Proprietorship Firm

Accounting of Proprietorship Entities

The basic principle and methods of Accounting is same for Proprietorship Firm also. The major distinction is that the net Profit / Loss is transferred to Proprietor’s Capital Account (as Proprietor is the sole owner).

Normally, Non-Manufacturing proprietorship Firm splits the Profit & Loss Account in 2 parts, Trading Account and Profit & Loss Account.

Manufacturing proprietorship Firm further creates Manufacturing Account. So, they prepare Profit & Loss Account in 3 parts, Manufacturing Account, Trading Account and Profit & Loss Account.

A Proprietorship Firm has to prepare Performance Statement (i.e Trading & Profit & Loss Account) and Position Statement (Balance Sheet), as part of their Periodical Financial Statement.

Accounting Principles

While preparing the Final Accounts, the Accounting principles should be adhered to. The main principles normally applied in Proprietorship Firm are :

  • Capital & Revenue : Capital & Revenue receipts & payments should be distinguished. Only Revenue Items are to be considered in Trading / Profit & Loss Account, while Cap[ital. Items are to be taken In Balance Sheet.
  • Periodicity : All Income & Expenses related to the relevant Accounting Period should be considered. Items related to another accounting period should be separated. The Items of Expenditure & Income should be segregated into significant Account Heads. Though the accounts are to be maintained continuously (as business is a going concern), transactions of subsequent period should be cut off from the previous period.
  • Segregation of Business Items: Items related to personal income / expenses should be separated from Business income / expenses. Transactions solely related to business should only be considered while preparing the Financial statements
  • Valuation : Asset should be valued at Historical Cost. They should be valued in the same method as done in previous year. Liabilities should be recorded at current value payable.
  • Provisions : All provisions for expenses (expenses incurred but not paid for).  Similarly provisions for Income (Income accrued but not received), should be made.
  • Depreciation : Depreciation on all Assets should be charged on the same method as previous year and debited to Profit & Loss Account, and same amount should be credited to the respective Asset Account.
  • Prepaid Expenses & Advances : Any payment made during the accounting period, related to next accounting period should be segregated. Prepaid expenses should be taken as Asset in Balance Sheet. Similarly, any advance received in respect of any materials or services, not delivered or earned, should be segregated and taken as Liability in Balance Sheet.
  • Outstanding Expenses & Accrued Income:  All expenses not paid for should be properly assessed and  added to expenses for the period, and also taken into Balance Sheet as Liability. Similarly, Income earned but not received, should be added to Income and also taken into Balance Sheet as Asset.
  • Materiality : Every information, material for judging the performance or position of the business,. For example, obsolete goods which cannot be sold even at cost, should be separately valued at Realisable Value.  Doubtful Debts  (or estimated amount of it) should be separately disclosed and accounted for.

Inter-relationship of P L statement & Balance Sheet

All the Items of accounts are split into two [parts. Item of Income / Expenses are placed in Trading / Profit & Loss Account, while Items of Capital, Assets & Liabilities are placed in Balance Sheet. However, these 2 statements, apparently viewed as separate & distinct statements, are closely inter related.

The value of Inventory remaining at the end of the year is taken out and shown in Balance Sheet, reducing from the Profit & Loss Account. In the next year, this is charged to Profit & Loss year.

The amount of depreciation diminution in value of Asset) is reduced from Assets and charged to Profit & Loss Account.

The net Profit / Loss of the period is then carried to Capital Account of the Proprietor and taken into the Liability side of Balance Sheet.

So, the amount charged to  Trading / Prfit & Loss Accou nt should be properly determined, otherwise both Statements would become incorrect.

Trading Account

The aim of Trading Account  is to know the performance of Trading Activity, i.e, to find out the operational profit margin of the trade. This is very Important from the owner’s point of view to set the Selling price etc, make business decisions.

The gross profit %, computed as (Gross Profit /Sales) x 100% is a very significant ratio and enables the owner to find out whether the Gross profit is enough to meet the other standing expenses (which are charged to profit & Loss Account), and also indicates the anticipated net profit of the enterprise.

Format of Trading Account

ExpensesDrIncomeCr
To Opening Inventory20,000By Sales               8,00,000 Less Sales Returns.50,000  7.50,000
To Purchase                         5,00,000 Less Purchase Returns …     40,000  4.60,000By Closing Inventory70,000
To Purchase Expenses30,000  
To Gross Profit carried to P L A/c3.10,000  
 8,20,000 8,20,000

Elements of Trading Account

As Trading Account is a part of Profit & Loss Account, the following elements of Profit & Loss Account, as we have seen earlier, are taken into Trading Account, rest of the elements of Profit & Loss Account, are taken in Profit & Loss Accounts as usual.

Opening Inventory : The closing Inventory of the previous year, carried forward from the previous year balances, if any, is debited to Trading Account. This item is first put in the debit side of Trading Account. In first year of start of business, there may not be any Opening Inventory.

Purchase & Purchase Returns : The organisation normally maintain separate Ledger Accounts for Purchase & Purchase Returns

  • Purchases : The debit Balance of Purchase Account, representing the Cost of Purchase during the year, would be shown in the Debit side of Trading Account.
  • Purchase Returns : The Credit Balance of Purchase Returns Account, representing the value of Purchased Items returned to supplier during the year, would be reduced from the Cost of Purchase, in the Debit Side of Trading Account

The net Amount of Purchase & Purchase Return is then shown in the Debit side of Trading Account

The Journal entry would be

Trading A/c  Dr

To Purchase Account

(Cost of Purchases)

Purchase Return A/c Dr

To Trading Account

(Cost of Purchase Returns)

Sales & Sales Returns : The organisation normally maintain separate Ledger Accounts for Sales & Sale Returns

  • Sales : The credit Balance of  Sales Account, representing the value of sales during the year, would be shown in the Credit side of Trading Account.
  • Sales Returns : The Debit Balance of Sales Returns Account, representing the value of Sold Items returned by customers during the year, would be reduced from the  value of Sales, in the Credit Side of Trading Account

The net Amount of Sales  & Sales Return is then shown in the credit side of Trading Account

The Journal entry would be

Sales A/c Dr

To Trading A/c  Cr

(Value of Sales)

Trading A/c  Dr

To Sales Return Account

(Value of Goods retuned by customers)

Purchase Expenses: All expenses for bringing the goods to the place of business like Carriage, Freight,  Tax on purchased Items, are to be shown in the Debit side of Trading Account.

Wages : Normally Wages are paid in manufacturing Enterprise. However, if any wages is paid for bringing the goods to the place of business, is also debited to Trading Account (Staff Salary is not included in Trading Account, but debited to Profit & Loss Account).

Duties & Taxes : There 3 types of principal duty & taxes on goods, applicable at 3 principle stages of business activity. Customs / Import Duty on materials purchased. It is part of cost of purchase and charged to Purchase Account. Excise Duty is paid on manufacture of goods (so it is applicable for Manufacturing Entities only). VAT is charged on sales. VAT is charged on Sales realised from customers in Sales Invoice. The amount is set off from the VAT paid on purchase and excess is paid to government. An entity registered under VAT  realises  VAT on Sales from customers, adjusts the VAT paid on Purchase, and pays the balance to government. So, normally unpaid VAT appears in balance Sheet as Liability. Unregistered party pays VAT on purchase, which is part of purchase cost, and consequently charged to Trading Account.

Closing Inventory :  Unlike all other accounting heads, normally, there is no account for Inventory (i.e Goods lying in the hands of  the entity), tough it is part of Asset. The value of closing Inventory is derived from the Stock item ledgers, physical verification and valued as per valuation method adopted in previous period. While valuing the Inventory, applying the principle of conservatism, Inventory which cannot be sold even at Cost, are valued at Realisable Value (at lower than Cost).

The amount of Closing Inventory is debited Closing Inventory and shown as Asset in Balance Sheet, with corresponding  credit to Trading Account. On recording the Journal Entry for Closing Inventory, it then appears in Trial Balance.

Sequence of Closing Entries for Trading Account

The entries for preparation of Trading Account as shown are:

  • Opening Inventory : Trading A/c Dr.  20000, Inventory A/c Cr 20000
  • Purchase Returns : Purchase Returns Dr  40,000 Purchase A/c Cr 40,000
  • Purchase A/c : Trading A/c Dr 4,60,000, Purchase A/c Cr 4,60,000
  • Expenses A/c : Trading A/c Dr  30,000, Purchase Expenses Cr 30,000
  • Sales Returns : Sales Dr 50,000, Sales Returns Cr 50,000
  • Sales : Sales Dr 7,50,000 Trading A/c 7,50,000
  • Closing Inventory : Inventory A/c Dr 70,000, Trading A/c Dr 70,000

Having entered the Journal entries, the Trading Account would show the Gross Profit as credit balance (in case of profit).

Now this balance is to be transferred to Profit & Loss Account and the trading Account would be closed.

Transfer of Gross Profit : Trading A/c Dr  3,10,000, P L Account Cr 3,10,000

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