How to Prepare final accounts for business: Profit and Loss Account and Balance Sheet of Sole Proprietorship

 Final Accounts

While finalising the accounts, a sole proprietorship entity prepares financial statements to determine its financial results (by Income Statement) and financial position (by Balance Sheet).

 Accordingly, the components of financial statements of a sole proprietorship organisation include – 

a. Manufacturing Account (only in case of manufacturing entities) 

b. Trading Account 

c. Profit and Loss Account 

d. Balance Sheet Sole proprietorship firms do not require any Profit and Loss Appropriation Account as the entire profit is attributable to the sole owner.

Trading Account: 

Trading accounts shows the results of buying and selling of goods, Trading accounts represents the Gross Profit/Gross Loss of the concern out of sale and purchase for the particular accounting period, It is a nominal account, and is closed by transfer of the Gross Profit/ Gross Loss to the P/L A/c. 

Study of Debit side of Trading Account 

(a) Opening Stock: 

Unsold closing stock of the last financial year is appeared in debit side of the Trading Account as “To Opening Stock“ of the current financial year. 

(b) Purchases: 

Total purchases (net of purchase return) including cash purchase and credit purchase of traded goods during the current financial year appeared as “To Purchases” in the debit side of Trading Account.

 (c) Direct Expenses: 

Expenses incurred to bring traded goods at business premises/warehouse called direct expenses. Freight charges, cartage or carriage charges, custom and import duty in case of import, gas, electricity fuel, water, packing material, wages, and any other expenses incurred in this regards comes under the debit side of Trading Account and appeared as “To Particular Name of the Expenses”.

 (d) Sales Account: 

Total Sale of the traded goods including cash and credit sales will appear at outer column of the credit side of Trading Account as “By Sales.” Sales should be on net releasable value excluding Central Sales Tax, Vat, Custom, and Excise Duty. 

(e) Closing Stock: 

Total Value of unsold stock of the current financial year is called as closing stock and will appear at the credit side of Trading Account. 

Closing Stock = Opening Stock + Net Purchases – Net Sale 

(f) Gross Profit:

 Gross profit is the difference of revenue and the cost of providing services or making products. However, it is calculated before deducting payroll, taxation, overhead, and other interest payments. Gross Margin is used in the US English and carries same meaning as the Gross Profit. 

Gross Profit = Sales – Cost of Goods Sold 

(g) Operating Profit: 

Operating profit is the difference of revenue and the costs generated by ordinary operations. However, it is calculated before deducting taxes, interest payments, investment gains/losses, and many other non-recurring items. 

Operating Profit = Gross Profit – Total Operating Expenses 

(h) Net Profit: 

Net profit is the difference of total revenue and the total expenses of the company. It is also known as net income or net earnings. 

Net Profit = Operating Profit – (Taxes + Interest)

2. Manufacturing Account 

Manufacturing account prepared in a case where goods are manufactured by the firm itself. Manufacturing accounts represent cost of production. Cost of production then transferred to Trading account where other traded goods also treated in a same manner as Trading account.

Important Point Related to Manufacturing Account 

Apart from the points discussed under the section of Trading account, there are a few additional important points that need to be discuss here:

(a) Raw Material: 

Raw material is used to produce products and there may be opening stock, purchases, and closing stock of Raw material. Raw material is the main and basic material to produce items. 

(b) Work-in-Progress: 

Work-in-progress means the products, which are still partially finished, but they are important parts of the opening and closing stock. To know the correct value of the cost of production, it is necessary to calculate the correct cost of it. 

(c) Finished Product:

 Finished product is the final product, which is manufactured by the concerned business and transferred to trading account for sale. Raw Material Consumed (RMC) − It is calculated as. 

RMC = Opening Stock of Raw Material + Purchases – Closing Stock

3. Profit and Loss Account 

Profit & Loss account represents the Gross profit as transferred from Trading Account on the credit side of it along with any other income received by the firm like interest, Commission, etc. Debit side of profit and loss account is a summary of all the indirect expenses as incurred by the firm during that particular accounting year. For example, Administrative Expenses, Personal Expenses, Financial Expenses, Selling, and Distribution Expenses, Depreciation, Bad Debts, Interest, Discount, etc.

The following items will appear in the debit side of the Profit & Loss A/c: 

(i) Cost of Sales: 

This term refers to the cost of goods sold. The goods can be manufactured and sold or can be directly purchased and sold. Fundamentals of Financial and Cost Accounting 240 The Institute of Cost Accountants of India 

(ii) Other Expenses: 

All expenses which are not directly related to main business activity will be reflected in the P&L Account. These are mainly the Administrative, Selling and Distribution expenses. Examples are salary to office staff, salesmen commission, insurance, legal charges, audit fees, advertising, free samples, bad debts etc. It will also include items like loss on sale of fixed assets, interest and provisions. Students should be careful to include accrued expenses as well. 

(iii) Abnormal Losses: 

All abnormal losses are charged against Profit & Loss Account. It includes stock destroyed by fire, goods lost in transit etc. The following items will appear in the credit side of Profit & Loss A/c: 

(i) Revenue Incomes: 

These incomes arise in the ordinary course of business, which includes commission received, discount received etc. 

(ii) Other Incomes:

 The business will generate incomes other than from its main activity. These are purely incidental. It will include items like interest received, dividend received, etc. The end result of one component of the P&L A/c is transferred over to the next component and the net result will be transferred to the Balance Sheet as addition in owners’ equity. The profits actually belong to owners of business. In case of company organizations, where ownership is widely distributed, the profit figure is separately shown in Balance Sheet.

d. Balance Sheet

 

Balance Sheet is the financial statement that is prepared to show the exact financial position of the organisation on a specific date. It is prepared after drafting Income Statements i.e., Trading Account and P/L Account. It reflects the assets and liabilities of a concern at a particular point of time. 

The Balance Sheet may be drafted either in Horizontal format or in Vertical format. In the horizontal format, the Liabilities appear on the left-hand side, while the Assets appear on the right-hand side of the Balance Sheet. This is the traditional format followed by non-corporate commercial organisations.

The components of assets and liabilities are discussed below. 

A. Liabilities

 (a) Capital:

 This indicates the cumulative claim of the owner of the business. 

(b) Long Term or Non-Current Liabilities: 

These are obligations which are to be settled over more than one accounting period. These funds are raised by way of loans from banks and financial institutions. Such loans are normally obtained on the basis of some security e.g., against a charge on the fixed assets. They are called “Secured Loan”. 

(c) Short Term or Current Liabilities: 

These are liabilities expected to be settled within the same accounting period or same operating cycle period.

 These include - 

(i) Sundry Creditors: 

It represents amounts payable to suppliers against purchase of goods. 

(ii) Advances from customers:

 It represents amounts taken from the customers as advance against the orders already placed by them. 

 (iii) Outstanding Expenses: 

These represent services procured but not paid for. 

(iv) Bills Payable: 

These are bills accepted by the firm to the creditors.

 (v) Bank Overdrafts: 

This represents amount utilised over and above the balance in account as approved by the bank in form of a short-term loan. 

B. Assets 

(a) Fixed Assets/ Non-current Assets: 

These represent the facilities or resources owned by the business for a longer period of time. The basic purpose of these resources is not to buy and sell them, but to use for future earnings. The benefit from use of these assets is spread over a very long period. The fixed assets could be in tangible form such as buildings, machinery, vehicles, computers etc, whereas some could be in intangible form viz. patents, trademarks, goodwill etc. The fixed assets are subject to wear and tear which is called as depreciation. In the balance sheet, fixed assets are always shown as “original cost less depreciation”.

 (b) Investments: 

These are funds invested outside the business on a temporary basis. At times, when the business has surplus funds, and they are not immediately required for business purpose, it is prudent to invest it outside business e.g., in mutual funds or fixed deposit. The purpose is to earn a reasonable return on this money instead of keeping them idle.

 Investments can be classified into Current Investments and Non-current Investments. Non-current Investments are investments which are restricted beyond the current period as to sale or disposal. Whereas, current investments are investments that are by their nature readily realizable and is intended to be held for not more than one year from the date on which such investment is made. 

(c) Current Assets: 

An asset shall be classified as Current when it is expected to be realised in, or is intended for sale or consumption in the organisation’s normal Operating Cycle. It is held primarily for the purpose of being traded. 

Current assets comprise of: 

(i) Stocks/Inventories: 

This includes stock of raw material, semi-finished goods or WIP, and finished goods.

 (ii) Debtors:

 They represent customer balances which are not paid. The bad debts or a provision for bad debt is reduced from debtors and net figure is shown in balance sheet.

 (iii) Bills receivables: 

Credit to customers may be given based on a bill to be signed by them and payable to the business at an agreed date in future. 

(iv) Cash in Hand: 

This represents cash actually held by the business on the balance sheet date. 

(v) Cash at Bank: 

this represents funds held as balances with bank. 

(vi) Prepaid Expenses: 

They represent payments made against which services are expected to be received in a very short period. 

(vii)Advances to suppliers:

 They represent amounts paid to suppliers in advance for which goods or services are not received till the balance sheet date.