Preparation of Final Accounts of Sole Proprietors — Final Accounts of Non-Manufacturing Entities

Figure 1: Final Accounts include Trading Account, Profit & Loss Account and Balance Sheet.

Learning Outcomes

• Draw final Accounts of Non-manufacturing entities.
• Learn the relationship between Profit and Loss Account and Balance Sheet.
• Understand the Trading Account items. This will help you to learn which of the transactions and events should be shown in the Trading Account.
• Understand the items shown in the Profit and Loss Account. By that you will learn the technique of preparing Profit and Loss Account and deriving the Profit and Loss balance.
• Learn how to adjust outstanding and pre-paid expenses, accrued income and income received in advance.
• Understand the items to be shown in the balance sheet. Also learn the classification of assets and liabilities and the order by which they are presented in the Balance Sheet.

1.1 Introduction

• Non-manufacturing entities are the trading entities, which are engaged in the purchase and sale of goods for profit without changing the form/underlying use of such goods.
• At the end of the accounting year, the entity must be interested in knowing the results of the business.
• Financial Statements are the systematically organized summary of all the ledger account heads and presented in such a manner that it gives detailed information about the financial position and the performance of the entity.

KNOWLEDGE NUGGET

• Two Levels of Profit Measurement:
• Gross Profit or Gross Loss
• Net Profit or Net Loss
• Income Statement: Trading & Profit & Loss Account
• Position Statement: Balance Sheet

COMPARISON — INCOME STATEMENT vs POSITION STATEMENT

Income Statement	Position Statement
Profit or loss is presented for the financial year	Exhibits assets and liabilities as at the close of the financial year
Income Statement is sub-divided into Trading Account and Profit & Loss Account	Additional statements may also be prepared (Cash Flow Statement, etc.)
Discloses net profit or net loss after adjusting all expenditures	Discloses assets and liabilities position as on a particular date

1.2 Preparation of Final Accounts

• The principal function of final accounts is to exhibit truly and fairly the performance and the financial position of the business.

Basic Principles

• (i) A distinction should be made between capital and revenue receipts and payments.
• (ii) Income and expenses relating to a period of account should be separated from those of another period.
• (iii) Different items of income and expenditure should be accumulated under significant heads.

Inter-relationship of the Two Statements

• The Profit and Loss Account and the Balance Sheet are thoroughly inter-related.
• The assets shown in the Balance Sheet are mostly only the remainder of the expenditure incurred after a suitable amount has been charged to the Profit and Loss Account.

MATCHING PRINCIPLE

• Expenses incurred to earn the revenue should be properly matched.
• If revenue is entered, all expenses relating to it (whether or not payment has been made) should be debited.
• If expense has been incurred but sale will take place next year, it should be carried forward as an asset.
• If income is received in current year but work against it has to be done next year, it should be shown as "income received in advance".

1.3 Trading Account

• Gross Profit is the difference between the selling price and the cost of the goods sold.

FORMULA — COST OF GOODS SOLD

Cost of Goods Sold = Opening Stock + Purchases (Net) + Direct Expenses — Closing Stock

TRADING ACCOUNT FORMAT

Debit Side	Amount (₹)	Credit Side	Amount (₹)
To Opening Stock	XXX	By Sales (Net)	XXX
To Purchases (Net)	XXX	By Closing Stock	XXX
To Direct Expenses	XXX	By Gross Loss c/d*	XXX
To Gross Profit c/d*	XXX

*Only one will appear

Trading Account Items

• (1) Opening Inventory: Put as the first item on the debit side of the Trading Account.
• (2) Purchases and Purchase Returns: Net amount is shown on the debit side.
• (3) Carriage or Freight Inwards: Debited to Trading Account.
• (4) Wages: Debited to Trading Account (if for godown/stores).
• (5) Sales and Sales Returns: Net amount is entered on the credit side.
• (6) Closing Inventory: Valued at cost or net realisable value whichever is lower.

CLOSING ENTRIES TO TRADING ACCOUNT

• (1) Trading A/c Dr. To Opening Inventory / Purchases / Wages / Freight on Purchases, etc.
• (2) Sales A/c Dr. / Closing Inventory A/c Dr. To Trading A/c
• (3) Gross Profit: Trading A/c Dr. To Profit and Loss A/c
• (4) Gross Loss: Profit and Loss A/c Dr. To Trading A/c

1.4 Profit and Loss Account

• The Profit and Loss Account starts with gross profit on the credit side.
• All those expenses and losses which have not been entered in the Trading Account are written on the debit side.
• Incomes and gains, other than sales, are written on the credit side.

PROFIT & LOSS ACCOUNT FORMAT

Debit Side	Amount (₹)	Credit Side	Amount (₹)
To Gross Loss b/d	XXX	By Gross Profit b/d	XXX
Management Expenses	XXX	Other Income	XXX
Selling Expenses	XXX	Non-trading Income	XXX
Financial Expenses	XXX	Abnormal Gains	XXX
Abnormal Losses	XXX	By Net Loss*	XXX
To Net Profit*	XXX

*Only one will appear

Important Items in Profit & Loss Account

• Drawings: Debited to Capital Account, not Profit & Loss.
• Income Tax (Sole Proprietorship): Debited to Capital Account.
• Discount Allowed: Debited to Profit & Loss Account.
• Discount Received: Credited to Profit & Loss Account.
• Bad Debts: Debited to Profit & Loss Account.

Adjustments

(1) Expenses Accrued and Outstanding

ENTRY

Appropriate Expense Account Dr.

 To Expenses Accrued/Outstanding Account

• Profit & Loss: Add to concerned expense.
• Balance Sheet: Show under Liabilities.

(2) Income Accrued and Accruing

ENTRY

Interest/Fees etc. Accruing Account Dr.

 To Appropriate Income Account

• Profit & Loss: Add to concerned income.
• Balance Sheet: Show under Assets.

(3) Income Received in Advance

ENTRY

Appropriate Income Account Dr.

 To Income Received in Advance Account

• Profit & Loss: Deduct from concerned income.
• Balance Sheet: Show under Liabilities.

(4) Payments Made in Advance (Prepaid Expenses)

ENTRY

Expenses Prepaid Account Dr.

 To Appropriate Expenses Account

• Profit & Loss: Deduct from concerned expense.
• Balance Sheet: Show under Assets.

(5) Provision for Bad and Doubtful Debts

ENTRY

Profit and Loss Account Dr.

 To Provision for Bad and Doubtful Debts Account

• Balance Sheet: Deduct from Sundry Debtors.

(6) Provision for Depreciation

ENTRY

Profit/Loss Account Dr.

 To Depreciation/Provision for Depreciation

• Balance Sheet: Deduct from concerned asset.

1.5 Certain Adjustments and Their Treatments

1. Abnormal Loss of Inventory

ENTRIES

(i) Loss by Fire Account Dr. XXX

 To Purchases/Trading Account XXX

(ii) Insurance Company's A/c Dr. (Claim admitted) XXX

 Profit & Loss A/c Dr. (Uninsured portion) XXX

 To Loss by Fire A/c XXX

2. Goods Sent on Approval Basis

ENTRIES

(i) Sales A/c Dr. (Selling Price)

 To Trade Receivables A/c (Selling Price)

(ii) Stock on Approval A/c Dr. (Cost Price)

 To Trading A/c (Cost Price)

3. Goods Used Other Than for Sale

ENTRIES

For Donation: Donation A/c Dr. To Purchases A/c

For Personal Use: Drawings A/c Dr. To Purchases A/c

As Free Samples: Free Samples/Advertisement A/c Dr. To Purchases A/c

For Construction: Building/Plant & Machinery A/c Dr. To Purchases A/c

4. Commission Based on Profit

FORMULAE

(i) Before charging commission:

Commission = Profit before commission × Rate / 100

(ii) After charging commission:

Commission = Profit before commission × Rate / (100 + Rate)

1.6 Balance Sheet

• The balance sheet may be defined as "a statement which sets out the assets and liabilities of a firm or an institution as at a certain date".
• Assets are shown on the right hand side and liabilities and capital on the left hand side.

Characteristics

• (i) It is prepared at a particular date, rather the close of a day and not for a period.
• (ii) It is prepared only after the preparation of the Profit and Loss Account.
• (iii) The two sides of the Balance Sheet must have the same totals.

Classification of Assets

• Current Assets: Meant to be converted into cash within one year (Cash, Trade Receivables, Inventories).
• Long Term Assets/Fixed Assets: Meant to be used over a long period (Machinery, Building).
• Intangible Assets: No physical existence (Patents, Copyrights).

Classification of Liabilities

• Current Liabilities: Must be settled in one year or less (Creditors, Bills Payable).
• Long Term Liabilities: Exist for more than one year (Long term loans).

BALANCE SHEET FORMAT

Liabilities	Amount (₹)	Assets	Amount (₹)
Capital A/c	XXX	Tangible Fixed Assets	XXX
Long Term Loans	XXX	Intangible Assets	XXX
Short Term Loans	XXX	Investments	XXX
Current Liabilities	XXX	Current Assets	XXX
Provisions	XXX	Cash in Hand / Bank	XXX

1.9 Provisions and Reserves

• Provision means "any amount written off or retained by way of providing for depreciation, renewal or diminution in the value of assets or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy".
• Reserve is the portion of earnings, receipts or other surplus of an enterprise appropriated by the management for a general or a specific purpose other than a provision.
• Reserve Fund signifies the amount standing to the credit of the reserve that is invested outside the business in securities.

PROVISION vs RESERVE

• Provision: A charge against profits
• Reserve: An appropriation of profits
• Reserve Fund: Reserve invested outside the business

SUMMARY OF ADJUSTMENTS

Adjustment	If Given in Trial Balance	If Not Given in Trial Balance
1. Closing Stock	Balance Sheet — Asset Side	(a) Trading A/c — Credit Side (b) Balance Sheet — Asset Side
2. Outstanding Expenses	Balance Sheet — Liability Side	(a) Trading/P&L A/c — Debit Side (b) Balance Sheet — Liability Side
3. Prepaid Expenses	Balance Sheet — Asset Side	(a) Deduct from concerned expense (b) Balance Sheet — Asset Side
4. Income Outstanding	Balance Sheet — Asset Side	(a) Add to concerned income (b) Balance Sheet — Asset Side
5. Income Received in Advance	Balance Sheet — Liability Side	(a) Deduct from concerned income (b) Balance Sheet — Liability Side

1.10 Limitations of Financial Statements

• (a) Historical Cost: Effect of subsequent changes in the value of money is not taken into account.
• (b) Intangible strengths and weaknesses: Loyalty and calibre of staff cannot be shown in the balance sheet.
• (c) Perpetual continuity and periodical account: Expenditure has to be distributed arbitrarily over a number of years.
• (d) Different accounting policies: Different policies for preparation of accounts, valuation of assets.
• (e) Management policies: Management can have different accounting policies.

Summary

• Non-manufacturing entities are engaged in the purchase and sale of goods without changing the form of the goods.
• Profit is measured at two levels: Gross Profit and Net Profit.
• The principal function of final statements is to exhibit truly and fairly the profitability and the financial position of the business.
• Gross Profit is the difference between the selling price and the cost of the goods sold.
• Cost of Goods Sold = Opening Stock + Purchases (Net) + Direct Expenses — Closing Stock.
• Final Accounts include: Trading Account, Profit & Loss Account, and Balance Sheet.

Test Your Knowledge

True and False

• 1. The income statement shows either net profit or net loss for a particular period. True
• 2. Gains from the sale or exchange of assets are not considered as the revenue of the business. False
• 3. The salary paid in advance is not an expense because it neither reduces assets nor increases liabilities. True
• 4. A loss is an expenditure which does not bring any benefit to the concern. True
• 5. All liabilities which become due for payment within the year are classified as long-term liabilities. False
• 6. The term current asset is used to designate cash and other assets or resources which are reasonably expected to be realized or sold or consumed within one year. True
• 7. An asset gives rise to expenditure when it is acquired and to an expense when it is consumed. True
• 8. If the balance of an account on the debit side of the trial balance where the benefit has already expired then it is treated as an expense. True
• 9. Sales less cost of goods sold = gross profit. True
• 10. If the debit side of the trading account exceeds its credit side then the balance is termed as gross profit. False
• 11. The provision for bad debts is debited to Sundry Debtors Account. False
• 12. The provision for discount on creditors is often not provided in keeping with the principle of conservatism. True
• 13. The debts written off as bad, if recovered subsequently are credited to Debtors Account. False
• 14. The adjustment entry in respect of income received in advance is debit Income received in advance account and credit income account. False
• 15. Premium paid on the life policy of a proprietor is debited to profit and loss account. False
• 16. Depreciation account appear in the trial balance is taken only to profit and loss account. True
• 17. Personal purchases included in the purchases day book are added to the sales account in the Trading account. False
• 18. Medicines given to the office staff by a manufacturer of medicines will be debited to salaries account. True
• 19. Goods worth ₹600 taken by the proprietor for personal use should be credited to Capital Account. False
• 20. If Closing Stock appears in the Trial Balance, the Closing inventory is then not entered in Trading Account. It is only shown in the Balance Sheet. True

Multiple Choice Questions

1. A debit to an account may	(a) increase expense (b) decrease an asset. (c) increase a liability.
2. Prepayment of insurance premium will appear in the Balance Sheet and in the Insurance Account respectively as:	(a) a liability and a debit balance. (b) an asset and a debit balance. (c) an asset and a credit balance.
3. Gross profit is the difference between:	(a) sales and purchases (b) sales and cost of sales. (c) sales and total expenses.
4. Payment made to a creditor subject to cash discount will:	(a) reduce a liability, reduce an asset and add to expenses. (b) reduce a liability, add to an asset, and add to revenue. (c) reduce an asset, reduce a liability, and add to revenue.
5. A customer returns goods already charged to him. We should:	(a) debit his account. (b) credit his account. (c) make no entry on his account.
6. Capital is the difference between	(a) Income and expenses (b) Sales and Cost of goods sold (c) Assets and liabilities
7. The capital of a sole trader would change as a result of:	(a) A creditor being paid his account by cheque. (b) Raw materials being purchased on credit. (c) Wages being paid in cash.
8. A decrease in the provision for doubtful debts would result in:	(a) An increase in liabilities. (b) A decrease in working capital. (c) An increase in net profit.
9. A Company wishes to earn a 20% profit margin on selling price. Which of the following is the profit mark up on cost, which will achieve the required profit margin?	(a) 33% (b) 25% (c) 20%
10. If sales is ₹2,000 and the rate of gross profit on cost of goods sold is 25%, then the cost of goods sold will be	(a) ₹2,000 (b) ₹1,500 (c) ₹1,600
11. Sales for the year ended 31st March, 2022 amounted to ₹10,00,000. Sales included goods sold to Mr. A for ₹50,000 at a profit of 20% on cost. Such goods are still lying in the godown at the buyer's risk. Therefore, such goods should be treated as part of	(a) Sales. (b) Closing Inventory. (c) Goods in transit.
12. If sales revenues are ₹4,00,000; cost of goods sold is ₹3,10,000 and expenses are ₹60,000, the gross profit is	(a) ₹30,000. (b) ₹90,000. (c) ₹3,40,000.

High-Yield Interactive Quiz — Final Accounts of Non-Manufacturing Entities

Q1. Gross Profit is the difference between:

Correct Answer: B. Gross Profit is the difference between the selling price and the cost of the goods sold (Cost of Sales).

Q2. Cost of Goods Sold is calculated as:

Correct Answer: B. Cost of Goods Sold = Opening Stock + Purchases (Net) + Direct Expenses — Closing Stock.

Q3. Which of the following is NOT an example of Direct Expenses in Trading Account?

Correct Answer: C. Salaries are an indirect expense and are shown in the Profit & Loss Account, not in the Trading Account.

Q4. Closing Inventory is valued at:

Correct Answer: C. Closing Inventory is valued at cost or net realisable value whichever is lower, following the principle of Conservatism.

Q5. Outstanding Expenses are shown in the Balance Sheet as:

Correct Answer: B. Outstanding Expenses are shown on the Liabilities side of the Balance Sheet.

Q6. Provision for Bad Debts is shown in the Balance Sheet as:

Correct Answer: C. Provision for Bad Debts is deducted from Sundry Debtors on the Assets side of the Balance Sheet.

Q7. Income Received in Advance is shown in the Balance Sheet as:

Correct Answer: B. Income Received in Advance is shown as a Liability in the Balance Sheet.

Q8. If the debit side of the Trading Account exceeds its credit side, the balance is called:

Correct Answer: B. If the debit side of the trading account exceeds its credit side, the balance is termed as gross loss.

Q9. Capital is the difference between:

Correct Answer: C. Capital is the difference between Assets and Liabilities (Capital = Assets — Liabilities).

Q10. Which of the following is a Current Asset?

Correct Answer: B. Inventory is a current asset. Land and Building and Machinery are fixed assets. Goodwill is an intangible asset.

Q11. The Profit and Loss Account starts with:

Correct Answer: B. The Profit and Loss Account starts with Gross Profit on the credit side. If there is Gross Loss, it is written on the debit side.

Q12. Depreciation is a charge against:

Correct Answer: B. Depreciation is a charge against profit and is debited to the Profit and Loss Account.