Understanding Income Statement Components – A Guide to Trading | Profit and Loss | Appropriation Accounts

Income statement components refer to the key financial statements used to determine the operating results of a business, showing its profit or loss over a specific period. For non-corporate organizations like proprietorships and partnerships, these include the Trading Account, which calculates gross profit or loss by matching direct costs against sales; the Profit & Loss Account, which determines net profit or loss by accounting for indirect expenses and incomes; and the Profit & Loss Appropriation Account, used mainly in partnerships to allocate net profit among partners, distribute dividends, or create reserves. These components collectively provide a comprehensive view of a business's financial performance.

Table of Contents

1. Important Concepts
2. Balance Sheet

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1. Important Concepts

1.1 Income Statement

The term ‘Income Statements’ is a generic term which refers to those components of financial states which are associated with determination of operating result i.e. ascertainment or profit earned or loss suffered. For non-corporate commercial organisations (i.e. proprietorship businesses, partnership firms etc.) the income statements include Trading Account, Profit & Loss Account (P/L A/c) and Profit & Loss Appropriation Account.

The components of income statements of non-corporate commercial organisations

1.1.1 Trading Account

This is the first income statement prepared by a non-corporate trading business It is prepared to determine the gross operating results (i.e. Gross Profit or Gross Loss). Its principle involves matching of the Cost of Goods Sold (COGS) of an accounting period against the corresponding Sales. It considers only the direct costs and direct income (i.e. Sales) for determination of Gross Profit/ Gross Loss. It is a nominal account, and is closed by transfer of the Gross Profit/ Gross Loss to the Profit and Loss A/c.

The following items will appear in the debit side of the Trading Account:

• Opening Stock: In case of trading concern, the opening stock means the finished goods The amount of opening stock should be taken from Trial Balance.
• Purchases: The amount of purchases made during the Purchases include cash as well as credit purchase. The deductions can be made from purchases, such as, purchase return, goods withdrawn by the proprietor, goods distributed as free sample etc.
• Other Direct expenses: It means all those expenses which are incurred from the time of purchases to making the goods in suitable condition. This expenses includes freight inward, octroi, wages etc.
• Gross profit: If the credit side of Trading A/c is greater than debit side of Trading A/c gross profit will arise.

The following items will appear in the credit side of Trading Account:

• Sales Revenue: The sales revenue denotes income earned from the main business activity or activities. The income is earned when goods or services are sold to customers. If there is any return, it should be deducted from the sales As per the accrual concept, income should be recognized as soon as it is accrued and not necessarily only when the cash is paid for.
• Closing Stocks/Inventories: In case of trading business, there will be closing stocks of finished goods According to convention of conservatism, stock is valued at cost or net realizable value whichever is lower.
• Gross Loss: When debit side of trading account is greater than credit side of trading account, gross loss will appear.

1.1.2 Profit & Loss Account

The second income statement is the Profit & Loss It is drafted after the determination of Gross operating result i.e. Gross Profit or Gross Loss. This account determines the Net Profit or Net Loss of an organisation for a particular accounting period. It is prepared by charging the indirect expenses and losses against the Gross Profit and other indirect incomes. It is closed by transfer of the Net Profit or Net Loss to the Capital Account(s) of the proprietor or partners.

The following items will appear in the debit side of the Profit & Loss A/c:

• Cost of Sales: This term refers to the cost of goods The goods could be manufactured and sold or can be directly identified with goods.
• Other Expenses: All expenses which are not directly related to main business activity will be reflected in the P & L component. These are mainly the Administrative, Selling and distribution expenses.

Examples are salary to office staff, salesmen commission, insurance, legal charges, audit fees, advertising, free samples, bad debts etc. It will also include items like loss on sale of fixed assets, interest and provisions.

• Abnormal Losses: All abnormal losses are charged against Profit & Loss Account. It includes stock destroyed by fire, goods lost in transit etc.

The following items will appear in the credit side of Profit & Loss A/c:

• Revenue Incomes: These incomes arise in the ordinary course of business, which includes commission received, discount received etc.
• Other Incomes: The business will generate incomes other than from its main activity. These are purely incidental. It will include items like interest received, dividend received, etc. The end result of one component of the P & L A/c is transferred over to the next component and the net result will be transferred to the balance sheet as addition in owners’ The profits actually belong to owners of business. In case of company organizations, where ownership is widely distributed, the profit figure is separately shown in balance sheet.

1.1.3 Profit & Loss Appropriation Account

This component of income statement shows the appropriation of the net profit among the partners of a partnership business. Sole proprietorship businesses are not required to prepare the P/L Appropriation account. The net profit may be used by the business to distribute dividends, to create reserves etc. In order to show these adjustments, a P & L Appropriation A/c is maintained. Distribution of profits is only appropriation and does not mean expenses. After passing such distribution entries, the remaining surplus is added in owner’s equity

2. Balance Sheet

Balance Sheet is the financial statement that is prepared to show the financial position of the organisation on a specific date. It is prepared after drafting Income Statements i.e. Trading Account and P/L Account. It reflects the assets and liabilities of a concern at a particular point of time. The Balance Sheet may be drafted either in Horizontal format or in Vertical format. In the horizontal format, the Liabilities appear on the left-hand side, while the Assets appear on the right-hand side of the Balance Sheet. This is the traditional format followed by non-corporate commercial organisations. In the vertical format, the liabilities and assets appear in a top-down order.

The various items should appear in the Balance Sheet in a specific order which is known as Marshalling. When the assets which are most permanent in nature appear at the top, and the current assets appear below them, and for liabilities, the capital and long-term liabilities appear above the short-term liabilities, it is known as marshalling under Rigidity Order or Permanence Order. When the reverse ordering is followed as regards the assets and liabilities, it is known as marshalling under Liquidity Preference Order or Realisability Order.