Trading accounting is the first step of final account. The main objective of preparing trading account is to find out gross profit earned or loss suffered during an accounting period. Since, it is a nominal account, all direct expenses are debited and direct incomes are credited. It includes opening stock, purchase and expenses relating to purchase and factory expenses in the debit side. Similarly, sales and closing stock are included in the credit side. When the credit side is heavier than debit side, gross profit appear and vice versa.
Importance or Objective of Trading Account
it is necessary for a business to know the result of buying or manufacturing and sales during a particulars period of time. Hence, it is necessary to ascertain the gross profit or loss.
The main importance or objectives of preparing a trading account are below:
- To know gross profit or gross loss
- To provides safety or gross loss
- To provides information about the direct expenses
- To have comparison stock with the stock of last years.
Advantages of Trading Account
- It shows the relationship between gross profit and sales which help to measure profitability position of the business.
- It also show the ration between costs of goods sold and gross profit.
- It provides the information regarding efficiency of trading activities.
- It make easier to compare between sales, cost of goods sold and gross profit.
- It helps to provide information regarding closing stock, sales and cost of goods sold.
Items that are recorded in the debit side of the trading account
- Opening Stock: In case of a merchandising business, the opening stock consists of different types of finished goods. In case of manufacturing concern, opening stock consists of raw materials work in progress and finished goods. The amount of the opening stock is obtained from trial balance.
- Purchase: it is also obtained from trial balance which includes both cash and credit purchase.
- Purchase Returns: In the trial balance, it appears in the credit side. There are two ways of showing the purchase return in the trading account. It may be shown by deduction from purchases in the account. An alternative way to show the purchase returns in the credit side of trading account.
- Direct Expenses: Direct expenses are those expenses which are directly attributable to the purchase of goods or to bring the goods in salable condition.
Some examples of direct expenses are as follows:
Freight or freight inward or freight on purchase: Freight related with acquiring goods or making them saleable is called freight or carriage inward.
Carriage or carriage inward or carriage on purchase: Carriage paid for bringing the goods to the go-down of factory is carriage inward.
Wages or wages & salary or labor or direct labor: Wages incurred in a business is direct, when it is incurred on manufacturing or merchandise on making it salable. Other wages are indirect and debited to profit and loss account. If it is not mentioned whether wages are indirect or direct, it it should be assumed as direct and should appear in the trading account.
Fuel, motive power and lighting expenses: Fuel and power expenses are incurred for running the machines. They are considered as direct expenses since they are directly related with the production and debited to trading account. Lighting expenses of factory is also charged to trading account.
Packing charge: There are certain types of goods, which cannot be sold without a container or proper packing. These form a part of the finished product.
Duty on purchase: Any duty paid for the purchase of goods is debited to trading account. E.g. import duty or customs duty.
Octroi: When goods are brought into the municipal limits, octroi duty has to be paid to municipal committee or Municipal Corporation. It is a direct expense.
Manufacturing expenses: They are the expenses incurred in factory for manufacturing the goods such as factory rent, factory insurance, factory lighting etc.
Consumable stores: While manufacturing goods, various petty items of store are required to run the machine and to make the production possible. Such items including nuts, botls, grease oil, cotton waste cloth etc. total cost of stores consumed during the year are treated as direct expenses and debited to trading account.
Royalty: Royalty refers to the annual payment in the form of rent-payment to the owner of an asset for acquiring the right to use the patent or copyright or land. If royalty is paid on the basis of production, it is considered as direct expenses.
Commission on purchase: Commission paid on purchase of goods is a part of cost of good purchased. Therefore it is also a direct expense.
Items that are recorded in credit side of trading account
Sales: Sale include both and credit sales of goods.
Sales Return: When goods are return by the customers for some reasons, it is knows as sales return or return from customers or return inward. Sales return should is deducted from total sales so as to come up with the net sales.
Closing Stock: The value of goods, which remain unsold at the end of the accounting period, is treated as closing stock. In case of merchandising business the closing stock consists of different types of finished goods. In case of manufacturing concern, closing stock consists of raw material; work is progress and finished goods. The closing stock is valued at cost or market price which is less. Generally closing stock does not appear in trial balance. The sheet only. However, the closing stock given in adjustment or outside the trial balance is recorded in credit side of trading account as well.
Balancing of trading account to ascertain cross profit/loss
After recording the above items in the respective side, the trading account is balanced to calculate gross profit or gross loss. If the credit side exceeds the debit side, the differences represent gross profit. Conversely, if the debit side is heavier than credit side, the different is gross loss. The profit and loss are transferred to credit and debit side of profit and loss account respectively.