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Parti • Introduction to financial accounting

The total of all the items recorded in all the accounts on the debit side should equal the total of
all the items recorded on the credit side of the accounts.

Do you remember the alternate form of the accounting equation you were
shown in Chapter 1? What does it tell you has happened when it does not
balance?

We need to check that for each debit entry there is also an equal credit entry. In order to check
that there is a matching credit entry for every debit entry, we prepare something called a trial
balance.
A type of trial balance could be drawn up by listing all the accounts and then entering the total
of all the debit entries in each account in one column and the total of all the credit entries in each
account into another column. Finally, you would add up the two columns of figures and ensure
they are equal. Using the worked example in Section 3.8, this trial balance would be:

Trial balance as at 31 May 2017

Dr Cr
£ £

Purchases 994
Sales 490
Returns outwards 15
Returns inwards 16
D. Small 220 220
A. Lyon & Son 624
D. Hughes 60 60
M.Spencer 45 16
Cash 445 355
1,780 1,780

Total debit balances = Total credit balances

The method described in Section 6.1 is not the accepted method of drawing up a trial balance, but
it is the easiest to understand at first. The form of trial balance used by accountants is a list of
account balances arranged according to whether they are debit balances or credit balances.
Let's balance-off the accounts you saw in Section 3.8. The new entries are in blue so that you
can see the entries required to arrive at the closing balances that are used in the trial balance.
You may find it worthwhile trying to balance these accounts yourself before reading any further.

Purchases

2017 £ 2017 £
May 1 D. Small 220 May 31 Balance c/d 994
2 A. Lyon & Son 410
12 Cash 150
31 A. Lyon & Son 214
994 994
June 1 Balance b/d 994

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Chapter 6 • The trial balance

Sales

2017 £ 2017 £
May 31 Balance c/d 490 May 5 D. Hughes 60
6 M. Spencer 45
11 Cash 210
21 Cash 175
490 490
June 11 Balance b/d 490

Returns tsutwards

2017 £ 2017 £
May 31 Balance c/d 15 May 10 D. Small 15
June 1 Balance b/d 15

Returns inwards

2017 £ 2017 £
May 19 M. Spencer 16 May 31 Balance c/d 16
June 1 Balance b/d 16

D. S mall

2017 £ 2017 £
May 10 Returns outwards 15 May 1 Purchases 220
22 Cash 205
220 220

A. Lyor & Son

2017 £ 2017 £
May 31 Balance c/d 624 May 2 Purchases 410
31 Purchases 214
624 624
June 1 Balance b/d 624

D. Hiighes

2017 £ 2017 £
May 5 Sales 60 May 30 Cash 60

M. Sp encer

2017 £ 2017 £
May 6 Sales 45 May 19 Returns inwards 16
31 Balance c/d 29
45 45
June 1 Balance b/d 29

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Parti • Introduction to financial accounting

Cash

2017 £ 2017 £
May 11 Sales 210 May 12 Purchases 150
21 Sales 175 22 D. Small 205
30 D. Hughes 60 31 Balance c/d 90
445 445
June 1 Balance b/d 90

If you tried to do this before looking at the answer, be sure you understand any mistakes you made
before going on.

If the trial balance was drawn up using these closing account balances, it would appear as
follows:

Trial balance as at 31 May 2017

Dr Cr
£ £
Purchases 994
Sales 490
Returns outwards 15
Returns inwards 16
A. Lyon & Son 624
M.Spencer 29
Cash 90
1,129 1,129

The trial balance always has the date of the last day of the accounting period to which it relates.
It is a snapshot of the balances on the ledger accounts at that date.

Just like the trial balance you saw in Section 6.1, the two sides of this one also 'balance'.
However, the totals are lower. This is because the £220 in D. Small's account, £60 in D. Hughes'
account, £16 in M. Spencer's account and £355 in the cash account have been cancelled out from
each side of these accounts by taking only the balances instead of the totals. As equal amounts
have been cancelled from each side, £651 in all, the new totals should still equal one another, as
in fact they do at £1,129. (You can verify this if you subtract the new total of £1,129 from the
previous one of £1,780. The difference is £651 which is the amount cancelled out from both sides.)
This form of trial balance is the easiest to extract when there are more than a few transactions
during the period and it is the one accountants use.

Note that a trial balance can be drawn up at any time. However, it is normal practice to pre-
pare one at the end of an accounting period before preparing a 'statement of profit or loss' and a
'statement of financial position'. The statement of profit or loss shows what profit has been earned
in a period. (You will be looking at statements of profit or loss in the next chapter.) The statement
of financial position shows what the assets and liabilities of a business are at the end of a period.

Go back to Chapter 1 to refresh your understanding of the statement of financial position.

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Chapter 6 • The trial balance

What advantages are there in preparing a trial balance when you are about to
prepare a statement of profit or loss and statement of financial position?

As you've just learnt from Activity 6.3, trial balances are not just done to find errors.

Trial balances and errors

Many students new to accounting assume that when the trial balance 'balances', the entries in
the accounts must be correct. This assumption is incorrect. While it means that certain types of
error have not been made (such as forgetting to enter the credit side of a transaction), there are
several types of error that will not affect the balancing of a trial balance - omitting a transaction
altogether, for example.
Examples of the errors which would be revealed, provided there are no compensating errors
which cancel them out, are addition errors, using one figure for the debit entry and another figure
for the credit entry, and entering only one side of a transaction.

We shall consider addition errors in greater detail in Chapter 33.

If a trial balance fails to agree, what steps would you take in order to find the
cause of the difference?

Multiple choice self-test questions

A common practice of examining boards is to set multiple choice questions in accounting. In fact,
this has become so popular with examiners that all the largest professional accounting bodies now
use them, particularly in their first-level examinations.
Multiple choice questions give an examiner the opportunity to cover large parts of the syllabus
briefly, but in detail. Students who omit to study areas of the syllabus will be caught out by an
examiner's use of multiple choice questions. It is no longer possible to say that it is highly prob-
able a certain topic will not be tested - the examiner can easily cover it with a multiple choice
question.
We have deliberately included sets of 20 multiple choice questions at given places in this text-
book, rather than a few at the end of each chapter. Such questions are relatively easy to answer a
few minutes after reading the chapter. Asking the questions later is a far better test of your powers
of recall and understanding. It also gives you practice at answering questions covering a range of
topics in one block, as in an examination.
Each multiple choice question has a 'stem' (a part which poses the problem), a 'key' (which is
the one correct answer), and a number of 'distractors', i.e. incorrect answers. The key plus the
distractors are known as the 'options'.
If you do not know the answer, you should guess. You may be right by chance, or you may
remember something subconsciously. In any event, unless the examiner warns otherwise, you will
be expected to guess if you don't know the answer.
Read through the Learning Outcomes for this chapter and then attempt Multiple Choice Set 1.

Answers to all the multiple choice questions are given in Appendix 2 at the end of this book.

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Parti • Introduction to financial accounting

Closing inventory

Inventory at the end of a period is not usually to be found in an account in the ledger. It has to be
found from inventory records and physical stocktaking. As it is typically not to be found in the
ledger, it does not generally appear among the balances in a trial balance. However, the value of
inventory at the beginning of a reporting period (opening inventory) is often recorded in a ledger
account, in which case the inventory balance at the start of a period would be included in the trial
balance prepared at the end of that period.

Memory aid

The following diagram may help you to remember which accounts to debit and credit when
they increase in value:

Debit Credit

Expenses Revenues

Losses Profits

Assets Liabilities

Capital

Learning outcomes
•••••••••
You should now have learnt:

1 How to prepare a trial balance.

2 That trial balances are one form of checking the accuracy of entries in the accounts.

3 That errors can be made in the entries to the accounts that will not be shown up by the
trial balance.

4 That the trial balance is used as the basis for preparing statements of profit or loss and
statements of financial position.

Answers to activities

6.1 (a) Dr Van account £9,000


Cr Bank account £9,000
(fa) Dr Drawings account £40
Cr Purchases account £40

6.2 The alternate form of the accounting equation is Assets = Capital + Liabilities. All the accounts with
debit balances are assets and all the accounts with credit balances are either capital or liabilities. This
means that so long as you enter a debit for every credit, the alternate accounting equation must
always balance. If the alternate accounting equation does not balance, you've made an error some-
where, either in your double entries, or in your arithmetic within the individual accounts. Virtually all
occurrences where the accounting equation does not balance that arise in practice are the result of
double entry errors.

6.3 Firstly, you can verify whether the total of the debit balances equals the total of the credit balances.
They need to be equal, or your statement of profit or loss and statement of financial position will

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Chapter 6 • The trial balance

be incorrect and your statement of financial position will not balance. (That is, the accounting equation will not
balance.) Secondly, you need to know what the balance is on every account so that you can enter the appropri-
ate figures into the statement of profit or loss and statement of financial position. If you don't prepare a trial
balance, you will find it much more difficult to prepare these two accounting statements.

6.4 You need to check each entry to verify whether or not it is correct but firstly, it is best to start by checking that
the totals in the trial balance have been correctly summed. Then, check that no account has been omitted from
the trial balance. Then, check each account in turn.

Multiple choice questions: Set 1

Now attempt Set 1 of multiple choice questions. (Answers to all the multiple choice questions are
given in Appendix 2 at the end of this book.)

Each of these multiple choice questions has four suggested answers, (A), (B), (C) and (D). You should
read each question and then decide which choice is best, either (A) or (B) or (C) or (D). Write down
your answers on a separate piece of paper. You will then be able to redo the set of questions later
without having to try to ignore your answers.

MCI Which of the following statements is incorrect?

(A) Assets - Capital = Liabilities


(B) Liabilities + Capital = Assets
(C) Liabilities + Assets = Capital
(D) Assets - Liabilities = Capital

MC2 Which of the following is not an asset?

(A) Buildings
(B) Cash balance
(C) Accounts receivable
(D) Loan from K. Harris

MC3 Which of the following is a liability?

(A) Machinery
(B) Accounts payable for goods
(C) Motor vehicles
(D) Cash at bank

MC4 Which of the following is incorrect?

Assets Liabilities Capital


£ £ £
(A) 7,850 1,250 6,600
(B) 8,200 2,800 5,400
(C) 9,550 1,150 8,200
(D) 6,540 1,120 5,420

MC5 Which of the following statements is correct?

Effect upon
Assets Liabilities
(A) We paid a creditor by cheque - Bank - Accounts payable
(B) A debtor paid us £90 in cash + Cash + Accounts receivable

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Parti • Introduction to financial accounting

Effect upon
Assets Liabilities
(C) J. Hall lends us £500 by cheque + Bank - Loan from Hall
(D) Bought goods on time + Inventory + Capital

MC6 Which of the following are correct?

Accounts To record Entry in the account


(/) Assets an increase Debit
a decrease Credit
(//) Capital an increase Debit
a decrease Credit
{Hi) Liabilities an increase Credit
a decrease Debit

(A) (/") and (//)


(B) (//) and {Hi)
(C) (/■) and {Hi)
(D) (/"), (//) and {Hi)

MC7 Which of the following are correct?

Account to be debited Account to be credited


(/) Bought office furniture for cash Office furniture Cash
(//) A debtor, P. Sangster, pays us by cheque Bank P. Sangster
{Hi) Introduced capital by cheque Capital Bank
(/V) Paid a creditor, B. Lee, by cash B. Lee Cash

(A) (/), (//) and {Hi) only


(B) (//), {Hi) and (/V) only
(C) (/), (/7) and (/V) only
(D) (/) and (/V) only

MC8 Which of the following are incorrect?

Account to be debited Account to be credited


(/) Sold van for cash Cash Van
(//) Returned some of Office Office Equipment Suppliers Ltd
Equipment to Suppliers Ltd
{Hi) Repaid part of loan from Loan from C. Charles Bank
C. Charles by cheque
(/V) Bought machinery on time from Betterways Ltd Machinery
Betterways Ltd

(A) (//) and (/V) only


(B) {Hi) and (/V) only
(C) (/7) and {Hi) only
(D) (/) and {Hi) only

MC9 Which of the following best describes the meaning of 'Purchases'?

(A) Items bought


(B) Goods bought on time
(C) Goods bought for resale
(D) Goods paid for

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Chapter 6 • The trial balance

MC10 Which of the following should not be called 'Sales'?

(A) Office fixtures sold


(B) Goods sold on time
(C) Goods sold for cash
(D) Sale of item previously included in 'Purchases'

MC11 Of the following, which are correct?

Account to be debited Account to be credited


(/) Goods sold on time to R. Williams R. Williams Sales
(//■) S. Johnson returns goods to us Returns inwards S. Johnson
{Hi) Goods bought for cash Cash Purchases
(/V) We returned goods to A. Henry A. Henry Returns inwards

(A) (/) and {Hi) only


(B) (/) and (//) only
(C) (/7) and (/V) only
(D) {Hi) and (/V) only

MC12 Which of the following are incorrect?

Account to be debited Account to be credited


(/■) Goods sold for cash Cash Sales
('/) Goods bought on time from T. Carter Purchases T. Carter
m Goods returned by us to C. Barry C. Barry Returns outwards
(/V) Van bought for cash Purchases Cash

(A) (/) and {Hi) only


(B) {Hi) only
(C) {if) and (/V) only
(D) (/V) only

MC13 Given the following, what is the amount of Capital? Assets: Premises £20,000; Inventory
£8,500; Cash £100. Liabilities: Accounts payable £3,000; Loan from A. Adams £4,000

(A) £21,100
(B) £21,600
(C) £32,400
(D) £21,400

MC14 Which of the following is correct?

(A) Profit does not alter capital


(B) Profit reduces capital
(C) Capital can only come from profit
(D) Profit increases capital

MC15 Which of the following are correct?


Account to be debited Account to be credited
(/) Received commission by cheque Bank Commission received
{if) Paid rates by cash Rates Cash
{Hi) Paid motor expenses by cheque Motor expenses Bank
(/V) Received refund of insurance by cheque Insurance Bank

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Parti • Introduction to financial accounting

(A) (/) and (//) only


(B) (/), (/7) and (///) only
(C) (/7), (///) and (/V) only
(D) (/), (/V) and (/V) only

MC16 Of the following, which are incorrect?

Account to be debited Account to be credited


('■) Sold van for cash Cash Sales
Hi) Bought stationery by cheque Stationery Bank
(///) Took cash out of business for Cash Drawings
private use
(/V) Paid general expenses by cheque General expenses Bank

(A) (//) and (/V) only


(B) (/) and (//) only
(C) (/) and {Hi) only
(D) (/7) and {Hi) only

MC17 What is the balance on the following account on 31 May 2017?

C. De Freitas

2017 £ 2017 £
May 1 Sales 205 May 17 Cash 300
14 Sales 360 28 Returns 50
30 Sales 180

(A) A credit balance of £395


(B) A debit balance of £380
(C) A debit balance of £395
(D) There is a nil balance on the account

MC18 What would have been the balance on the account of C. De Freitas in MC17 on
19 May 2017?

(A) A debit balance of £265


(B) A credit balance of £95
(C) A credit balance of £445
(D) A credit balance of £265

MC19 Which of the following best describes a trial balance?

(A) It shows the financial position of a business


(B) It is a special account
(C) It shows all the entries in the books
(D) It is a list of balances on the books

MC20 Is it true that the trial balance totals should agree?

(A) No, there are sometimes good reasons why they differ
(B) Yes, except where the trial balance is extracted at the year end
(C) Yes, always
(D) No, because it is not a statement of financial position

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Chapter 6 • The trial balance

Review questions

6.1 You are to enter up the necessary accounts for the month of October from the following infor-
mation relating to a small printing firm. Then balance-off the accounts and extract a trial balance as
at 31 October 2017.

2017 1 Started in business with capital in cash of £3,600 and £8,400 in the bank.
October 2 Bought goods on time from: A. Bell £1,220; J. Smith £1,030; T. Hand £348; L.
Smart £690; S. long £1,084
4 Sold goods on time to: P. Hunt £680; A. Dexter £1,440; P. Spin £2,304.
6 Paid rent by cash £820.
9 P. Hunt paid us his account by cheque £680.
10 P. Spin paid us £2,000 by cheque.
12 We paid the following by cheque: T. Hand £348; A. Bell £1,220.
15 Paid carriage in cash £76.
18 Bought goods on time from J. Smith £582; L. Smart £1,880.
21 Sold goods on time to A. Dester £1,620.
31 Paid rent by cheque £980.

6.2 Enter the following transactions of an antiques shop in the accounts and extract a trial balance
as at 31 March 2017.

2017 1 Started in business with £8,000 in the bank.


March 2 Bought goods on time from: L. Frank £550; G. Byers £540; P. Lee £610.
5 Cash sales £510.
6 Paid wages in cash £110.
7 Sold goods on time to: J. Snow £295; K. Park £360; B. Tyler £640.
9 Bought goods for cash £120.
10 Bought goods on time from: G. Byers £410; P. Lee £1,240.
12 Paid wages in cash £110.
13 Sold goods on time to: K. Park £610; B. Tyler £205.
15 Bought shop fixtures on time from Stop Ltd £740.
17 Paid G. Byers by cheque £700.
18 We returned goods to P. Lee £83.
21 Paid Stop Ltd a cheque for £740.
24 B. Tyler paid us his account by cheque £845.
27 We returned goods to L. Frank £18.
30 G. Prince lent us £1,000 by cash.
31 Bought a van paying by cheque £6,250.

6.3A Record the following details relating to a carpet retailer for the month of November 2017
and extract a trial balance as at 30 November 2017.

2017 Nov 1 Started in business with £15,000 in the bank.


3 Bought goods on time from: J. Small £290; F. Brown £1,200; T. Rae £610;
R. Charles £530.
5 Cash sales £610.
6 Paid rent by cheque £175.
7 Paid business rates by cheque £130.

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Parti • Introduction to financial accounting

11 Sold goods on time to: T. Potts £85; J. Field £48; T. Gray £1,640.
17 Paid wages by cash £290.
18 We returned goods to: J. Small £18; R. Charles £27.
19 Bought goods on time from: R. Charles £110; T. Rae £320; F. Jack £165.
20 Goods were returned to us by: J. Field £6; T. Potts £14.
21 Bought van on time from Turnkey Motors £4,950.
23 We paid the following by cheque: J. Small £272; F. Brown £1,200; T. Rae £500.
25 Bought another van, paying by cheque immediately £6,200.
26 Received a loan of £750 cash from B. Bennet.
28 Received cheques from: T. Potts £71; J. Field £42.
30 Proprietor brings a further £900 into the business, by a payment into the
business bank account

6.4A Record the following transactions for the month of January of a small finishing retailer,
balance-off all the accounts, and then extract a trial balance as at 31 January 2016.

2016 1 Started in business with £10,500 cash.


Jan 2 Put £9,000 of the cash into a bank account.
3 Bought goods for cash £550.
4 Bought goods on time from: T. Dry £800; F. Hood £930; M. Smith £160;
G. Low £510.
5 Bought stationery on time from Buttons Ltd £89.
6 Sold goods on time to: R. long £170; L. Fish £240; M. Singh £326; A. Tom £204.
8 Paid rent by cheque £220.
10 Bought fixtures on time from Chiefs Ltd £610.
11 Paid salaries in cash £790.
14 Returned goods to: F. Hood £30; M. Smith £42.
15 Bought van by cheque £6,500.
16 Received loan from B. Barclay by cheque £2,000.
18 Goods returned to us by; R. Tong £5; M. Singh £20.
21 Cash sales £145.
24 Sold goods on time to: L. Fish £130; A. Tom £410; R. Pleat £158.
26 We paid the following by cheque: F. Hood £900; M. Smith £118.
29 Received cheques from: R. Pleat £158; L. Fish £370.
30 Received a further loan from B. Barclay by cash £500.
30 Received £614 cash from A. Tom.

6.5 Note, this question should not be attempted until cash discounts and trade discounts have
been covered (see Chapters 13 and 14). It should also be noted that this is an example of the excep-
tion to the rule that closing inventory does not generally appear in a trial balance.

On 1 October 2016, the owner of the USS Enterprise, Mr Kirk, decides that he will boldly go and
keep his records on a double entry system. His assets and liabilities at that date were:

£
Fixtures and equipment 20,000
Inventory including weapons 15,000
Balance at Universe Bank 17,500
Cash 375

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Chapter 6 • The trial balance

£
Accounts payable - Spock 3,175
- Scott 200
- McCoy 500

Kirk's transactions during October were as follows:

1 Sold faulty phasers, original cost £500, to Klingon Corp, for cash £5,000
2 Bought Photon Torpedoes (weapons), on time from Central Council £2,500
3 Sold goods to Aardvarks, original cost £250, on time, £1,500
4 Bought Cloaking Device (Fixture and Fittings) from Klingon Corp £3,500
5 Paid the balance owed to Spock at 1 October less a 5 per cent cash discount
6 Paid Central Council full amount due by cheque
7 Received full amount due from Aardvarks by cheque
8 Paid Klingon Corp by cheque after deducting 20 per cent trade discount
9 Paid, by bankers order, £10,000 for repairs to Enterprise following disagreement over amount
owing to Klingon Corp and faulty phasers.

Required:
Open Enterprise's ledger accounts at 1 October, record all transactions for the month, balance the
ledger accounts, and prepare a trial balance as at 31 October.

87
THE FINANCIAL STATEMENTS

OF SOLE PROPRIETORS

V.

V>

Introduction

This part is concerned with preparing from double entry records, the
financial statements of sole proprietors.

7 Statements of profit or loss: an introduction 91

8 Statements of financial position 103

9 Statements of profit or loss and statements of financial position:


further considerations 111

10 Accounting concepts and assumptions 124


chapter

Statements of profit or loss: an

introduction

Learning objectives
»•••••
After you have studied this chapter, you should be able to;

• explain why statements of profit or loss are not part of the double entry system

• explain why profit is calculated

• calculate cost of goods sold, gross profit, and net profit

• explain the difference between gross profit and net profit

• explain the relationship between the trading account and the profit and loss account

• explain how the trading account and the profit and loss account fit together to create the
statement of profit or loss

• explain how to deal with closing inventory when preparing the trading account section of
a statement of profit or loss

• close down the appropriate accounts and transfer the balances to the trading account

• close down the appropriate accounts and transfer the balances to the profit and loss
account

• prepare a statement of profit or loss from information given in a trial balance

• make appropriate double entries to incorporate net profit and drawings in the capital
account

Introduction
••••••••
In this chapter, you will learn how to close down revenue and expenditure accounts in
order to calculate profit and prepare a statement of profit or loss. You will learn how to
adjust purchases with inventory and arrive at the cost of goods sold, and will discover
the difference between gross profit and net profit. Finally, you will learn how to transfer
net profit and drawings to the capital account at the end of a period.

91
Part 2 • The financial statements of sole proprietors

O Purpose of statements of profit or loss

The main reason why people set up businesses is to make profits. Of course, if the business is not
successful, it may well incur losses instead. The calculation of such profits and losses is probably
the most important objective of the accounting function. The owners will want to know how the
actual profits compare with the profits they had hoped to make. Knowing what profits are being
made helps businesses to do many things, including:

• planning ahead
• obtaining loans from banks, from other businesses, or from private individuals
• telling prospective business partners how successful the business is
• telling someone who may be interested in buying the business how successful the business is
• calculating the tax due on the profits so that the correct amount of tax can be paid to the tax
authorities.

Chapter 4 dealt with the grouping of revenue and expenses prior to bringing them together to
compute profit. In the case of a trader (someone who is mainly concerned with buying and selling
goods), the profits are calculated by drawing up a statement of profit or loss.
When it is shown in detail rather than in summary form (as is the case for the published state-
ments of profit or loss of companies), it contains something called the trading account. The
trading account is prepared in order to arrive at a figure for gross profit.
Below the trading account is shown a summary of another account - the profit and loss
account. This profit and loss account should not be confused with the 'statement of profit OR
loss'. The profit AND loss account is prepared so as to arrive at the figure for net profit.
It is these two accounts that together comprise the statement of profit or loss. Both the trading
account and the profit and loss account are part of the double entry system. At the end of a finan-
cial period, they are closed off. They are then summarised and the information they contain is then
copied into a statement of profit or loss. Statements of profit or loss are not part of the double entry
system.

Gross profit

One of the most important uses of statements of profit or loss is that of comparing the results
obtained with the results expected. In a trading organisation, a lot of attention is paid to how
much profit is made, before deducting expenses, for every £l of sales revenue. As mentioned in
Section 7.1, so that this can easily be seen in the profit calculation, the statement in which profit
is calculated is split into two sections - one in which the gross profit is found (this is the trading
account section of the statement), and the next section in which the net profit is calculated (this
is the 'profit and loss account' section of the statement).
Gross profit is the excess of sales revenue over the cost of goods sold. Where the cost of goods
sold is greater than the sales revenue, the result is a gross loss. By taking the figure of sales rev-
enue less the cost of goods sold to generate that sales revenue, it can be seen that the accounting
custom is to calculate a trader's profits only on goods that have been sold.

What does this tell you about the costs and revenues that are included in the
calculation of gross profit? {Hint: what do you not include in the calculation?)

92
Chapter 7 • Statements of profit or loss: an introduction

To summarise:

Gross profit is the excess of sales revenue over the


(calculated in the trading account) cost of goods sold in the period.

Calculate the gross profit or gross loss of each of the following businesses:
Cost of goods purchased Sales Gross profit!(Gross loss)
£ £ £
A 9,820 10,676
B 7,530 14,307
C 10,500 19,370
D 9,580 9,350
E 8,760 17,200

Net profit

Net profit, found in the profit and loss account section of the statement of profit or loss, consists
of the gross profit plus any revenue other than that from sales, such as rents received or commis-
sions earned, less the total costs used up during the period other than those already included in
the 'cost of goods sold'. Where the costs used up exceed the gross profit plus other revenue, the
result is said to be a net loss. Thus:

Net profit is what is left of the gross profit after all


(calculated in the profit and loss account) other expenses have been deducted.

Using the answer to Activity 7.2, complete the following table:

Other revenues Expenses Net profit/(Net loss)

£ £ £
A 2,622
B 4,280 2,800
C 500 2,500
D 1,780
E 3,260 2,440

Information needed
O

Before drawing up a statement of profit or loss you should prepare the trial balance. This contains
nearly all the information needed. (Later on in this book you will see that certain adjustments have
to be made, but we will ignore these at this stage.)
We can now look at the trial balance of B. Swift, drawn up as on 31 December 2016 after the
completion of his first year in business.

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Part 2 • The financial statements of sole proprietors

Exhibit 7.1

B. Swift
Trial balance as at 31 December 2016
Dr Cr

£ £
Sales 38,500
Purchases 29,000
Rent 2,400
Lighting expenses 1,500
General expenses 600
Fixtures and fittings 5,000
Accounts receivable 6,800
Accounts payable 9,100
Bank 15,100
Cash 200
Drawings 7,000
Capital 20,000
67,600 67,600

Note : To make this easier to follow, we shall assume that purchases consist of goods that are resold
without needing any further work. You'll learn later that these are known as 'finished goods' but,
for now, we'll simply refer to them as 'goods'.

We have already seen that gross profit is calculated as follows:

Sales — Cost of goods sold = Gross profit

It would be easier if all purchases in a period were always sold by the end of the same period.
In that case, cost of goods sold would always equal purchases. However, this is not normally the
case and so we have to calculate the cost of goods sold as follows:

What we bought in the period: Purchases


Less Goods bought but not sold in the period: (Closing inventory)
= Cost of goods sold

In Swift's case, there are goods unsold at the end of the period. However, there is no record
in the accounting books of the value of this unsold inventory. The only way that Swift can find
this figure is by checking his inventory at the close of business on 31 December 2016. To do this
he would have to make a list of all the unsold goods and then find out their value. The value he
would normally place on them would be the cost price of the goods, i.e. what he paid for them.
Let's assume that this is £3,000.
The cost of goods sold figure will be:

£
Purchases 29,000
Less Closing inventory (3,000)
Cost of goods sold 26,000

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Chapter 7 • Statements of profit or loss: an introduction

Based on the sales revenue of £38,500 the gross profit can be calculated:

Sales - Cost of goods sold = Gross profit


£38,500 - £26,000 = £12,500

We now have the information we need to complete the trading account section of the statements
of profit or loss. Next, we need to close off the sales and purchases accounts at the end of the
period so that they start the next period with no balance. To do so, we need to create a trading
account (this is not the same as the trading part of the statements of profit or loss, though it does
produce the same gross profit figure) and then make the following entries:

(A) The balance of the sales account is transferred to the trading account by:

1 Debiting the sales account (thus closing it).


2 Crediting the trading account.

(B) The balance of the purchases account is transferred to the trading account by:

1 Debiting the trading account.


2 Crediting the purchases account (thus closing it).

(C) There is, as yet, no entry for the closing inventory in the double entry accounts. This is
achieved as follows:

1 Debit a closing inventory account with the value of the closing inventory.
2 Credit the trading account (thus completing the double entry).

The trading account will look like this:

Trading

2016 £ 2016 £
Dec 31 Purchases (B) 29,000 Dec 31 Sales (A) 38,500
31 Closing inventory (C) 3,000

We now close off the trading account in the normal way. In this case, revenues exceed costs so
we describe the balance as 'gross profit'.

Trading

2016 £ 2016 £
Dec 31 Purchases (B) 29,000 Dec 31 Sales (A) 38,500
31 Gross profit 12,500 31 Closing inventory (C) 3,000
41,500 41,500

Note that the balance shown on the trading account is described as 'gross profit' rather than being
described as a balance. Also, note that the balance (i.e. the gross profit) is not brought down to
the next period. The other accounts used in these double entries appear as shown below. (Note
that there is no detail of the entries prior to the end of the period as all the information we have
been given is the closing balances. These closing balances are simply described here as 'balance'.)

Sales

2016 £ 2016 £
Dec 31 Trading 38,500 Dec 31 Balance 38,500

Purchases

2016 £ 2016 £
Dec 31 Balance 29,000 Dec 31 Trading 29,000

95