Commercial gain or profit is the most critical component for anyone engaging in business. This is one of the most crucial factors determining the economic viability of any business.
Businesses need to understand how much income or revenue they generate and the profit earned. Various methods or accounts can be adopted to analyze this information.
Two of the most crucial income and profitability statements are Trading Account and Profit and Loss Account.
Key Takeaways
- A trading account is a financial statement summarizing the revenue and expenses of buying and selling goods. In contrast, a profit and loss account is a financial statement that summarizes all revenue and expenses, including non-operating items.
- The trading account calculates a business’s gross profit or loss, while the profit and loss account calculates the net profit or loss.
- A trading account is primarily used by businesses engaged in trading activities, while a profit and loss account applies to all types of businesses.
Trading Account vs Profit and Loss Account
A Trading account is a financial statement that shows the gross profit or loss of a business over a specified period. A Profit and Loss account, also known as an Income statement, is a financial statement that summarizes a company’s revenues, expenses, and net profit or loss over a specified period.
However, the above is not the only difference. A comparison between both the terms on specific parameters can shed light on subtle aspects:
Comparison Table
| Parameter of Comparison | Trading Account | Profit and Loss Account |
|---|---|---|
| Meaning | Account showing the gross profit or gross loss from business activities | Statement showing the net profit earned or net loss sustained from business |
| Purpose | Summarize the overall result of the business activities in monetary terms | Summarize specific profit generated or loss sustained |
| Stage of accounts preparation | First stage | Second stage |
| Which is prepared first | Trading Account is ready before the Profit and Loss Account | The profit and Loss Account is designed after the preparation of the Trading Account |
| Type of profit summarized | Gross Profit | Net profit |
| Dependency on the trial balance | No | The profit and loss account depends on the Trading Account’s figures. |
| Utility | Trading Account is less valid because it does not consider indirect income or expenses. | A profit and Loss Account is more beneficial as it denotes the net profit or loss. |
| Treatment in the balance sheet | No | Yes, the balance is added or subtracted from the capital account |
What is Trading Account?
Trading Account is a type of income or financial statement. Ideally, this is the first income statement any business prepares to ascertain the business operations results.
A trading account is the first statement in which a business can understand its financial position.
A trading Account indicates gross profit or loss, which is based on a formula whereby the cost of goods sold is subtracted from net sales to arrive at the final figure. Gross profit only will include direct income and direct expenses.
So, in formula terms,
Gross Profit or Gross Loss = Net Sale less Cost of Goods Sold
Trading Account indicates the profit earned or loss sustained from trading operations. Trading Account will not take into consideration any indirect incomes or indirect expenses.
The depicted gross profit or loss can be considered the awful result of trading activities.
Trading Account contains two sides: a debit side or a column denoting direct expenses. The other side, viz., the credit side, is for signifying immediate income.
For a business, direct expenses can be considered the cost incurred to manufacture goods. Such costs may include raw materials, power, freight, etc.
The income will denote the money received from selling the goods/services.
What is Profit and Loss Account?
A profit and Loss Account is an essential financial statement for any business. Profit and Loss Statement is considered critical for any business that needs to understand if they are indeed operating at a net profit or a net loss which data may not be available from preliminary financial statements.
The profit and Loss Account is also known as Income Statement.
The profit and Loss Account indicates the net profit earned or the net loss sustained by the business selling the goods or providing the services. A profit and Loss Account can provide the net figure of either a profit or loss because it considers specific other monetary components such as operating and non-operating expenses and revenues.
The profit and Loss Account indicates either net profit or net loss, which is calculated by considering any indirect income or expenses. Therefore, in formula terms,
Net Profit or Net loss= (Gross Profit or Gross Loss) + (Indirect Income – Indirect Expenses), where
Indirect incomes denote the income generated from activities other than the primary activities of a business, and indirect expenses signify all expenses other than direct business expenses.
The profit and Loss Account is ideally developed once the Trading Account is finalised. This is so because the balance from the Trading Account needs to be transferred to the Profit and Loss Account to determine the net profit/loss.
A profit and Loss Account has two sides, viz., a debit side and a credit side. The debit side is for indicating expenses, and the credit side is for denoting incomes.
The profit and Loss Account will show a net profit when the credit side amount is more than the debit side and a net loss when the debit side is more than the credit side.
The balance from the Profit and Loss Account (irrespective of whether it is a net profit or net loss) is finally transferred to the balance sheet (under the capital account).
Main Differences Between Trading Accounts and Profit and Loss Accounts
- Trading Account shows the overall monetary results of the business. The profit and Loss Account shows specific financial consequences of trade.
- Trading Account provides information on gross profit or gross loss. A profit and Loss Account is helpful in ascertaining net profit or a net loss.
- Trading Account provides information on direct expenses and direct revenues. The profit and Loss Account provides insight into indirect costs and income figures.
- Trading Account is prepared before the finalization of the Profit and Loss Account. The profit and Loss Account is prepared after the finalization of the Trading Account.
- The Trading Account balance is transferred to the Profit and Loss Account. The profit and Loss Account balance is transferred to the capital account in the Balance Sheet.
- Trading Account is not dependent on figures from the trial balance. The profit and Loss Account depends on the trading account’s gross profit/loss figures.
- https://content.sciendo.com/view/journals/kbo/23/2/article-p36.xml
- http://ns1.upet.ro/annals/economics/pdf/2011/part4/Rascolean-Isac-Szabo.pdf
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