Income Statement was previously referred to as the Trading and Profit and Loss Account.
The Trading Account outlays the revenues, and the relevant expenses incurred in selling those goods. This implies that the trading account simply outlines the gross profit of the company. It has two broader components, the revenue part, and the Cost of Goods Sold part, which eventually is netted to calculate the gross profit of the company.
The Profit and Loss Account uses the Gross Profit figure and subsequently calculates the profitability, after deducting the relevant expenses incurred in the company.
The trading account includes information pertaining to the trading activities of the business. In other words, it enlists all the expenses that are incurred as a result of the core operations of the business. For example, if the company is a manufacturing concern, the trading account will include the Cost of Manufacturing of the company, based on which companies can duly calculate the Gross Profit of the company.
Definition of Trade Expenses:
Trade Expenses can be defined as direct expenses that are incurred for the purchase and the production of goods and services. They are mostly related to the core business operations of the business entity, and therefore, they are referred to as direct product costs too.
Therefore, all the expenses that are incurred in the business from the beginning, i.e. purchase of raw materials, till the time when the finished goods are brought to a sellable condition are referred to as trading expenses. Examples of Trade Expenses include carriage inwards, manufacturing expenses, and wages.
Categories of Trade Expenses
Trade Expenses can be broadly categorized into two expenses, including direct expenses, and indirect expenses.
Direct expenses are expenses that are directly attributable to the product. For example, for an organization that is a manufacturing concern, factory rent, and labor charges will be considered as a direct expense.
On the contrary, indirect expenses are expenses that are not directly relevant to the production process, and therefore, they are not considered direct expenses. These indirect expenses tend to be recorded in the financial statements under the Profit and Loss Account.
Accounting Treatment of Trade Expenses
Trade Expenses, just like normal expenses, are debited to the Income Statement. Since these are expenses that are most directly relatable to the trade expenses, it can be seen that they are referred to as direct production costs of the company.
However, some trade expenses are also considered to be indirect expenses. This implies that these expenses cannot be directly attributable to a single product itself. Direct Costs, therefore, impact the cost of goods procured and sold. For trade expenses that are direct expenses, expenses are charged to the Trading Account, whereas for trade expenses that are indirect expenses, expenses are charged to the Income Statement, since they do not directly impact the Gross Profit.
Under the accrual basis of accounting, trade expenses are recorded in the financial statements as they are incurred. This implies that all the expenses that are pertinent to the current year are supposed to be recorded in the financial statements for the relevant period.
In the case where the payments have been made in advance, it is recorded as Prepaid Trade Expense, or Accrued Trade Expense. Since it is an asset (or a liability), it is duly recorded as such in the Financial Statements of the company.
Therefore, to summarize, the following holds true:
- Trade Expenses are recorded in the Income Statement as they are incurred.
- In case of any prepaid, or accrued payment for trade expenses, the amount is disclosed in the financial statements under Current Assets, or Current Liabilities.
What is the journal entry for Trade Expenses?
Trade Expenses are regarded as expenses incurred during the course of production. Therefore, it is important for accountants to categorize trade expenses in a proper manner. The journal entry to record trade expenses is as follows:
The aforementioned journal entries show the incurrence of trade expenses, as a debit to the Income Statement. The corresponding double entry for trade expenses would be a credit to the Cash account since cash has been used to pay back the amount billed.
On the other hand, if trade expenses have not yet been settled before the year-end, the following journal entries are made:
|Creditors – Current Liability
Example of Trade Expenses
Hilly Co. is a manufacturing concern that produces footballs. During the year ended 31st December 2019, they incurred trade expenses equivalent to $25,000. Half of these expenses were settled in cash, whereas the other half was supposed to be settled by 10th June 2020.
In the example above, it can be seen that the total trade expenses for Hilly Co. amounted to $25,000. However, some of these expenses were settled in cash, whereas the other half was supposed to be settled in credit. In order to reflect this, the following journal entries were made:
|Creditors (Current Liability)
The aforementioned categories show that the trade expenses involve both, cash, as well as credit expenses. Therefore, there are two credits made, in order to reflect the payment in cash, as well as the outstanding amount that is supposed to be settled by the next year. The outstanding amount would be reflected in the Statement of Financial Position as a Current Liability.
Why are trade expenses important?
All expenses are considered to be important from the perspective of the company. Trade expenses are considered to be more important from the point of view of the company, primarily because it directly impacts the gross profits of the company.
Gross profits are defined as the surplus of revenues over the cost of goods sold by the company. Trade expenses need to be highlighted as important features, primarily because of the fact that it helps investors, and decision-makers make important decisions regarding the overall efficacy of the company.
Hence, from an internal decision-making perspective, trading expenses hold tantamount value since it indicates if the company has the right margins to work with. Investors normally use gross profit margins in order to compare the business scope across different industries. For example, if a company has a higher gross margin as compared to their competitor, which implies that their trading expenses are better managed, as compared to the company with a lower gross margin.
Hence, companies strive to keep their trading expenses low, so that they have competitive gross margins, which can be used to deliver better results from the perspective of the company. Indirect expenses also impact profitability, but direct trade expenses are an indicator of the business model, and if the company is making the correct decisions pertaining to their suppliers.