ELEMENTARY FINANCE
- 0N LINE
Chapter 2 Lesson A - Profit and Loss Account
Introduction of the Host
Mrs.Geetha Dasaraty is a commerce graduate with a Masters in Business Administration specialising in finance. Her stint with a Coimbatore based company and later with a consulting firm in Chennai has provided her with a decade of experience in project finance and appraisals, accounting and tax laws. She is a freelance writer and money matters are her forte. She is currently pursuing her final course in Company Secretaryship and is doing a course on Vaishnavism. She has a passion for literature and Carnatic music. She is also a violinist.
About the Class12 lessons, one a month. Each lesson is further subdivided into 4 chapters.
Chapter 2 Lesson A, - Profit and Loss Account
In this chapter we will acquaint ourselves with the following:
- Nature of Receipts
- Nature of Expenditure
- Trading Account
- Profit and Loss Account
The Profit and Loss Account or the income statement should be prepared in such a way that anyone going through it will be able to ascertain the profit made, or the loss suffered during a particular period.
What is a Profit and Loss Account all about?
A profit and loss account reveals the following:
- The revenues or incomes earned by the concern.
- Expenses incurred to earn the above revenue and any other losses incurred.
When the revenues exceed the expenses there is a profit and if the expenses exceed the revenue, there is a loss.
Matching Principle:
The revenues and expenses relevant to a particular period should be matched to give a true and fair picture.
- When a revenue item is entered in the Profit and Loss account, all the relevant expenses should be entered on the expense side.
- Where expenses are made for which revenue will be earned in the next period, the amount should be carried forward to the next and treated as an expense in the next period. It will be shown as an asset in the Balance Sheet.
- Where revenue is received, but the service is to be rendered or the goods are to be supplied in future, the amount should be treated as revenue only in the year of rendering service or supply of goods. It will be shown as a liability in the Balance Sheet.
Capital Expenditure
A capital expenditure is one, which results in the acquisition of tangible or intangible asset, which can be sold and which results in an increase in the earning capacity of a business.
Where the benefits arising from the expenditure are expected to accrue for a long period of time, the expenditure is a capital expenditure.
Revenue Expenditure
An expenditure, whose benefit expires within the year of expense, is revenue expenditure.
These expenses are incurred to maintain the business.
Deferred Revenue expenditure
In certain cases, the benefit of revenue expenditure may extend, for more than two or three years. Such expenditure is known as 'Deferred Revenue Expenditure'. Deferred revenue expenditure is written off over a period of a few years and is not written off wholly in the year in which it is incurred.
Alterations and Improvements
With regard to alterations and improvements, where the expenditure results in an increase in the earnings capacity or when it helps to decrease the working expenditure, it will be taken as capital expenditure.
Development Expenditure
In the case of certain business, a certain period of time has to expire before goods can be manufactured and sold. Such expenditure is called development expenditure and is capital in nature.
An example is the tea industry. Tea plantations usually require around five years to mature. Expenditure incurred during this period is known as development expenditure.
Capital and Revenue Receipts
Revenue receipts are those receipts earned from the operations of the business. Examples are the revenue from the sale of goods, interest, commission earned etc. Income not earned from the normal operations of the business is capital receipt. Examples are sale of fixed assets
To ascertain the profit from a business, only the revenue receipts should be taken into account. Capital receipts will not affect the profit or loss of a business.
Trading Account
A trading account is prepared to know the trading results of a particular period. Generally trading accounts are prepared for manufacturing organisations, to ascertain the gross profit.
All items relating to stock & purchases and expenses related to this will find a place in the trading account. The items that appear in the trading account are stock, purchases, wages, freight, Fuel and Power, Lighting, rent on factory buildings, sales
Profit And Loss Account
The Profit and Loss Account is prepared to ascertain the profit or loss of a certain period. This account starts with the credit from the trading account in respect of gross profit or debit if there is a loss, from the gross profit of the trading account the expenses are deducted and the income is added to find out the net profit.
When the income is more than the expense, there is a net profit and where the expense is more than the income there is a net loss.
The net profit or net loss will be transferred to the capital accounts.
The expenses are debited to the profit and loss account and the income are credited to the profit and loss account.
Given below is a list of the usual Expenses and Incomes in any business.
Expenses
Salaries
Rent and Rates
Insurance
Cash Discounts allowed
Carriage outwards
Advertising
Travelling and Conveyance
Bad debts and their provisions
Electricity
Sales Commission
Telephone
Postage
Stationery
Interest
Depreciation
Bank Charges
Audit fees
Income
Cash discount
Rent received
Interest received
Bad debts recovered
Commission earned
Profit on sale of investments
Points to note:
- Drawings are not an expense and hence will not be debited to the profit and loss account. It should be debited to the Capital account.
- Income tax paid also is not an expense and hence should not be debited to the profit and loss account. It should be debited to the capital account.
- Deferred revenue expenditure should be spread over three to five years and one third or one fifth, as the case may be should be debited to the profit and loss account.
Certain provisions
Bad Debts
When debts due become irrecoverable they are a loss and are called bad debts. The entry for this will be:
Bad Debts a/c Dr
To debtor's a/c
Provision for doubtful Debts
Sometimes there is some unpredictability in the recovery of bad debts. In such cases a provision for doubtful debts is made. The entry for this will be
Profit and loss account Dr.
To Provision for doubtful Debts.
This provision will be shown as a deduction from the debtors on the assets of the balance sheet.
Provision for discount on debtors
This provision is calculated as a percentage on good debtors.
The entry will be:
Profit and Loss account Dr.
To Provision for discount on debtors.
Provision for discount on creditors
Creditors may offer discount for prompt payment, which is calculated as a percentage on the sundry creditors.
The entry is
Provision for discount on creditors Dr.
To profit and Loss a/c.
Questions Lesson 1, Chapter 1(d)
1.Draw up a Trial Balance using imaginary accounts and figures.
2.Rectify the following:
a. Purchase book has been overcast by Rs.200
b. Sales book total is carried forward by Rs.200 more.
c. Purchases from A for Rs.200 has been posted to the debit side of her account.
d. Sales to A Rs.152 posted have been posted to her account as Rs.125.