are some indirect incomes also like dividend received, profit on sale of investments or machinery, interest received, etc. These are credited to P & L A/c.

4.1 Items Debited to Profit & Loss A/c

1. Administrative Expenses:

(a) Office Salaries

(b) Office Rent and Rates

(c) Lighting

(d) Audit Fees

(e) General Expenses

(f) Printing and Stationery

2. Selling and Distribution Expenses:

(a) Salesmen’s Salaries

(b) Godown Rent

(c) Advertising

(d) Delivery Van Expenses

(e) Freight and Carriage on sales

(f) Packing expenses

3. Finance Charges:

(a) Interest on Loan

(b) Interest on bank overdraft

(c) Interest element in Finance Lease

4. Abnormal Items:

(a) Loss by theft

(b) Loss on sale of fixed assets

(c) Loss by fire to the extent not covered by insurance

4.2 Items Credited to Profit & Loss A/c

1. 1. Gross Profit as per Trading account
   2. Interest received
   3. Rent received
   4. Discount received
   5. Profit on sale of fixed assets
   6. Extraordinary gain

NOTE: The following items are shown separately in P & L A/c, one to the debit side and other to the credit side:

1. 1. Interest expense and interest received
   2. Discount allowed and discount received
   3. Bad debts and bad debt recovered

4.3 Closing entries in respect of Profit and Loss Account

The following are the relevant closing entries:

4.4 Format of P & L Account

The format of Profit & Loss Account is as follows:

Illustration 2

Consider the following information in relation with Sunrise Traders:

Gross profit ` 4,36,000, Discount Received ` 19,200, Salaries ` 99,840, Interest Received ` 8,800, Miscellaneous Income ` 13,920, Bank Charges ` 3,200, Consultancy fees ` 16,800, Loss by Fire ` 4,800, Depreciation ` 43,440, Audit fees ` 1,920, Electricity charges ` 17,840, Stationery ` 5,600, Legal charges ` 25,920, Discount allowed ` 21,600, Telephone, postage & Telegrams ` 11,200, Bad debts ` 8,560, Interest ` 40,800.

Prepare profit and loss account of Sunrise traders for the year ended on 31st march, 2019.

Solution

In the books of Sunrise traders

Profit & Loss Account

For the year ended 31st March, 2019

5. Balance Sheet

Balance Sheet is a statement showing the total assets and liabilities of an entity as at a particular date. It is important to note that Trading A/c and Profit & Loss A/c are prepared for a particular period as periodical statements. But Balance Sheet is a positional statement. It shows the financial position of the business on a particular date. Usually in case of non-corporate entities, Balance Sheet is prepared in horizontal format i.e. T shape format. In this case, the right and left hand sides of the balance sheets are called as Assets and Liabilities. Balance sheet is not an account rather it is simply a statement showing closing balances of real and personal accounts.

5.1 Arrangement of Assets and Liabilities

As such there is no prescribed format of balance sheet for non-corporate business entities. Here two terms “Grouping” and “Marshalling” are important. Grouping means putting together items of similar nature under a common heading like current assets, fixed assets, etc. Marshalling means the order in which the various items are shown in the Balance Sheet. This order may be liquidity or permanence.

5.2 Format of Balance Sheet (In order of Liquidity)

Liquidity means the most liquid asset like cash is shown first and least liquid assets like Goodwill is disclosed in last.

5.3 Format of Balance Sheet (In order of Permanence)

Permanence means the permanent i.e. least liquid item is shown first and most liquid item is shown in last.

Illustration 3

After having prepared the Trading and Profit and Loss Accounts, Vipul Enterprises provides the following information:

Solution

In the books of Vipul Enterprises

Balance Sheet

As on 31st March, 2019

Also Read:
Golden Rules of Accounting
Method of Accounting
Indian Accounting Standards