Final Accounts and Concept of Trading, Profit and Loss account and Balance Sheet (with and without adjustments), Marshalling of Balance Sheet | ISC Class 11 Accounts Notes

This note covers capital and revenue expenditure, receipts, profits and losses with examples, deferred revenue expenditure, provisions and reserves and their types, the meaning, objectives and importance of the Trading and Profit and Loss Account and Balance Sheet of a sole trader in horizontal format without and with adjustments (closing stock, outstanding and prepaid items, accrued income and income received in advance, depreciation, bad debts, provision for doubtful debts, provision for discount on debtors, manager's commission, goods taken by the owner, goods given as free samples, abnormal loss), adjusted purchases and cost of goods sold, operating profit, marshalling of a balance sheet by order of permanence and order of liquidity, and adjusting, closing and transfer entries.

What are capital expenditure and revenue expenditure?

Whenever a payment or an outlay is made for a purpose other than settling an existing liability, it is called expenditure. Expenditure is incurred with the expectation that it will benefit the business.

If the benefit of an expenditure extends to one accounting period only, it is termed revenue expenditure; such items are normally incurred for the day-to-day conduct of the business, for example payment of salaries or rent.

If the benefit of an expenditure extends over more than one accounting period, it is termed capital expenditure, for example payment to acquire furniture, which will give benefits for many accounting periods to come.

Definition: Capital expenditure. Expenditure incurred to acquire fixed assets for the operation of the business, or to make additions or extensions to fixed assets, the benefit of which extends beyond one accounting year.

Points of distinction worth noting are that capital expenditure increases the earning capacity of the business whereas revenue expenditure is incurred to maintain the earning capacity; capital expenditure is incurred to acquire fixed assets whereas revenue expenditure is incurred on the day-to-day conduct of business; revenue expenditure is generally recurring and capital expenditure is non-recurring by nature; and capital expenditure (subject to depreciation) is recorded in the balance sheet whereas revenue expenditure (subject to adjustment for outstanding and prepaid amounts) is transferred to the trading and profit and loss account.

Expenditure is a wider term than expense: expenditure is any outlay made or incurred by the business, while the part of expenditure perceived to have been used or consumed in the current year is termed the expense of that year.

Capital expenditure is spread over more than one accounting period through depreciation; for example, furniture costing ₹50,000 expected to be used for 5 years is treated as an expense of ₹10,000 per year.

What is deferred revenue expenditure?

Sometimes it is difficult to classify expenditure as capital or revenue. Advertising expenditure, in normal usage, is termed revenue expenditure, but heavy advertising expenditure is likely to benefit the firm for more than one accounting period.

Such revenue expenditure, likely to give benefit for more than one accounting period, is termed deferred revenue expenditure.

The treatment of deferred revenue expenditure is the same as that of capital expenditure: it is written off over its expected period of benefit rather than charged in full in the year it is incurred.

Definition: Deferred revenue expenditure. Revenue expenditure which is likely to give a benefit for more than one accounting period and is therefore written off over that expected period, in the same way as capital expenditure.

What are capital and revenue receipts, profits and losses?

A similar distinction is made for receipts. If a receipt implies an obligation to return the money, it is a capital receipt; the examples given are additional capital brought in by the owner, or a loan taken from the bank, and both lead to obligations, the first to the owner (called equity) and the other to outsiders (called liabilities).

The sale of a fixed asset, such as old machinery or furniture, is also a capital receipt.

If a receipt does not incur an obligation to return the money and is not the sale of a fixed asset, it is a revenue receipt; the examples given are sales made by the firm and interest on investment received.

Because revenue items are shown in the trading and profit and loss account and capital items in the balance sheet, misclassification distorts both the profit figure and the assets shown.

A revenue expenditure of ₹20,000 on repairs wrongly added to the cost of machinery (treated as capital expenditure) means expenses are understated, so profit on paper rises from ₹1,80,000 to ₹2,00,000, overstating profit.

The reverse error, treating a capital item such as furniture as a purchase, understates both profit and assets.

Capital profits are also taxed differently from revenue profits, so correct classification matters for taxation as well as for a true and fair view of the business.

Capital profit or income and revenue profit or income

A capital profit (also called capital income) is a profit that does not arise from the normal trading operations of the business. It arises from transactions of a capital nature, such as the sale of a fixed asset at more than its book value, or a premium received on the issue of shares.

A revenue profit is the profit earned from the ordinary trading operations of the business during an accounting period, such as the gross profit and net profit shown by the trading and profit and loss account.

The distinction matters when profit is measured. In a sole trader's final accounts a capital profit, such as a profit on the sale of a fixed asset or an investment, is shown on the credit side of the profit and loss account as a non-operating income, and it is left out when operating profit is calculated. A company generally transfers a capital profit, such as a premium on the issue of shares, to a capital reserve instead of distributing it.

Capital loss and revenue loss

A capital loss arises from a transaction of a capital nature, for example the sale of a fixed asset at less than its book value, or the loss of a fixed asset by fire or theft.

A revenue loss arises in the ordinary course of trading, for example bad debts, loss of stock by fire, or a loss on the sale of goods.

A revenue loss is debited to the profit and loss account and reduces both the net profit and the operating profit of the period. A capital loss, such as a loss on the sale of old furniture, is not a trading expense: it is also debited to the profit and loss account, but as a non-operating expense, so it reduces net profit while being left out of operating profit.

What are provisions and reserves, and what types of reserves are there?

A provision is an amount set aside, out of profits or other surpluses, for a known liability or an anticipated loss of uncertain amount, such as the amount likely to become irrecoverable from debtors.

A reserve is an amount set aside out of profits to strengthen the financial position of the business, to meet unforeseen contingencies, or to fund expansion.

The essential difference is that a provision is a charge against profit made in anticipation of a known loss or liability, while a reserve is an appropriation of profit made for a future need and is not a charge needed to arrive at the correct profit figure.

Definition: Provision. An amount charged against profit, set aside to meet a known liability or an anticipated loss of uncertain amount, for example provision for doubtful debts.

Definition: Reserve. An amount appropriated out of profits, set aside to strengthen the financial position of the business or to meet a future need, rather than a charge against a known liability.

Advantages of reserves

Reserves strengthen the financial position of a business by building up funds internally rather than relying on outside borrowing, provide a cushion against future losses or contingencies, and allow funds to be ploughed back into the business for expansion or replacement of assets without raising fresh capital.

Limitations of secret reserves

Secret reserves reduce the transparency of financial statements because the true financial position is not disclosed to shareholders and other stakeholders, and because the balance sheet does not present a true and fair view, companies are generally not permitted to create secret reserves except within limits allowed for certain classes of business such as banking and insurance.

What is a trading account and how is gross profit calculated?

A trading and profit and loss account is prepared to determine the profit earned or loss sustained by a business during an accounting period; it is a summary of revenues and expenses that calculates the net figure termed profit or loss.

It is prepared by transferring the balances of revenue and expense accounts from the trial balance to this account, which itself has debit and credit sides like any other account.

The trading account, the first part, ascertains the result of the basic operational activities of manufacturing, purchasing and selling goods.

Besides purchases, the remaining expenses are divided into direct expenses (connected with manufacturing, purchase of goods and bringing them to the point of sale, such as wages, carriage inwards, freight inwards, factory lighting, coal, water and fuel, and royalty on production) and indirect expenses, which go to the profit and loss account.

Gross Profit = Sales − (Purchases + Direct Expenses)

Items appearing on the debit side of the trading account include opening stock, purchases less returns (net purchases), wages, carriage inwards or freight inwards, and expenses on fuel, water, power or gas, packaging material, and gross profit carried down.

On the credit side appear sales less returns (net sales) and closing stock, and gross loss brought down where expenses exceed revenue.

If the amount of purchases plus direct expenses is more than sales revenue, the result is a gross loss rather than a gross profit. The gross profit or gross loss is transferred to the profit and loss account.

Worked example 1. From the following particulars for the year ended 31 March 2026, prepare a trading account: Opening stock ₹37,500; Purchases ₹1,05,000; Sales ₹2,70,000; Wages ₹30,000.

Answer: Debit side totals Opening stock ₹37,500 + Purchases ₹1,05,000 + Wages ₹30,000 = ₹1,72,500. Credit side is Sales ₹2,70,000. Gross profit = ₹2,70,000 − ₹1,72,500 = ₹97,500, shown on the debit side so both sides total ₹2,70,000.

What is a profit and loss account and how is net profit calculated?

The indirect expenses are transferred to the debit side of the second part, the profit and loss account, which also carries all gains and revenues other than sales on its credit side, together with gross profit brought down.

Items on the debit side include salaries, rent, rates and taxes, interest paid, commission paid, repairs, and miscellaneous or sundry expenses; items on the credit side include other incomes such as rent received, dividend received, interest received, discount received and commission received.

Net Profit = Gross Profit + Other Incomes − Indirect Expenses

If the credit side total exceeds the debit side total, the difference is net profit for the period; if the debit side total is larger, the difference is a net loss.

Net profit or net loss is transferred to the capital account in the balance sheet, by debiting the Profit and Loss Account and crediting the Capital Account for a profit, or debiting Capital Account and crediting Profit and Loss Account for a loss.

Worked example 2. Prepare a profit and loss account for the year ending 31 March 2026 from: Gross profit ₹60,000; Rent ₹5,000; Salary ₹15,000; Commission paid ₹7,000; Interest paid on loan ₹5,000; Advertising ₹4,000; Discount received ₹3,000;

Printing and stationery ₹2,000; Legal charges ₹5,000; Bad debts ₹1,000; Depreciation ₹2,000; Interest received ₹4,000; Loss by fire ₹3,000.

Answer: Debit side total = Rent 5,000 + Salary 15,000 + Commission 7,000 + Interest paid 5,000 + Advertising 4,000 + Printing and stationery 2,000 + Legal charges 5,000 + Bad debts 1,000 + Depreciation 2,000 + Loss by fire 3,000 = ₹49,000.

Credit side total = Gross profit 60,000 + Discount received 3,000 + Interest received 4,000 = ₹67,000. Net profit = ₹67,000 − ₹49,000 = ₹18,000, transferred to the capital account.

What is operating profit?

Operating profit is the profit earned through the normal operations and activities of the business: it is the excess of operating revenue over operating expenses, and while calculating it, incomes and expenses of a purely financial nature, and abnormal items such as loss by fire, are not taken into account. Operating profit is therefore profit before interest and tax.

Operating Profit = Net Profit + Non-operating Expenses − Non-operating Incomes

Worked example 3. A trader's trading and profit and loss account shows a net profit of ₹19,000 for the year ended 31 March 2026, after charging interest of ₹500 on a 10% long-term loan as the only non-operating item, with no non-operating income. Calculate operating profit.

Answer: Operating profit = Net profit + Non-operating expenses − Non-operating incomes = ₹19,000 + ₹500 − nil = ₹19,500.

How is a balance sheet of a sole trader prepared?

A balance sheet is a statement, prepared for showing the financial position of the business, summarising its assets and liabilities at a given date. Assets reflect debit balances and liabilities (including capital) reflect credit balances.

It is prepared at the end of the accounting period after the trading and profit and loss account has been prepared, and is called a balance sheet because it lists balances of ledger accounts not transferred to the trading and profit and loss account, which are carried forward to the next year through an opening entry.

Format of the balance sheet

In the horizontal format, accounts of capital and liabilities are shown on the left-hand side, known as Liabilities, and assets and other debit balances on the right-hand side, known as Assets.

There is no prescribed form of balance sheet for proprietary and partnership firms.

Current and fixed items in the balance sheet

Items generally included are current assets (cash in hand or at bank, bills receivable, stock, sundry debtors, short-term investments and prepaid expenses, all either cash or convertible into cash within a year), current liabilities (bank overdraft, bills payable, sundry creditors, short-term loans and outstanding expenses, expected to be paid within a year out of current assets), fixed assets (land, buildings, plant and machinery, furniture, held on a long-term basis and not acquired for resale), intangible assets (goodwill, patents, trademarks, which cannot be seen or touched), investments (shown at cost price), and long-term liabilities such as long-term loans, usually payable after one year.

Capital and drawings

Capital is the excess of assets over liabilities due to outsiders, representing the amount contributed by the proprietor increased by profit and decreased by drawings;

drawings are amounts withdrawn by the proprietor and are shown by way of deduction from capital.

What is marshalling of a balance sheet?

Arrangement of assets and liabilities in a balance sheet in a particular order is known as marshalling. Assets and liabilities can be arranged either in the order of permanence or the order of liquidity.

Definition: Marshalling. The arrangement of assets and liabilities in a balance sheet in a particular order, either of permanence or of liquidity.

In the order of permanence, the most permanent asset or liability is placed at the top and the remaining items follow in reducing level of permanence; capital, being the most important and long-lasting source of finance, comes before long-term loan, which comes before creditors, and furniture (the most permanent asset) comes before debtors, bank and cash, with cash the most liquid of all.

In the order of liquidity, this order is reversed, so that the most easily realisable items, such as cash and bank, are shown first.

Items appearing in the balance sheet can also be grouped, meaning similar items are put together under a common heading, such as cash, bank and debtors grouped under 'current assets', and all fixed assets and long-term investments grouped under 'non-current assets', with capital and long-term loan grouped as owners' funds and non-current liabilities respectively.

How are closing stock, outstanding expenses and prepaid expenses adjusted?

Under the accrual basis of accounting, revenues must be considered on an earned basis and expenses on an incurred basis, not on a receipt or payment basis.

Several items therefore need adjustment while preparing financial statements: closing stock, outstanding expenses, prepaid expenses, accrued income, income received in advance, depreciation, bad debts, provision for doubtful debts, provision for discount on debtors, manager's commission and interest on capital.

All adjustments are reflected at two places in the final accounts to complete the double entry.

Closing stock

Closing stock, the cost of unsold goods at the end of the accounting period, does not normally appear in the trial balance and is brought into the books through the entry Closing Stock A/c Dr., To Trading A/c, which shows it on the credit side of the trading account and as a current asset in the balance sheet.

Outstanding expenses

Outstanding expenses are expenses of an accounting period that remain unpaid at its end, such as unpaid wages; they relate to the current year's revenue, so they are added to the concerned expense through the entry Concerned Expense A/c Dr., To Outstanding Expense A/c, and the new Outstanding Expenses account is shown on the liabilities side of the balance sheet.

Worked example 4. Ankit's trial balance shows wages of ₹8,000, of which ₹500 is owed to an employee for wages relating to the current year. Show the adjustment.

Answer: The correct wages expense is ₹8,000 + ₹500 = ₹8,500, debited in the trading account.

The entry Wages A/c Dr. ₹500, To Wages Outstanding A/c ₹500 opens a new liability shown at ₹500 on the liabilities side of the balance sheet, and net profit falls from ₹19,500 to ₹19,000 because of the additional expense.

Prepaid expenses

Prepaid expenses are amounts paid in the current year whose benefit extends partly into the next year, such as salary advanced to an employee; this portion is deducted from the total of the expense and carried forward through the entry Prepaid Expense A/c Dr., To Concerned Expense A/c, and shown as a current asset.

How are accrued income and income received in advance adjusted?

Accrued income is income that has been earned in the current accounting period but not yet received in cash by the date the accounts are closed, such as interest earned on investments that will be received only in the following year.

It is brought into the books by debiting a new Accrued Income account and crediting the concerned income account, so that the full income earned is credited to the profit and loss account and the amount still to be received is shown as a current asset in the balance sheet.

Income received in advance is the opposite case: cash has been received during the year for a service or benefit that will actually be provided in the following accounting period, such as rent received for a period extending beyond the year end.

The portion relating to the next year is deducted from the income shown in the profit and loss account and is credited to a new Income Received in Advance account, shown as a current liability in the balance sheet, because the business still owes that benefit to the payer.

Both adjustments follow the same accrual logic as outstanding and prepaid expenses: income is recognised in the period it is earned, not the period it is received in cash, and any mismatch between the two is carried forward as either an asset (accrued income still to be collected) or a liability (income received in advance that is still to be earned).

How are depreciation, bad debts and provisions for doubtful debts and discount on debtors adjusted?

Depreciation is the gradual and permanent fall in the value of a fixed asset due to use, wear and tear, or the passage of time.

Because it is not recorded during the year on a day-to-day basis, it is adjusted at the time of preparing the final accounts: the amount of depreciation is debited to the profit and loss account as an expense and is deducted from the value of the concerned fixed asset shown in the balance sheet.

When debts owed by customers become irrecoverable, they are written off as bad debts, debited to the profit and loss account and deducted from sundry debtors in the balance sheet.

Besides bad debts already written off and appearing in the trial balance, further bad debts may need to be written off as an adjustment, and are debited to the profit and loss account and deducted from debtors.

A provision for doubtful debts is created, on the remaining good debtors after deducting further bad debts, as an estimate of the amount likely to prove irrecoverable in future; it is debited (or, if an opening provision already exists, only the increase is debited) to the profit and loss account and shown as a deduction from sundry debtors in the balance sheet.

In the absence of information about the amount of the new provision, the remaining balance of debtors is taken to be good, or the same percentage of provision is applied to the closing debtors as was applied at the beginning of the year.

A provision for discount on debtors is similarly created on the good debtors remaining after deducting the provision for doubtful debts, to allow for cash discount likely to be given to customers who pay promptly; it is debited to the profit and loss account and deducted from debtors in the balance sheet, after the provision for doubtful debts has already been deducted.

Definition: Provision for doubtful debts. An amount set aside out of profit, on the good debtors remaining after further bad debts are written off, to cover debts expected to become irrecoverable in the future.

How is manager's commission calculated, and how are goods taken by the owner, free samples and abnormal loss treated?

Manager's commission before and after charging

A manager may be entitled to a commission on the net profit of the business, which may be calculated either before charging such commission or after charging it.

If the commission is a percentage of profit before charging the commission, it is simply that percentage of the net profit computed before any deduction for commission.

If the commission is a percentage of profit after charging the commission, the commission itself reduces the profit on which it is calculated, so it must be computed as a fraction of the net profit before commission.

Commission before = Net Profit × r/100

Commission after = Net Profit × r/(100 + r)

Where r is the rate of commission and Net Profit in both formulas is the profit before charging the manager's commission.

The commission is debited to the profit and loss account as an expense and shown as outstanding commission payable, a current liability, in the balance sheet, until it is actually paid.

Goods taken by the owner and goods given as free samples

Goods taken by the owner for personal use reduce the stock available for sale and are not part of business expense, so the value of such goods is deducted from purchases in the trading account and added to drawings, reducing capital in the balance sheet.

Goods distributed as free samples for advertisement are similarly deducted from purchases in the trading account, but the value is debited to the profit and loss account as an advertisement expense, since the purpose is promotional rather than personal.

Abnormal loss

An abnormal loss, such as stock destroyed by fire or theft, is deducted from purchases (or from closing stock) in the trading account at its cost, so that normal gross profit is not understated by an abnormal event.

The amount of loss is then shown in the profit and loss account, less any amount recoverable from an insurance company, which is shown as a current asset (insurance claim receivable) in the balance sheet; the portion not covered by insurance is a net loss to the business.

What are adjusted purchases, cost of goods sold, and adjusting, closing and transfer entries?

Adjusted purchases and cost of goods sold

Sometimes the opening and closing stock are adjusted directly through the purchases account rather than shown separately.

The closing stock is recorded by Closing Stock A/c Dr., To Purchases A/c, and the opening stock already in the trial balance is removed by Purchases A/c Dr., To Opening Stock A/c.

The resulting net figure is called adjusted purchases, and in this situation neither opening stock nor closing stock is shown separately in the trading account; instead, the trial balance itself shows the closing stock (as an item in the trial balance, not as additional information) and the adjusted purchases figure, which is debited in the trading account, while closing stock is shown only on the assets side of the balance sheet.

Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses − Closing Stock

Adjusting entries

Adjusting entries are the entries passed at the end of the accounting period to bring into the books items that are not yet recorded, or are recorded wrongly, so that the final accounts show the true profit or loss and the true financial position.

Each adjusting entry has a double effect: it changes an item in the trading and profit and loss account and at the same time creates or changes an item in the balance sheet.

Examples are Concerned Expense A/c Dr., To Outstanding Expense A/c for an unpaid expense, Prepaid Expense A/c Dr., To Concerned Expense A/c for an expense paid in advance, Accrued Income A/c Dr., To Concerned Income A/c for income earned but not received, and Depreciation A/c Dr., To Asset A/c for depreciation on a fixed asset.

Closing entries

Preparing financial statements requires closing the balances of all revenue and expense accounts by transferring them to the trading and profit and loss account. The following sequence of closing entries is used:

1. Opening stock, purchases, wages, carriage inwards and other direct expenses accounts are closed to the debit side of the trading account: Trading A/c Dr., To Opening Stock A/c, To Purchases A/c, To Wages A/c, To Carriage Inwards A/c, To All Other Direct Expenses A/c.
2. Purchases returns (returns outwards) is closed by transferring its balance to the purchases account: Purchases Return A/c Dr., To Purchases A/c.
3. Sales returns (returns inwards) is closed by transferring its balance to the sales account: Sales A/c Dr., To Sales Return A/c.
4. The sales account is closed to the credit side of the trading account: Sales A/c Dr., To Trading A/c.
5. Items of expenses and losses are closed by Profit and Loss A/c Dr., To Expenses (individually) A/c, To Losses (individually) A/c.
6. Items of incomes and gains are closed by Incomes (individually) A/c Dr., Gains (individually) A/c Dr., To Profit and Loss A/c.

Transfer entries

A transfer entry moves a balance from one account to another within the books, without any outside transaction taking place.

The gross profit shown by the trading account is transferred to the credit of the profit and loss account, and the net profit shown by the profit and loss account is transferred to the credit of the capital account, while a net loss is transferred to the debit of the capital account.

Drawings are transferred to the debit of the capital account, and the balance of the drawings account is thus closed and shown as a deduction from capital in the balance sheet.

Opening entry

After the final accounts are prepared, the balances of assets, liabilities and capital accounts, which remain in the balance sheet, are carried forward to the next accounting period through an opening entry, which debits all asset accounts and credits all liability and capital accounts afresh at the start of the next year; the balance sheet of one period in effect becomes the opening trial balance of the next.

What are the objectives and importance of the trading and profit and loss account and the balance sheet?

The basic objectives of preparing financial statements are to present a true and fair view of the financial performance of the business and to present a true and fair view of the financial position of the business.

The trading and profit and loss account, also known as the income statement, shows the financial performance in the form of the profit earned or the loss sustained by the business during a period. The balance sheet shows the financial position in the form of assets, liabilities and capital at a given date.

Objectives of the trading and profit and loss account

The trading account ascertains the result of the basic operational activities of the business, namely manufacturing, purchasing and selling goods, and so shows the gross profit or gross loss for the period.

The profit and loss account then ascertains the net profit or net loss of the business after taking into account all indirect expenses, losses, incomes and gains.

The net result so found is transferred to the capital account, so the account also shows the effect of the year's trading on the owner's capital.

Objectives of the balance sheet

A balance sheet has to be prepared to know the financial position of the business, and the nature and values of its assets and liabilities.

All the accounts which have not been closed till the preparation of the profit and loss account are shown in the balance sheet, and its totals of assets and liabilities are always equal because it portrays the accounting equation.

The information contained in a balance sheet is true only on the date on which it is prepared.

Importance of these statements

The information provided by the financial statements is useful to management to plan and control the business operations, and the statements are also useful to creditors, shareholders and employees of the enterprise.

They give a true and fair view of the profit earned and of the financial position, which lets the owner judge the progress of the business and compare it with earlier years.

They also form the basis on which outsiders such as lenders and suppliers decide whether to deal with the business, because the statements show its ability to pay its liabilities.

Glossary

• Capital expenditure — expenditure whose benefit extends over more than one accounting period, usually to acquire or extend a fixed asset.
• Revenue expenditure — expenditure whose benefit is normally confined to one accounting period, incurred for the day-to-day conduct of business.
• Deferred revenue expenditure — heavy revenue expenditure likely to benefit more than one accounting period and written off over that period.
• Capital receipt — a receipt that creates an obligation to repay, such as fresh capital or a loan, or arises from the sale of a fixed asset.
• Revenue receipt — a receipt that does not create an obligation to repay, such as sales revenue or interest received.
• Capital profit — a profit from a capital transaction, such as profit on sale of a fixed asset, shown as a non-operating income.
• Revenue profit — profit earned from the ordinary trading operations of the business during an accounting period.
• Capital loss — a loss from a capital transaction, such as loss on sale of a fixed asset, shown as a non-operating expense.
• Revenue loss — a loss arising in the ordinary course of trading, such as bad debts, debited to the profit and loss account.
• Provision — an amount charged against profit to meet a known liability or anticipated loss of uncertain amount.
• Reserve — an amount appropriated out of profit to strengthen the business or meet a future need.
• Gross profit — the excess of sales over purchases and direct expenses, ascertained in the trading account.
• Net profit — gross profit plus other incomes less indirect expenses, ascertained in the profit and loss account.
• Operating profit — profit from normal business operations, before non-operating and abnormal items.
• Marshalling — arranging assets and liabilities in a balance sheet by order of permanence or order of liquidity.

Common errors and misconceptions

• Misconception: all advertising spending is revenue expenditure. Correct: heavy advertising likely to benefit more than one year is deferred revenue expenditure and is written off over that period.
• Misconception: closing stock is shown only in the balance sheet. Correct: it is also credited in the trading account, unless adjusted purchases are used, in which case it is not shown separately there.
• Misconception: outstanding expenses reduce the expense figure. Correct: outstanding expenses are added to the concerned expense and shown as a current liability.
• Misconception: provisions and reserves mean the same thing. Correct: a provision is a charge against profit for a known liability, while a reserve is an appropriation of profit for a future need.
• Misconception: manager's commission on net profit after charging commission equals the same percentage of net profit before commission. Correct: it must be calculated as Net Profit × r/(100 + r), a smaller figure than Net Profit × r/100.
• Misconception: marshalling in order of liquidity and order of permanence give the same arrangement. Correct: the two orders are exact reverses of each other, for both assets and liabilities.
• Misconception: a capital profit is part of operating profit, like trading profit. Correct: a capital profit is a non-operating income; it appears in the profit and loss account but is left out when operating profit is calculated.

Exam-style questions with model answers

Q1. State whether the following is true or false: a provision for doubtful debts is created on the good debtors remaining after deducting further bad debts. [1 mark]

1. True. The provision is calculated on the debtors left after further bad debts are written off, and is charged to the profit and loss account.

Q2. Define a capital receipt and give one example. [2 marks]

1. A capital receipt is a receipt that implies an obligation to return the money, or arises from the sale of a fixed asset.
2. An example is additional capital brought in by the owner, or a loan taken from the bank.

Q3. Distinguish between capital loss and revenue loss, giving one example of each. [3 marks]

1. A capital loss arises from a transaction of a capital nature, for example the sale of a fixed asset at less than its book value.
2. A revenue loss arises in the ordinary course of trading, for example bad debts or loss of stock by fire.
3. A revenue loss is debited to the profit and loss account and reduces net profit, while a capital loss is debited as a non-operating expense, so it is left out of operating profit.

Q4. A trial balance shows wages of ₹8,000. Wages of ₹500 for the current year remain unpaid at the year end. Pass the adjusting entry and state where it appears in the final accounts. [3 marks]

1. The entry is: Wages A/c Dr. ₹500, To Wages Outstanding A/c ₹500.
2. In the trading account, wages are shown at ₹8,000 + ₹500 = ₹8,500 on the debit side.
3. Wages Outstanding of ₹500 is shown as a current liability on the liabilities side of the balance sheet.

Q5. Distinguish between a provision and a reserve. [4 marks]

1. A provision is a charge against profit made for a known liability or an anticipated loss of uncertain amount, such as provision for doubtful debts, whereas a reserve is an appropriation of profit made to strengthen the business or meet a future need.
2. A provision must be made whether or not the business earns a profit, because it relates to a known liability, whereas a reserve is created only when there is adequate profit available for appropriation.
3. A provision is deducted from the related asset or shown as a liability in the balance sheet, whereas a reserve is shown on the liabilities side as part of owners' funds.
4. A provision reduces the profit available for distribution as it is a charge, whereas a reserve is a distribution of profit already available, retained for future use.

Q6. From the following, calculate cost of goods sold and gross profit: Opening stock ₹3,00,000; Purchases ₹15,00,000; Wages ₹1,00,000; Freight inwards ₹1,00,000; Closing stock ₹4,00,000; Sales ₹20,00,000. [4 marks]

1. Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses − Closing Stock.
2. Direct expenses here are Wages ₹1,00,000 + Freight inwards ₹1,00,000 = ₹2,00,000.
3. Cost of Goods Sold = ₹3,00,000 + ₹15,00,000 + ₹2,00,000 − ₹4,00,000 = ₹16,00,000.
4. Gross profit = Sales − Cost of Goods Sold = ₹20,00,000 − ₹16,00,000 = ₹4,00,000.

Q7. A manager is entitled to a commission of 10% on net profit. Net profit before charging the commission is ₹1,10,000. Calculate the manager's commission (a) if it is calculated before charging such commission, and (b) if it is calculated after charging such commission. [5 marks]

1. (a) Commission before charging = Net Profit × r/100 = ₹1,10,000 × 10/100 = ₹11,000.
2. (b) Commission after charging means the commission is a percentage of the profit remaining after deducting the commission itself.
3. Commission after charging = Net Profit × r/(100 + r) = ₹1,10,000 × 10/110 = ₹10,000.
4. In both cases the commission is debited to the profit and loss account as an expense.
5. Any unpaid commission at the year end is shown as a current liability, outstanding commission, in the balance sheet.

Q8. From the following trial balance figures for a sole trader for the year ended 31 March 2025, prepare the trading account: Opening stock ₹10,000; Purchases ₹78,000; Sales ₹2,28,000; Carriage inwards ₹2,500; Wages ₹11,000; Closing stock ₹22,000. [6 marks]

1. Debit side of the trading account: Opening stock ₹10,000, Purchases ₹78,000, Carriage inwards ₹2,500 and Wages ₹11,000, giving total debit expenses of ₹1,01,500.
2. Credit side: Sales ₹2,28,000 and Closing stock ₹22,000, giving a total of ₹2,50,000.
3. Gross profit = Credit side total − Debit side expenses = ₹2,50,000 − ₹1,01,500 = ₹1,48,500.
4. The trading account is balanced by entering gross profit ₹1,48,500 on the debit side, so that both sides total ₹2,50,000.
5. This gross profit is then carried down and transferred to the credit side of the profit and loss account.
6. Closing stock is also shown as a current asset in the balance sheet, since the trading account credit entry and the balance sheet asset together complete the double entry.

Key takeaways

• Capital expenditure benefits more than one accounting year and appears in the balance sheet; revenue expenditure normally benefits one year and appears in the trading and profit and loss account.
• Deferred revenue expenditure is heavy revenue spending written off over its expected period of benefit, not charged all at once.
• Capital profits and losses are non-operating items: they appear in the profit and loss account but are left out of operating profit, unlike revenue profits and losses.
• A provision is a charge against profit for a known liability; a reserve is an appropriation of profit for a future need.
• Gross profit is sales less purchases and direct expenses; net profit is gross profit plus other incomes less indirect expenses.
• Operating profit excludes non-operating incomes and expenses and abnormal items, leaving only profit from normal operations.
• Closing stock is credited in the trading account and shown as a current asset, unless adjusted purchases are used instead.
• Outstanding expenses are added to expenses and shown as current liabilities; prepaid expenses are deducted and shown as current assets.
• Manager's commission after charging commission is calculated as Net Profit × r/(100 + r), smaller than commission calculated before charging.
• Marshalling arranges a balance sheet by order of permanence or order of liquidity, the two orders being exact reverses of each other.

Test yourself

Why is registration fee paid when purchasing a building treated as capital expenditure?

It is incurred to acquire the fixed asset and forms part of its cost, giving benefit over the whole life of the building, not just one accounting year.

What is the effect on profit of wrongly treating a revenue expense as capital expenditure?

Expenses are understated for the year, so profit is overstated, and the asset to which the amount is wrongly added is also overstated.

Give two examples of current liabilities.

Bank overdraft and sundry creditors are current liabilities; bills payable and outstanding expenses are also current liabilities.

Why is gross profit transferred from the trading account to the profit and loss account?

Gross profit represents the result of basic trading operations and forms the starting point for arriving at net profit after adjusting for indirect expenses and other incomes.

How does an abnormal loss affect the trading account?

The cost of goods abnormally lost is deducted from purchases or closing stock so that normal gross profit is not understated, and the loss, net of any insurance claim, is charged to profit and loss.

What journal entry is passed when goods are distributed as free samples?

The value is credited to purchases (reducing cost of goods sold) and debited to advertisement expense, since the goods are given for promotional purposes.

In which order would debtors, bank and cash be listed under order of liquidity?

Cash first, then bank, then debtors, since cash is the most liquid asset and debtors take the longest to convert back into cash.

What is the double effect of an adjusting entry?

It changes an item in the trading and profit and loss account and at the same time creates or changes an item in the balance sheet, so the double entry is complete.