Figuring Out Profitability From Gross Sales And Expenses Taxes Formula Trading and Profit and Loss Account

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Trading and Profit and Loss Account

Trading account

As discussed earlier, the first section of the trading and profit and loss account is called trading account. The purpose of preparing the trading account is to find out the gross profit or gross loss while the second section is to find out the net profit or net loss.

Preparation of business accounts

A trading account is mainly prepared to know the profit of goods purchased (or manufactured) by the trader. The difference between the selling price and the cost of goods sold is the merchant’s earnings. So to calculate gross income, it is necessary to know:

(a) Cost of goods sold.

(b) Sale.

Total sales can be traced from the sales account. However, the cost of goods sold is calculated. To calculate the cost of sales it is necessary to know its meaning. ‘Cost of goods’ includes the purchase price of the goods and the costs incurred in purchasing the goods and bringing the goods to the place of business. To calculate the cost of goods “we have to deduct the value of goods on hand from the total cost of goods purchased. We can study this phenomenon with the help of the following formula:

Opening Stock + Cost of Purchases – Closing Stock = Cost of Sales

It has already been discussed that the purpose of preparing business accounts is to calculate the gross profit of the business. It can be described as the amount of ‘sales’ over ‘cost of sales’. This definition can be explained in terms of the following equation:

Gross Profit = Cost of Goods Sold or (Sales + Closing Stock) – (Beginning Stock + Purchases + Direct Expenses)

Open stock and purchases The cost of purchase and delivery (direct expenditure) is recorded on the debit side while the sale and closing stock is recorded on the credit side. If the credit side is Jeater than the debit side then the difference is written as gross profit on the debit side which is finally recorded in the credit side of the profit and loss account. When the debit side exceeds the credit side, the difference is the gross loss which is recorded on the credit side and finally shown on the debit side of the profit and loss account.

Common items in a business account:

A) Debit side

1. Open stock. This is the unsold stock at the end of the previous year. It must have been brought into the books with the help of an opening entry; So it always appears within the trial balance. Usually, it is shown as the first item on the debit side of the trading account. Of course, in the first year of business there will be no opening stock.

2. Purchases. It is usually the second item on the debit side of the business account. ‘Purchases’ means total purchases i.e. cash and credit purchases. Any return outside (purchase return) must be deducted from the purchases to find the net purchases. Sometimes the goods are received from the supplier before the relevant invoice. In such a case, an entry should be passed to debit the purchase account and credit the supplier’s account with the value of the goods on the date of preparation of the final accounts.

3. Purchase expenses. All expenses related to the purchase of goods are also debited to the trading account. These include wages, inland freight, customs duties, clearing charges, dock charges, excise duties, octroi and import duties etc.

4. Production costs. Such expenses are incurred by traders to produce or render goods in salable condition like, motive power, gas fuel, stores, royalties, factory expenses, salaries of foremen and supervisors etc.

As we prepare only trading accounts, although manufacturing expenses are strictly to be taken in the production account, these types of expenses can also be included in the trading account.

(B) Credit Aspect

1. Sales. Sales means total sales i.e. cash plus credit sales. If there are any sales returns, these should be deducted from the sale. Hence the net sales are credited to the trading account. If the firm’s assets are sold, it should not be included in the sale.

2. Closed stock. It is the value of unsold stock in the warehouse or store at the end of the accounting period. Normally the closing stock is given beyond the trial balance in which case it is shown on the credit side of the trading account. But if it is given within the trial balance, it will not be shown in the credit side of the trading account but only in the balance sheet as an asset. Closing stock cost or market value whichever is lower should be evaluated.

Valuation of closed stock

To determine the value of closing stock a complete inventory or inventory of all the items in stock with quantity is required. Stock inventory is prepared based on physical observations and total stock value is calculated based on unit price. Thus, it is clear that stock taking involves (i) listing, (ii) pricing. Each commodity is priced until the market price is lower. Pricing inventory at cost is easier if costs remain constant. But prices remain volatile; Stocks are therefore valued based on one of several valuation methods.

The preparation of trading accounts helps the business to know the relationship between the costs incurred and the revenue earned and the level of efficiency with which operations are conducted. The ratio of gross profit to sales is very important: it comes down to:

Gross profit X 100 / sales

With the help of GP ratio one can determine how efficiently he is running the business as higher the ratio, better will be the efficiency.

Closing entries related to business accounts

To transfer various accounts relating to goods and purchase expenses, the following closing entries are recorded:

(i) For stock opening: debit trading account and credit stock account

(ii) For Purchases: Debit Trading Account and Credit Purchase Account, amount after deducting Purchase Returns.

(iii) For Purchase Returns: Debit Purchase Returns Account and Credit Purchase Account.

(iv) For Inward Returns: Debit Sales Account and Credit Sales Returns Account

(v) For Direct Expenditure: Debit Trading Account and Credit Direct Expenditure Accounts individually.

(vi) For Sales: Debit Sales Account and Credit Trading Account. We will see closure of all the accounts mentioned above except the trading account

(vii) For Closing Stock: After recording the above entries in Debit Closing Stock Account and Credit Trading Account the Trading Account will be balanced and the difference between the two sides will be ensured. If the credit side is higher the result is gross profit for which the following entry is recorded.

(viii) For Gross Profit: Debit Trading Account and Credit Profit and Loss Account If the result is gross loss then the above entry is reversed.

Profit and Loss Account

A profit and loss account is opened by recording gross profit (on the credit side) or gross loss (on the debit side).

In order to earn net profit, businessmen have to spend a lot of money other than direct expenses. As those expenses are deducted from profit (or added to gross loss), the resulting figure will be net profit or net loss.

Expenses recorded in the profit and loss account are called indirect expenses. These will be categorized as follows:

Selling and distribution expenses.

These costs include the following:

(a) Salesman’s Salary and Commission

(b) Commission to Agents

(c) Shipping and Delivery on Sale

(d) Sales Tax

(e) Bad debt

(f) Advertising

(g) Packing expenses

(h) Export Duties

Administrative expenses.

These include:

(a) Salaries and wages of office

(b) Insurance

(c) Legal Expenses

(d) Business Expenses

(e) Rates and Taxes

(f) Audit Fees

(g) Insurance

(h) Rent

(i) Printing and Stationery

(j) Post and wire

(k) Bank charges

Financial expenses

These include:

(a) Exemption Permitted

(b) Interest on capital

(c) Interest on loans

(d) Exemption of discount charges on bills

maintenance, depreciation and provision etc.

This includes the following expenses

(a) Maintenance

(b) Depreciation on assets

(c) Provision or reserve for doubtful debts

(d) Reserve for relief on debtors.

Along with the above indirect expenses, the debit side of the profit and loss account also includes various business losses.

The items recorded on the credit side of the profit and loss account are:

(a) Exemption Received

(b) Commission received

(c) Rent received

(d) Interest received

(e) Income from investment

(f) Gain on sale of property

(g) Bad debt recovery

(h) Dividends received

(i) Apprenticeship premium etc.

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