Commercial gain or profit is the most critical component for anyone engaging in business of any kind. This is one of the most crucial factors determining the economic viability of any business.
Business needs to understand how much income or revenue they are generating and the profit earned. There are various methods or accounts which can be adopted to analyze this information. Two of the most important income and profitability statements are Trading Account and Profit and Loss Account.
Trading Account vs Profit and Loss Account
The main difference between a Trading Account and a Profit and Loss Account is that Trading Account depicts the gross profit earned or gross loss sustained due to the company activities conducted, while the Profit and Loss Account is a statement that indicates the net profit generated or net loss incurred from running the business.
However, the above is not the only difference. A comparison between both the terms on certain parameters can shed light on subtle aspects:
Comparison Table Between Trading Account and Profit and Loss Account (in Tabular Form)
|Parameter of Comparison||Trading Account||Profit and Loss Account|
|Meaning||Account showing the gross profit or gross loss from business activities||Account showing the net profit earned or net loss sustained from business|
|Purpose||Summarize 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 prepared before Profit and Loss Account||Profit and Loss Account is prepared after preparation of Trading Account|
|Type of profit summarized||Gross Profit||Net profit|
|Dependency on trial balance||No||Profit and Loss Account is dependent on the figures from the Trading Account|
|Utility||Trading Account is less useful because it does not take into account any indirect income or indirect expenses||Profit and Loss Account is more useful as it denotes the net profit or net loss|
|Treatment in balance sheet||No||Yes, the balance is added or subtracted from capital account|
What is Trading Account?
Trading Account is a type of income or financial statement. This is ideally the first income statement being prepared by any business to ascertain the business operations results. Trading Account can be considered as the first statement in which a business can understand its financial position.
Trading Account indicates either gross profit or gross loss which is based on a formula whereby the cost of goods sold is being subtracted from net sales to arrive at the final figure. Gross profit only will include direct incomes 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 gross profit or gross loss being depicted can be considered as the gross result of trading activities.
Trading Account contains two sides viz. a debit side or column denoting direct expenses. The other side viz. the credit side is for signifying direct income. For a business, direct expenses can be considered as the cost incurred to manufacture goods. Such costs may include the cost of raw materials, power, freight, etc. The incomes will denote the money received from selling the goods/services.
What is Profit and Loss Account?
Profit and Loss Account is an important 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. Profit and Loss Account is also known as Income Statement.
Profit and Loss Account indicates the net profit earned or the net loss sustained by the business selling the goods or providing the services. Profit and Loss Account can provide the net figure of either a profit or loss because it takes into account certain other monetary components such as operating and non-operating expenses and revenues.
Profit and Loss Account indicates either net profit or net loss which is calculated by taking into account any indirect income or indirect 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.
Profit and Loss Account is ideally developed once the finalization of the Trading Account is complete. 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.
Profit and Loss Account has two sides viz. a debit side and a credit side. The debit side is for indicating expenses and credit side for denoting incomes. Profit and Loss Account will show a net profit when the credit side amount is more than the debit side and will show 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 capital account).
Main Differences Between Trading Account and Profit and Loss Account
- Trading Account shows the overall monetary results of the business. Profit and Loss Account shows specific monetary results of business
- Trading Account provides information on gross profit or gross loss. Profit and Loss Account is useful in ascertaining net profit or net loss.
- Trading Account provides information on direct expenses and direct revenues. Profit and Loss Account provides insight on figures of indirect expenses and indirect incomes.
- Trading Account is prepared before the finalization of the Profit and Loss Account. Profit and Loss Account is prepared after the finalization of the Trading Account.
- Trading Account balance is transferred to Profit and Loss Account. Profit and Loss Account balance is transferred to the capital account in the Balance Sheet.
- Trading Account is not dependent on figures from trial balance. Profit and Loss Account is dependent on the gross profit/loss figures from the Trading Account.
Trading Account and Profit and Loss Account are two important financial statements for any business entity. Both these accounts summarise the business performance and monetary gains or losses. The type of account required at a certain point of time will vary depending on business needs i.e. whether the business intends to ascertain the overall picture or requires an insight on net gains or losses.
However, the best and prudent option which most businesses will implement is to prepare both the Trading Account and Profit and Loss Account and read them in a holistic and combined fashion to understand the true picture of the business.