Matching Revenue And Expenses

Matching Revenue And Expenses

To determine net profit for any particular accounting period we use the "Matching principle". The word matching refer to the close relationship that exists between certain expense and revenue realised a result of incurring these expenses. In other words, revenue of the relevant accounting period should be  matched against the expenses of the same period to ascertain profits or losses made by business. 

In the form of equation it may be stated  that;

                    Profit = Revenue - Expenses 

Again, it should be noted that this year's expenses are associated with this year's revenue. We do not compare this  year's expenses with last year's revenue because there is no close relationship between the two.

Trading Account

It has already been discussed that every business concern ascertain profit or loss of the business at the end of the year through the Final Account Business Concerns may be of the following two types:

1. Trading Concerns

Trading concerns are those which do not manufacture goods, rather, they but they finished goods from the manufacturer or wholesaler and sell them to retailer or direct to customers. 

There are four stages in the Final Accounts of a trading Concern:

(a) Trading Account

This shows gross result (Gross profit or Gross loss) of the business.

(b) Profit And Loss Account

This shows net result (net profit or net loss) of the business.

(c) Profit And Loss Account Appropriation Account

This shows how the net profit or net loss of the business has been distributed or disposed off. This is not prepared in the case of sole proprietorship business.

(d) Balance Sheet

This discloses the financial position of the business.

2. Manufacturing Concerns

Manufacturing concerns are those which produced or manufacture goods i.e. convert raw material into finish goods. They sell the goods to the wholesaler or dealers.

There are five stages in the Final Accounts of a manufacturing Concern:

(a) Manufacturing Accounting - this shows the cost of goods manufactured.

(b) Trading Account.

(c) Profit And Loss Account.

(d) Profit And Loss Account Appropriation Account.

(e) Balance Sheet.

All above mentioned stages are collectively known as Final Account or Final Statement. Profit or Loss of every business is generally determined in two stages. In the first stage Gross result, Gross profit or Gross Loss) is ascertained and in the second stage net profit or net loss is ascertained.

Gross Profit Or Gross Loss

Gross profit is ascertained by deducting cost of goods sold (all direct expenses like purchases, carriage, custom duty, stock charges, octori duty ) from sales.

          Gross profit = Total sales - All direct expenses 

For example,Suppose Salman purchased some goods for Rs. 10,000 and paid Rs.200 on account of carriage and Rs. 100 as octori duty. He sold the goods for Rs. 14,000. Now, the cost of goods sold will be Rs. 10,300 (10,000 + 200 + 100) and Gross profit will be Rs. 3700.

           Gross profit = Total sales - All Direct Expenses

              3700         = 14000 - 10300 (10,000 + 200 + 100)

2. Net Profit Or Loss

It is ascertained by deducting all indirect expenses (the expenses incurred for running the business and selling the goods) from the Gross profit.

 For example,Suppose in the above example Salman paid Rs. 1000 as salaries and Rs. 500 as rent. His net profit will be Rs.2200.

         Net  profit = Gross profit - All Indirect Expenses

         Net  profit = 3700 - (1000 + 500) = Rs.2200

Thus the account which is prepared for determining gross profit or gross loss of a business concern, is called "Trading Account" and the account which is prepared for determining net profit or loss net of a business concern is called "Profit and Loss Account".

Features

The Trading Account has the following features;

• It is the first stage of the Final Accounts of a trading concern.

• It is prepared on the last day of an accounting period.

• Only direct revenue and direct expenses are recorded on its debit side and direct revenue on its credit side.

• All items of direct expenses and direct revenue concerning current year are taken into account but no item relating to past or next year is considered in it.

• If its credit side exceeds - it represents Gross profit and if debit side exceeds - it shows Gross Loss.

Why is Trading Account Prepared?

We have already discussed that, the profit or loss determined by a Trading A/c is the gross result of the business but not the true result. Then a question arises - what is the use of preparing Trading Account ?

The Trading Account is necessary because it has the following advantages:

• Gross profit of a business is very important data, since all business expenses are met out of it. So the amount of gross profit should be adequate to meet all the indirect expenses of a business.

• The amount of net sales can be determined through this account. Gross sales can be ascertained from sales A/c in the ledger, but net sales are determined by deducting sales returns from gross sales in Trading A/c.

• The success or failure of a business can be ascertained by comparing net sales of the current year with that of the last year. It should be noted that an increase in the amount of net sales of the current year over the last year may not be regarded as a sign of success, since sales may increase because of rise in price level.

• Percentage of gross profit on net sales can be easily determined from Trading A/c. This percentage is a very important yardstick for measuring the success or failure of a business. Compared to last year, if the rate increase, it indicates success; on the other hand if the rate decreases , it is an indication of failure.

• Percentage of different items of buying expenses (direct expenses) on the gross profit can be easily determined by comparing the percentage of the current year with that of the previous year the variations can be ascertained. An analysis of variances will disclose their causes which will help in controlling the amount of expenses.

• Inventory or stock turnover can be determined from Trading A/c. The success or failure of a business can be measured by this rate. High rate indicates a favorable sign i.e. goods are sold soon after their purchase. On the other hand, low rate signifies deterioration , i.e. goods are sold long after their purchase