Final Accounts: Trading, P&L, Balance Sheet & Closing Entries

TAKEAWAYS:

• Final accounts summarize a business’s financial performance (Trading/P&L) and position (Balance Sheet) over a fiscal year.
• The Trading Account calculates Gross Profit by subtracting Cost of Goods Sold (COGS) from sales.
• The Profit & Loss Account deducts operating expenses from Gross Profit to show Net Profit/Loss.
• The Balance Sheet lists assets, liabilities, and equity at a specific date (e.g., year-end) using the accounting equation: Assets = Liabilities + Equity.
• Closing entries transfer temporary account balances (revenues/expenses) to retained earnings and reset them to zero for the next period.
• Adjusting entries (e.g., depreciation, accruals) ensure the matching concept (revenue vs. expense recognition in the same period) is followed.

1. Why Prepare Final Accounts?

Final accounts are the financial report card of a business. They answer critical questions:

• How much profit did we make? (P&L Account)
• What do we own and owe? (Balance Sheet)
• Did our sales cover our costs? (Trading Account)

In the real world:

• eSewa/Nepal: When you pay your electricity bill online, eSewa’s Profit & Loss Account tracks revenue from transaction fees vs. expenses (servers, salaries). Their Balance Sheet shows cash reserves, loans, and assets like data centers.
• Daraz (Nepal): Daraz’s Trading Account calculates Gross Profit by subtracting the cost of imported goods (COGS) from sales revenue. Their Balance Sheet lists inventory (goods in warehouses) as an asset.
• Kathmandu Traffic Police: Imagine a small Kathmandu tea shop (e.g., Chai Ghar). At year-end, the shopkeeper prepares:
  • Trading Account: Sales (Rs 500,000) – Cost of tea/coffee (Rs 200,000) = Gross Profit Rs 300,000.
  • P&L Account: Gross Profit (Rs 300,000) – Rent (Rs 100,000) – Salaries (Rs 50,000) = Net Profit Rs 150,000.
  • Balance Sheet: Lists cash (Rs 200,000), furniture (Rs 150,000), and loans (Rs 100,000).

2. The Three Key Statements

A. Trading Account (Income Statement Part 1)

Purpose: Calculate Gross Profit = Sales Revenue – Cost of Goods Sold (COGS). Format:

Worked Example: Kathmandu Retail Shop (FY 2079) Assume Thamel Book Shop has:

• Sales Revenue: Rs 1,200,000
• Opening Stock (1 Baishak 2079): Rs 100,000
• Purchases: Rs 800,000
• Closing Stock (30 Chaitra 2080): Rs 150,000

Calculation:

COGS = Opening Stock + Purchases – Closing Stock
     = 100,000 + 800,000 – 150,000
     = Rs 750,000
Gross Profit = Sales – COGS = 1,200,000 – 750,000 = Rs 450,000

Mermaid Diagram: Flow of Trading Account

flowchart TD
    A["Sales Revenue"] -->|"Dr"| B["Trading Account"]
    B --> C["Less: COGS"]
    C --> D["Opening Stock<br/>(Cr)"]
    C --> E["Purchases<br/>(Cr)"]
    C --> F["Closing Stock<br/>(Dr)"]
    B --> G["Gross Profit<br/>(Dr)"]

B. Profit & Loss (P&L) Account

Purpose: Calculate Net Profit/Loss by deducting operating expenses from Gross Profit. Format:

Worked Example: Thamel Book Shop (Continued) From the Trading Account (Gross Profit Rs 450,000), deduct:

• Salaries: Rs 100,000
• Rent: Rs 50,000
• Depreciation (on furniture): Rs 20,000
• Miscellaneous: Rs 30,000

Calculation:

Net Profit = Gross Profit – Total Expenses
           = 450,000 – (100,000 + 50,000 + 20,000 + 30,000)
           = Rs 250,000

Key Expenses to Remember:

• Direct Expenses: Directly linked to sales (e.g., wages of sales staff).
• Indirect Expenses: Overhead costs (e.g., rent, utilities).
• Non-Operating Expenses: Interest, taxes (shown separately).

C. Balance Sheet

Purpose: Show what a business owns (Assets) and owes (Liabilities) at a specific date, using: Accounting Equation:

Assets = Liabilities + Equity (Owner’s Capital + Retained Profit)

Format:

Worked Example: Thamel Book Shop (Balance Sheet as of 30 Chaitra 2080) From earlier:

• Net Profit (Retained Profit): Rs 250,000
• Owner’s Capital: Rs 500,000 (initial investment)
• Assets:
  • Cash: Rs 200,000
  • Inventory: Rs 150,000
  • Accounts Receivable: Rs 80,000
  • Furniture (cost Rs 150,000 – depreciation Rs 30,000): Rs 120,000
• Liabilities:
  • Bank Loan: Rs 100,000
  • Creditors: Rs 30,000
  • Bank Overdraft: Rs 50,000

Verification:

Total Assets = 200,000 + 150,000 + 80,000 + 120,000 = Rs 550,000
Total Liabilities + Equity = 50,000 + 30,000 + 100,000 + 500,000 + 250,000 = Rs 550,000

3. The Accounting Cycle: From Trial Balance to Final Accounts

flowchart TD
    A["Unadjusted Trial Balance"] --> B["Adjusting Entries<br/>(e.g., depreciation, accruals)"]
    B --> C["Adjusted Trial Balance"]
    C --> D["Prepare Trading Account<br/>(Gross Profit)"]
    D --> E["Prepare P&L Account<br/>(Net Profit/Loss)"]
    E --> F["Prepare Balance Sheet<br/>(Assets = Liabilities + Equity)"]
    F --> G["Closing Entries<br/>(Transfer revenues/expenses to Retained Earnings)"]
    G --> H["Post-Closing Trial Balance"]

Key Adjustments Before Final Accounts:

1. Accrued Expenses: Expenses incurred but not yet paid (e.g., unpaid salaries).
   • Journal Entry:

     Salaries Expense (Dr) 20,000
     Salaries Payable (Cr) 20,000
     

2. Prepaid Expenses: Paid in advance (e.g., prepaid rent).
   • Journal Entry:

     Rent Expense (Dr) 10,000
     Prepaid Rent (Cr) 10,000
     

3. Depreciation: Allocate cost of assets over their useful life.
   • Journal Entry (for furniture):

     Depreciation Expense (Dr) 20,000
     Accumulated Depreciation (Cr) 20,000
     

4. Closing Entries: Resetting Temporary Accounts

At year-end, temporary accounts (revenues/expenses) are closed to Retained Earnings and reset to zero.

Steps:

1. Close Revenue Accounts (Dr to Revenue, Cr to Retained Earnings):

   Sales (Dr) 1,200,000
   Retained Earnings (Cr) 1,200,000
   

2. Close Expense Accounts (Dr to Retained Earnings, Cr to Expenses):

   Retained Earnings (Dr) 200,000
   Salaries (Cr) 100,000
   Rent (Cr) 50,000
   Depreciation (Cr) 20,000
   Miscellaneous (Cr) 30,000
   

3. Net Effect: Retained Earnings increases by Net Profit (Rs 250,000).

T-Account for Retained Earnings:

Retained Earnings
Dr (Expenses) | Cr (Revenues)
--------------|--------------
200,000       | 1,200,000
              | 250,000 (Net Profit)
Balance: 250,000

5. Comparison Table: Trading vs. P&L vs. Balance Sheet

6. Common Mistakes to Avoid

1. Ignoring Closing Stock: Forgetting to deduct closing stock from COGS inflates profits.
   • ❌ COGS = Opening Stock + Purchases
   • ✅ COGS = Opening Stock + Purchases – Closing Stock
2. Mixing Capital and Revenue Expenditure:
   • Capital Expenditure (e.g., buying machinery) → Asset (Balance Sheet).
   • Revenue Expenditure (e.g., repairs) → Expense (P&L Account).
3. Incorrect Depreciation Treatment:
   • Depreciation is an expense (P&L Account) but reduces the book value of assets (Balance Sheet via Accumulated Depreciation).
4. Omitting Adjusting Entries: Leads to mismatched revenues/expenses (violates the matching concept).

7. Worked Example: Full Final Accounts for a Nepali Business

Scenario: Kathmandu Mobile Shop (FY 2079)

• Sales Revenue: Rs 3,000,000
• Opening Stock (1 Baishak 2079): Rs 400,000
• Purchases: Rs 1,800,000
• Closing Stock (30 Chaitra 2080): Rs 500,000
• Expenses:
  • Salaries: Rs 400,000
  • Rent: Rs 150,000
  • Depreciation (on equipment): Rs 50,000
  • Utilities: Rs 100,000
• Assets/Liabilities:
  • Cash: Rs 600,000
  • Equipment (cost Rs 1,000,000, accumulated depreciation Rs 200,000)
  • Loan from Bank: Rs 500,000
  • Owner’s Capital: Rs 1,500,000

Step 1: Trading Account

COGS = 400,000 + 1,800,000 – 500,000 = Rs 1,700,000
Gross Profit = 3,000,000 – 1,700,000 = Rs 1,300,000

Step 2: P&L Account

Net Profit = 1,300,000 – (400,000 + 150,000 + 50,000 + 100,000) = Rs 600,000

Step 3: Balance Sheet

8. Exam Tip: How to Score Full Marks

1. Structure Your Answer:

   • Start with headings (Trading Account, P&L Account, Balance Sheet).
   • Use tables for clarity (Dr/Cr columns).
   • Show workings (e.g., COGS calculation) separately.

2. Common Exam Questions:

   • From Trial Balance to Final Accounts: Start with adjusting entries, then prepare the three statements.
   • Depreciation Impact: Always show how depreciation affects both P&L (expense) and Balance Sheet (accumulated depreciation).
   • Closing Entries: Explain why revenues/expenses are transferred to Retained Earnings.

3. Key Formulas to Memorize:

   • Gross Profit = Sales – COGS
   • Net Profit = Gross Profit – Expenses
   • COGS = Opening Stock + Purchases – Closing Stock
   • Assets = Liabilities + Equity

4. Avoid:

   • Forgetting to total columns in the Balance Sheet.
   • Mixing nominal accounts (P&L) with real accounts (Balance Sheet).
   • Ignoring adjusting entries (e.g., outstanding expenses).

5. Real-World Link:

   • If asked about a company’s financial health, relate it to:
     • Liquidity: Current Assets > Current Liabilities (e.g., Daraz’s ability to pay suppliers).
     • Profitability: Net Profit Margin = (Net Profit / Sales) × 100 (e.g., eSewa’s transaction fee efficiency).

Final Note: Practice with past exam papers (e.g., TU/PU questions on share issues or depreciation). Always label your answers clearly and show all steps—examiners reward methodical work!