The trading account

The trading account is part of the double-entry bookkeeping system of an organisation that buys and sells goods with the intention of making a profi t. It is part of the income statement and is regularly produced by such an organisation during the year, often on a monthly basis.

The trading account compares the revenue derived from selling the goods with the costs of obtaining the goods sold. A typical trading account is as follows:

Trading account for the year ending 31 December 20X1

$ $

This presentation, as a ledger account, is known as the horizontal format .

73 FUNDAMENTALS OF FINANCIAL ACCOUNTING

SUMMARISING THE LEDGER ACCOUNTS

Transferring the balances to the trading account

The trading account is a ledger account in the normal sense, and must conform to the double-entry rule. Therefore, every entry in it must have an opposite entry elsewhere in the ledger accounts. For example, the credit in the trading account for ‘ sales ’ of $9,400 will also be debited in the sales account. In effect, the balance on the sales account is transferred into the trading account. In the example above, the sales account might have appeared as follows:

Sales

Once the balance has been transferred to the trading account, the sales account will appear as follows:

Note that there is now no balance on the sales account, and so the two sides can be totalled to confi rm that fact, and ruled off to prevent including them in the fi gures for the following year. The account is now said to be ‘ closed ’ , although it can still be used to record the sales for the next period, below the totals.

This process is repeated with all the other fi gures that appear in the trading account, but there are some transfers that are worthy of special mention.

(a) The inventories account . In Chapter 3, you were told never to use the inven-tories account for the purchase, sale or return of inveninven-tories, but that it was used only at the beginning and the end of the period.

In a business that has been trading in the past, there will be a balance on the inventories account at the start of the period, which will be a debit balance (rep-resenting an asset). In the example above, the inventories account at the start of the period would appear as follows:

Inventories

20X1 $ 20X1 $

1 Jan. Balance 500

As the trading account is being prepared, this balance is transferred into it, by crediting the inventories account and debiting the trading account. The invento-ries account then appears as follows:

STUDY MATERIAL C2

As the preparation of the trading account continues, it will be necessary to determine the value of the inventories at 31 December. This is often done by referring to a separate inven-tory control system, which is maintained outside the bookkeeping system (you will learn more about the valuation of inventories in Chapter 8). The fi gure is passed to the book-keeper, who then debits the inventories account with the new value, and credits the trading account.

The inventories account now appears as follows:

Inventories

20X1 $ 20X1 $

1 Jan. Balance 500 31 Dec. Trading account 500

31 Dec. Trading account 430

However, notice that in the trading account above, the closing inventories does not appear to have been credited to it, instead it has been deducted on the debit side of the account.

This is not normal practice for most ledger accounts, but is commonplace when the trading account is being prepared, because it is then possible to show the cost of goods sold fi gure.

An item deducted on the debit side of an account is equivalent to making a credit entry.

(b) Sales and purchase returns . The same type of entry is used with sales and purchase returns. In the trading account above, the sales returns have been deducted from the sales fi gure on the credit side of the account. This is the equivalent of making a debit entry. The opposite entry would be to credit the sales returns account.

The trading account thus brings together the revenue and costs of the trading function for a specifi ed period of time, and by comparing them calculates the gross profi t . It is com-mon for the gross profi t to be expressed as a percentage of the sales value, when it is known as the gross profi t margin, or as a percentage of the cost of sales, when it is known as the gross profi t mark-up.

The balance on the trading account

We have seen that the revenue from the sale of goods is compared with the cost of those goods in the trading account and the resulting difference is referred to as gross profi t. This fi gure is the balance on the trading account.

This balance is then carried down within the income statement.

Vertical presentation of the trading account

An alternative presentation of the trading account is shown below. This is known as the vertical format , and is used when producing an income statement.

75 FUNDAMENTALS OF FINANCIAL ACCOUNTING

SUMMARISING THE LEDGER ACCOUNTS

Trading account for the year ended 31 December 20X1

$ $

Prepare the trading account (in horizontal format) for Example 3.B, given that closing inventories were $1,200, and make the necessary entries in the ledger accounts.

Solution

Trading account for the month ended 31 May

$ $

Note: There were no opening inventories in this case, as the company commenced trading only on 1 May.

STUDY MATERIAL C2

Prepare the trading account for Exercise 3.3 (in vertical format), given that closing inven-tories were $50.

Solution

Trading account for the month ended 28 February 20X1

$ $

The rest of the income statement performs a similar function to the trading account by comparing (in the case of trading organisations) the other costs of operating the business and any non-trading revenue (such as interest received) with the gross profi t to identify whether the business has been profi table overall or not. In the case of organisations that provide a service rather than selling goods a trading account is not prepared. In this case, the word ‘ sales ’ is not normally used and some other word, such as ‘ services ’ or ‘ turnover ’ , is used instead.

The income statement as a whole, just as the sub-section of the trading account, is part of the double-entry bookkeeping system. In the case of the trading account, the word ‘ account ’ appears and this makes it obvious that it is a ledger ‘ account ’ which can be deb-ited and creddeb-ited. The word ‘ account ’ does not appear in the name ‘ income statement ’ but it is nevertheless a ledger account which can be debited and credited.

A typical income statement, in horizontal format, is shown below:

77 FUNDAMENTALS OF FINANCIAL ACCOUNTING

SUMMARISING THE LEDGER ACCOUNTS

Income statement for the year ended 31 December 20X1

$ $

The income statement thus summarises all the costs and revenues of the business for a specifi ed period of time. The various expenses (and sundry revenues, if there are any) are transferred out of the nominal ledger, and into the income statement. Those accounts are then closed off.

The resulting balance on the income statement is referred to as a net profi t (if it is a credit balance), or net loss (if it is a debit balance).

It is common for the net profi t (or loss) to be expressed as a percentage of the sales value shown in the trading account, and this is known as the net profi t percentage .

The income statement is presented in a vertical format when it is presented as part of the fi nancial statements. This is shown below:

Income statement for the year ended 31 December 20X1

$ $

Prepare the income statement in horizontal format for Example 3.B, and make the necessary entries in the ledger accounts.

STUDY MATERIAL C2 78

SUMMARISING THE LEDGER ACCOUNTS

Solution

Income statement for the month ended 31 May

$ $

Prepare the income statement in horizontal format for Exercise 3.3.

Solution

Income statement of A Thompson for the month ended 28 February 20X1

Rent 50 Gross profi t b/d 430

Advertising 25

Net profi t 355

430 430