Trading and Profit and Loss Account: Format and Worked Example

The traditional trading and profit and loss account explains how a business arrives at its profit for an accounting period. In modern financial reporting, it is normally called the statement of profit or loss or income statement.

The statement begins with revenue, deducts the cost of goods sold to calculate gross profit, and then includes other income and operating expenses to calculate profit for the period. This article explains the traditional format, modern terminology, important adjustments and a complete worked example.

Purpose of the Trading and Profit and Loss Account

The statement reports financial performance over a period, such as a month or year. It helps users understand:

• how much revenue the business earned;
• the cost of the goods or services sold;
• the gross profit generated by core trading activity;
• operating and other expenses;
• finance costs and tax where relevant; and
• the final profit or loss for the period.

Unlike a statement of financial position, which reports assets, liabilities and equity at a date, the profit and loss account covers activity during a period.

Traditional Two-Part Structure

Trading account

The trading account calculates gross profit:

Gross Profit = Net Sales − Cost of Goods Sold

If cost of goods sold exceeds net sales, the result is a gross loss.

Profit and loss account

The profit and loss section starts with gross profit, adds other income and deducts operating expenses:

Net Profit = Gross Profit + Other Income − Operating and Other Expenses

For companies, the statement may continue through finance costs, tax expense and discontinued operations before arriving at profit for the period.

Modern Statement of Profit or Loss

IAS 1 permits expenses to be analysed by their nature or by their function, whichever provides reliable and more relevant information. A cost-of-sales format is a function-of-expense presentation.

IFRS 18 replaces IAS 1 for annual reporting periods beginning on or after 1 January 2027, with earlier application permitted. IFRS 18 introduces defined categories and requires subtotals including operating profit and profit before financing and income taxes.

The traditional “trading account” remains useful for teaching and for smaller-business bookkeeping, but published financial statements should follow the applicable reporting framework.

Net Sales

Net sales are calculated after deducting sales returns, allowances and relevant trade discounts from gross sales:

Net Sales = Gross Sales − Sales Returns − Allowances

Recoverable sales taxes collected on behalf of a government are normally excluded from revenue.

Cost of Goods Sold

For a trading business, cost of goods sold is commonly calculated as:

Cost of Goods Sold = Opening Inventory + Net Purchases + Direct Costs − Closing Inventory

Net purchases may be calculated as purchases plus carriage inward, import duties and other directly attributable acquisition costs, less purchase returns and trade discounts.

Item	Treatment
Opening inventory	Add to goods available for sale
Purchases	Add, after purchase returns and relevant discounts
Carriage inward	Usually included in the cost of acquiring inventory
Closing inventory	Deduct from goods available for sale and recognise as a current asset

IAS 2 requires inventory to be measured at the lower of cost and net realisable value. Any necessary write-down affects cost of sales or another appropriate expense line.

Gross Profit and Gross Profit Margin

Gross profit measures the amount remaining after deducting the direct cost of goods sold from net sales.

Gross Profit Margin = Gross Profit ÷ Revenue × 100

A change in gross margin may result from selling-price changes, purchase-price movements, production efficiency, inventory write-downs, product mix, theft or errors in inventory measurement.

Operating Expenses

Operating expenses are expenses not included in cost of goods sold. Depending on the business and reporting format, they may include:

• selling and distribution costs;
• administrative expenses;
• employee costs;
• rent and utilities;
• depreciation and amortisation;
• advertising;
• insurance;
• bad-debt or impairment expense; and
• professional fees.

Expenses should not be classified merely to achieve a desired gross or operating profit. The classification must be consistent with the applicable accounting framework and the economic function or nature of the cost.

Worked Example

Assume the following information for Sunrise Traders for the year:

Item	Amount ($)
Sales	500,000
Sales returns	10,000
Opening inventory	60,000
Purchases	300,000
Purchase returns	8,000
Carriage inward	12,000
Closing inventory	75,000
Other income	5,000
Operating expenses	120,000
Finance costs	8,000
Income tax expense	15,000

Step 1: Calculate net sales

Net sales = $500,000 − $10,000 = $490,000.

Step 2: Calculate net purchases

Net purchases = $300,000 − $8,000 + $12,000 = $304,000.

Step 3: Calculate cost of goods sold

Cost of goods sold = $60,000 + $304,000 − $75,000 = $289,000.

Step 4: Calculate gross profit

Gross profit = $490,000 − $289,000 = $201,000.

Step 5: Calculate operating profit

Operating profit = $201,000 + $5,000 − $120,000 = $86,000.

Step 6: Calculate profit before and after tax

Profit before tax = $86,000 − $8,000 = $78,000.

Profit for the year = $78,000 − $15,000 = $63,000.

Illustrative Statement

Sunrise Traders — Statement of Profit or Loss	$
Revenue	490,000
Cost of sales	(289,000)
Gross profit	201,000
Other income	5,000
Operating expenses	(120,000)
Operating profit	86,000
Finance costs	(8,000)
Profit before tax	78,000
Income tax expense	(15,000)
Profit for the year	63,000

Important Year-End Adjustments

Closing inventory

Closing inventory reduces cost of goods sold and is recognised as a current asset. It must be adjusted for damaged, obsolete or slow-moving goods where net realisable value is below cost.

Accruals and prepayments

Expenses must be recognised in the correct period. Accrued expenses are added to the period’s expense, while relevant prepayments reduce it.

Depreciation

Depreciation allocates the depreciable amount of an asset over its useful life. It is an expense even though it does not normally involve a current-period cash payment.

Bad debts and expected credit losses

Receivables that are not recoverable must be written off, and an appropriate impairment allowance may be required.

Inventory loss

Inventory destroyed, stolen or lost is removed from inventory and recognised as an expense. Any insurance recovery is accounted for separately when its recognition criteria are satisfied.

Relationship with Capital and Equity

For a sole trader, profit increases the owner’s capital, while drawings reduce capital. Drawings are not operating expenses because they are distributions to the owner.

For a company, profit contributes to retained earnings after considering dividends and other equity movements. Profit does not automatically equal cash generated because revenue and expenses may include credit transactions, accruals and noncash items.

Common Errors

• Treating drawings as an expense;
• including closing inventory as both an expense and an asset without the correct adjustment;
• confusing carriage inward with distribution costs;
• recording asset purchases as ordinary operating expenses;
• ignoring sales and purchase returns;
• using gross sales instead of net sales;
• confusing gross profit with net profit; and
• assuming profit is the same as operating cash flow.

Frequently Asked Questions

What is the difference between gross profit and net profit?

Gross profit is revenue less cost of sales. Net profit also deducts operating, finance, tax and other relevant expenses and includes other income.

Why is closing inventory deducted from cost of goods sold?

It represents goods not sold during the period. Their cost remains an asset and should not be charged against the current period’s revenue.

Is a trading account still used?

It remains common in bookkeeping education and small-business accounts. Modern published statements generally present an integrated statement of profit or loss.

Are drawings an expense?

No. Drawings are withdrawals by the owner and reduce capital; they do not measure the cost of generating revenue.

What changes under IFRS 18?

IFRS 18, effective for annual periods beginning on or after 1 January 2027, introduces defined profit-or-loss categories and required subtotals including operating profit.

Related Accounting Topics

• Balance Sheet Explained
• Trial Balance Explained
• Accounting for Inventory Lost or Destroyed
• Cost Accounting Basics

Conclusion

The trading and profit and loss account shows how revenue is converted into gross profit, operating profit and final profit. Accurate calculation requires correct treatment of sales returns, purchases, carriage inward, inventory, accruals, depreciation and other adjustments.

The traditional format remains valuable for learning the accounting process, while modern financial statements must follow the applicable presentation requirements. From 2027, IFRS 18 will replace IAS 1 and introduce more defined categories and subtotals in the statement of profit or loss.

Authoritative references: IFRS Foundation — IAS 1 Presentation of Financial Statements, IFRS Foundation — IFRS 18, IFRS Foundation — IAS 2 Inventories, and ACCA — Adjustments to Financial Statements.

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