Category: Accounting

The increasing size of the market is making more and more difficult forthe manufacturer or wholesalerto come in direct contact with customers living at far off distances. This has made imperative forhim to enter into an agreementwith areliable local trader who can sell goods on his behalf and athis (Principal) risk for an agreed amount of commission. Such a despatch of goods from one person to another person at a different place for the purpose of warehousing and ultimate sale is termed as consignment. Goods so sent are termed as ‘Goods sent on Consignment’,the sender is called”Consignor” and the recipient ‘Consignee.’

For example if A of Bombay sends 100 radio sets toBof Delhito sell on his (A’s) behalf and at his (A’s) risk, the transaction between A and B is a consignment transaction. A isthe consignor and B is the consignee.

It should be noted that in the above example, A continues to be the owner of the goods. B is simply an agent ofA. He has not purchased the goods. He has agreed to sell the goods ofA to the best of his ability and capacity. He will, therefore, be responsible to A for payment only when he has sold away the goods. Of course, he will be reimbursed by A for any expenses incurred by him in obtaining and selling the goods besides remuneration for selling the goods as per the agreed terms.

The points of distinction between Profit and Loss Accoont and Balance Sheet are:

(i) A profit and loss account shows the profit or loss made by the business during a particular period. While a balance sheet shows the financial position of the business
on a particular date.

(ii) A profit and loss account incorporates those items which are of a revenue nature while a balance sheet incorporates those items which are of a capital nature.

(iii) Of course, both profit and loss account and the balance sheet are prepared from the Trial Balance. However, the accounts transferred to the profit and loss account are  finally closed while the accounts transferred to the balance sheet represent those accounts whose balances are to be carried forward to the next year.

The Trading Account simply tells about the gross profit or loss made by a businessman on purchasing and selling of goods. Jt does not take into account the other operating expenses incurred by him during the course of running the business. For example, he has to maintain   an office for getting orders and executing them, taking policy decision and implementing them. All such expenses are charged to the Profit and Loss Account. Besides this, a businessman may have other sources of income. For example, he may receive rent from some of his business properties. He may have invested surplus funds of the business in some securities. He might be getting interest or dividends from such investments. In order to ascertain the true profit or loss which the business has made during a particular period, it is necessary that all such expenses and incomes should be considered.

Important points regarding Profit and Loss Account 

Gross Profit or Gross Loss. The figure of gross profit or gross loss is brought down from the Tading Account. Of course, there will be only one figure, i.e., either of gross profit or gross loss.

Salaries. Salaries payable to the employees for the services rendered by them in running the business being of indirect nature are charged to the Profit and Loss Account. In case of a partnership firm, salaries may be allowed to the partners. Such salaries will also be charged to the Profit and Loss Account.

Interest: Interest on loans whether short-term or long-term is an expense of an indirect nature and, therefore, is charged to the Profit and Loss Account. However, interest on loans advanced by a firm to third-parties is an item of income and, therefore, will be credited to the Profit and Loss Account.

Commission:  Commission may be both an item of income as well as an item of expense. Commission on business hroughtby agents is an item of expense while commission earned by the business for giving business to others is an item of income, Commission to agents is, therefore, debited to the Profit and Loss Account while commission received is credited to the Profit and Loss Account

Bad debts:  Bad Debts denotes, the amount lost from debtors to whom the goods were sold on credit. It is a loss and therefore, should be debited to the Profit and Loss Account

Importance of the Trading Account

Trading Account provides the following information to a businessman regarding his business:

I. Gross Profit disclosed by the Trailing Account tells him the upper limit within which he should keep the operating expenses of the business besides saving something for himself. The cost of purchasing and the price at which he can sell the goods are governed largely by market factors over which he has no control. He can control only his operating expenses. For example, if the cost of purchasing an article is Rs 10 and it can be sold ii’ the market at Rs 10 per unit, the gross margin available on each article is Ps 5. In case a businessman proposes to sell 1,000 units of that article in a year, his gross profit or gross margin will be Rs 5,000. His other expenses should therefore be less than Rs 5,000 so that he can also save something for himself.

2. He can calculate his Gross Profit Ratio1 and compare his performance year after year. A fall in the Gross Profit Ratio means increase in the cost of purchasing the goods or decrease in the selling price of the goods or both. In order to maintain at least same figure of gross profit in absolute terms, he will have to push up the sales or make all out efforts to obtain goods at cheaper prices. Thus, he can prevent at least fall in the figure of his gross profit if can not bring any increase in it;

3. Comparison of stock figures of one period from another will help him in preventing unnecessary lock-up of funds in inventories.

4. In case of new products, the businessman can easily fix up the selling price of the products by adding to the cost of purchases, the percentage gross profit that he would like to maintain. For example, if the trader has been so far maintaining a mte of gross profit of 20% on sales and he introduces a new product in the market having a cost of Rs 100, he should lix the selling price at Its 125 in order to maintain the same nile of gross profit (i.e., 20% on sales).

Inventory cost The term Inventory includes (I) Stock of raw materials, (ii) Stock of work-in-progress, and (iii) Stock of finished Goods. The computation of the cost of inventory is also a tedious process. The vaftiation of tbe stock of raw materials will depend upon the method of pricing materials issues followed by the business. Materials may be issued to production according to First In First Out ([FIFO) Method, Last In First Out (LIFO) Method, Weighted Average Price Method, etc. In each of these cases, the value of the inventory of raw materials may widuly differ. This will be clear with the help of the following example.

A business buys raw materials in two different lots. In the first lot 1,000 units are purchased @ Rs 10 per unit. In the second lot, 2,000 units are purchased @ Rs 12 per unit. In case the stock of raw materials at the cod of the accounting period is of 1,000 units, the value of the inventory according to each of the methods stated above will be as follows:

FIFO method:

1,000 Units @ Ps 12 per unit = Rs 12,000

(Since materials first purchased will be taken to have been issued to production first of all, the inventory of raw material will, therefore, consist of latest purchases).

LIFO method:

l,000UuiLs@RslOperunit=Rs 10,000

(Since materials purchased in the last will be taken to have been issued to production first of all, the inventory will, therefore, consist of the earliest purchases).

Weighted Average Price Method:

1,000 Units @ Ps 11.333 = Rs 11,333

(The total units purchased are 3,000 for a total cost of Es 34,000. This gives a

weighted average priceRs 11.333 per unit).

INVENTORY SYSTEMS

Records pertaining to quantity and value of inventory-in-hand can be maintained according

to any of the following two systems:

(I) Periodic Inventory system.

(ii) Perpetual Inventory system.

Periodic Inventory System

In case of this system the quantity and value of inventory is found out only at the end of the accounting period after having a physical verification of the units in hand. The system does not provide the infomiation regarding the quantity and value of materials in hand on a continuous basis. The cost of materials used is obtained by adding the total value of inventory purchased during the period to the value of inventory in hand iii the beginning of the period and subtracting the value of inventory at the end of the period. For example, if the inventory in the beginning was 1,000 units of Rs 10,000, purchases during the period were of 5,(XX) units of Ps 50,000 and the closing inventory 1,500 units of Rs 15,000, the cost of materials used will be taken as Its 45,000 (i.e., Rs 10,000 + Rs 50,000— P.s 15,000). It is, thus, assumed that materials not in stock have been used. No accounting is done for shrinkage, losses, theft and wastage.

Perpetual Inventory System

It is also known an Automatic Inventory System.

According to the Chartered Institute of Management Accountants London, it is “a system of records maintained by the controlling department, which reflects the physical movement of stocks and their current balance.” The definition given by Wheldon is more exhaustive and explanatory. According to him, it is “a method of recording inventory balances after every receipt and issue, to facilitate regular checking and to obviate closing down for stocktaking”.’ In case of this system the stores ledger gives balance of raw materials, work-in-progress ledger gives the balance of work-in-progress and finished goods ledger gives the balance of finished goods in hand on a continuing basis. The basic objective of this system is to make available detailsabout the quantity and value of stock of each item at all times. The system, thus, provides a rigid control over stock of materials as physical stock can regularly be verified with the stock records kept in the stores and the cost office.

Cost of goods sold. Income determination requires in case of both manufacturing and trading concerns, the cost of goods sold. In case of trading concerns, the job is comparatively easy since the cost of goods sold can be easily found out be taking into account the cost at which the goods have been purchased. However, in case of manufacturing concerns, the cost of goods sold is to be found out taking into consideration the cost involved in their manufacture. Manufacturing costs can be both direct as well as indirect. Direct costs are those costs which can be directly, conveniently and wholly identified with specific products, jobs or manufacturing processes, e.g., cost of raw materials used for manufacturing the products, cost of factory labour etc. Indirect manufacturing costs are those costs which cannot be directly be identified with specific jobs products or processes, e.g., salary paid to the factory manager, rent, rates, lighting, depreciation of factory machines, etc. These cost are to be apportioned on different products on some reasonable basis e.g., the salary paid to the factory manager may be charged to different products on the basis of direct wages for each product. Similarly, rent paid for the factory may be charged to different products on the basis of departmental area occupied by each of the production departments. Apportionment of the indirect costs so made cannot be fairly accurate and, therefore, the cost of the products so computed cannot also be very accurate. Moreover, some costs such as depreciation of plant and machinery or depreciation of factory buildings cannot themselves be determined accurately. Depreciation depends on the cost of the assets, its scrap value and the estimated life of the assets. It is very difficult to make a fair estimate about the scrap value and life of the asset. The amount of depreciation charged may not, therefore, be very correct. Thus, when estimation of the various elements which constitute cost cannot correctly by made, the measurement of income on the basis of such estimates cannot also be very accurate.

MEANING OF INVENTORY

Inventories are unconsumed or unsold goods purchasecior manufactured. According to the International Accounting Standard: 2 (lAS: 2), inventories are tangible froperty.

(a) held for sale in the ordinary course of business,

(b) in the process of production for such sale, or

(c) to be consumed in the production of goods or services for sale.

Thus, the term inventory includes stock of (i) finished goods, (ii) work in-progress and (iii) raw matcrials and components. In case of a trading concern inventory primarily consists of finished goods while in case of a manufacturing concern, inventory consists of raw materials, components, stores, work-in-process and finished goods.