Big picture
At the end of the year, a sole trader wants two answers: How much profit did I make? and What is my business worth? The financial statements answer them:
the Trading Account finds the gross profit from buying and selling goods;
the Profit and Loss Account finds the net profit after all other expenses and incomes;
the Balance Sheet shows the financial position: assets, liabilities and capital on the last day of the year.
They are prepared from the trial balance, after making adjustments for items that are not yet recorded (closing stock, outstanding expenses, depreciation and so on). Each adjustment affects two places. A full problem with adjustments is one of the highest-mark questions in Class 11.
Learning goals
Distinguish capital and revenue items, and direct and indirect expenses.
Prepare a Trading Account and find gross profit.
Prepare a Profit and Loss Account and find operating and net profit.
Prepare a Balance Sheet with grouping and marshalling.
Pass closing entries.
Apply every common adjustment, showing both its effects.
Core ideas
1. Capital and revenue items
Capital items | Revenue items |
|---|---|
Capital expenditure: buying fixed assets, extending a building | Revenue expenditure: wages, rent, salaries, repairs |
Capital receipts: capital introduced, loans, sale of fixed assets | Revenue receipts: sales, commission received, interest received |
Go to the Balance Sheet | Go to the Trading and Profit and Loss Account |
Deferred revenue expenditure is revenue expenditure whose benefit lasts several years, such as a heavy advertising campaign; it is written off over those years.
2. Trading Account
The Trading Account matches the cost of goods sold with sales.
Debit side | Credit side |
|---|---|
Opening stock | Sales less sales returns |
Purchases less purchases returns | Closing stock |
Direct expenses: wages, carriage inwards (freight on purchases), import duty, octroi, manufacturing expenses, fuel and power, royalty on production | |
Gross profit (balancing figure) | Gross loss (balancing figure) |
Cost of goods sold = Opening stock + Net purchases + Direct expenses − Closing stock.
Gross profit = Net sales − Cost of goods sold.
3. Profit and Loss Account
Debit side | Credit side |
|---|---|
Gross loss (if any) | Gross profit |
Indirect expenses: office and administration (salaries, rent, insurance, printing, postage); selling and distribution (advertising, carriage outwards, commission on sales, bad debts); financial (interest on loans, bank charges, discount allowed); depreciation; losses (loss by fire, loss on sale of assets) | Incomes and gains: commission received, rent received, interest received, discount received, profit on sale of assets |
Net profit (balancing figure) | Net loss (balancing figure) |
Operating profit is profit from normal business operations: Net profit + Non-operating expenses − Non-operating incomes. Example: net profit ₹60,000, loss on sale of furniture ₹4,000, interest received on investments ₹6,000. Operating profit = 60,000 + 4,000 − 6,000 = ₹58,000.
4. Balance Sheet
The Balance Sheet lists liabilities and capital on one side and assets on the other. It is a statement, not an account (so there is no "To" and "By").
Grouping means showing similar items together (all current assets together). Marshalling is arranging them in an order:
Order of liquidity: most liquid assets first (cash, bank, debtors, stock … land) and most urgent liabilities first (creditors, bills payable … capital). Used by sole traders and partnerships.
Order of permanence: the reverse (land, buildings … cash; capital, long-term loans … creditors). Used by companies.
Capital in the balance sheet: Opening capital + Net profit (or − Net loss) + Additional capital − Drawings.
5. Closing entries
Revenue accounts are closed at the year end by transferring them to the Trading or Profit and Loss Account:
Trading A/c Dr, To Opening Stock, Purchases, Wages, Carriage inwards (and so on);
Sales A/c Dr, To Trading A/c; Closing Stock A/c Dr, To Trading A/c;
Profit and Loss A/c Dr, To each indirect expense; each income account Dr, To Profit and Loss A/c;
Net profit: Profit and Loss A/c Dr, To Capital A/c; Drawings: Capital A/c Dr, To Drawings A/c.
6. Adjustments
Each adjustment affects two places. The table shows the standard treatment.
Adjustment | First effect | Second effect |
|---|---|---|
Closing stock (given outside the trial balance) | Credit side of Trading A/c | Assets side of Balance Sheet |
Outstanding expenses (expense due but not paid) | Add to the expense in Trading or P&L A/c | Liabilities side |
Prepaid expenses (paid in advance) | Deduct from the expense | Assets side |
Accrued income (earned but not received) | Add to the income in P&L A/c | Assets side |
Income received in advance | Deduct from the income | Liabilities side |
Depreciation | Debit P&L A/c | Deduct from the asset |
Further bad debts | Add to bad debts in P&L A/c | Deduct from debtors |
Provision for doubtful debts (on debtors after bad debts) | Debit P&L A/c (net of any old provision) | Deduct from debtors |
Interest on capital | Debit P&L A/c | Add to capital |
Interest on drawings | Credit P&L A/c | Deduct from capital |
Goods taken by the proprietor | Deduct from purchases | Add to drawings |
Goods lost by fire (abnormal loss), partly insured | Credit Trading A/c with the full cost; debit P&L A/c with the uninsured loss | Insurance claim receivable on the assets side |
Manager's commission on net profit | Debit P&L A/c | Liabilities side (outstanding) |
Manager's commission. If the manager gets 10% of net profit after charging the commission, commission = Profit before commission × 10 ÷ 110. On a profit of ₹55,000, that is ₹5,000. If before charging it, commission = 10% of 55,000 = ₹5,500.
Provision for doubtful debts with an old provision. Debtors ₹60,000; further bad debts ₹1,000; new provision 5%; old provision ₹2,000 already in the trial balance. New provision = 5% of 59,000 = ₹2,950. Charge to P&L = bad debts 1,000 + new provision 2,950 − old provision 2,000 = ₹1,950 (plus any bad debts already in the trial balance).
7. A complete worked problem
Trial balance of Ramesh on 31 March 2025
Debit balances | ₹ | Credit balances | ₹ |
|---|---|---|---|
Opening stock | 30,000 | Capital | 1,90,000 |
Purchases | 1,50,000 | Sales | 2,80,000 |
Returns inward | 5,000 | Returns outward | 5,000 |
Wages | 20,000 | Creditors | 40,000 |
Carriage inwards | 5,000 | Commission received | 6,000 |
Salaries | 36,000 | ||
Rent | 18,000 | ||
Insurance | 6,000 | ||
Bad debts | 2,000 | ||
Debtors | 60,000 | ||
Cash | 25,000 | ||
Furniture | 40,000 | ||
Machinery | 1,00,000 | ||
Drawings | 24,000 | ||
Total | 5,21,000 | Total | 5,21,000 |
Adjustments: (1) closing stock ₹40,000; (2) outstanding salaries ₹4,000; (3) prepaid insurance ₹1,500; (4) depreciation on machinery 10% and furniture 5%; (5) further bad debts ₹1,000 and a provision for doubtful debts of 5% on debtors; (6) commission received in advance ₹1,000.
Trading Account for the year ended 31 March 2025
Particulars | ₹ | Particulars | ₹ |
|---|---|---|---|
Opening stock | 30,000 | Sales 2,80,000 less returns 5,000 | 2,75,000 |
Purchases 1,50,000 less returns 5,000 | 1,45,000 | Closing stock | 40,000 |
Wages | 20,000 | ||
Carriage inwards | 5,000 | ||
Gross profit c/d | 1,15,000 | ||
Total | 3,15,000 | Total | 3,15,000 |
Profit and Loss Account for the year ended 31 March 2025
Particulars | ₹ | Particulars | ₹ |
|---|---|---|---|
Salaries 36,000 + outstanding 4,000 | 40,000 | Gross profit b/d | 1,15,000 |
Rent | 18,000 | Commission 6,000 less received in advance 1,000 | 5,000 |
Insurance 6,000 less prepaid 1,500 | 4,500 | ||
Bad debts 2,000 + further 1,000 | 3,000 | ||
Provision for doubtful debts (5% of 59,000) | 2,950 | ||
Depreciation: machinery | 10,000 | ||
Depreciation: furniture | 2,000 | ||
Net profit transferred to capital | 39,550 | ||
Total | 1,20,000 | Total | 1,20,000 |
Balance Sheet of Ramesh as at 31 March 2025
Liabilities | ₹ | Assets | ₹ |
|---|---|---|---|
Creditors | 40,000 | Cash | 25,000 |
Outstanding salaries | 4,000 | Prepaid insurance | 1,500 |
Commission received in advance | 1,000 | Debtors 60,000 less bad debts 1,000 less provision 2,950 | 56,050 |
Capital 1,90,000 + net profit 39,550 − drawings 24,000 | 2,05,550 | Closing stock | 40,000 |
Furniture 40,000 less depreciation 2,000 | 38,000 | ||
Machinery 1,00,000 less depreciation 10,000 | 90,000 | ||
Total | 2,50,550 | Total | 2,50,550 |
The balance sheet agrees, which confirms that every adjustment was given both its effects.
A reliable problem-solving routine
List each adjustment and write its two effects before starting.
Prepare the Trading Account with direct items only; find gross profit.
Prepare the Profit and Loss Account with indirect items and incomes, applying the adjustments; find net profit.
Prepare the Balance Sheet in order of liquidity, applying the second effect of each adjustment.
Check that the Balance Sheet totals agree; if not, look for an adjustment given only one effect.
Connections that matter
Trial balance is the starting point of the financial statements.
Depreciation, provisions and reserves supply the depreciation and provision adjustments.
Theory base: accrual, matching and conservatism explain why adjustments are needed.
Class 12 partnership adds the Profit and Loss Appropriation Account after the net profit.
Common mistakes
Putting carriage outwards in the Trading Account. It is a selling expense (P&L); carriage inwards is direct (Trading).
Showing closing stock in the Trading Account when it is already in the trial balance (adjusted purchases). Then it goes only to the Balance Sheet.
Giving an adjustment only one effect. The balance sheet won't agree.
Calculating the provision for doubtful debts before deducting further bad debts.
Deducting drawings from net profit in the P&L Account. Drawings are deducted from capital.
Revision checklist
I can classify items as capital or revenue, direct or indirect.
I can prepare a Trading Account and find gross profit and cost of goods sold.
I can prepare a Profit and Loss Account and find operating and net profit.
I can prepare a Balance Sheet in order of liquidity or permanence.
I can apply every common adjustment with both its effects.