A Profit and Loss Account, also referred to as a Profit and Loss Statement plays a crucial role in the Financial Statements of any given entity for any business. Irrespective of the profit-motive, a non-profit organisation also prepare an Income and Expenditure Account to evaluate its performance. It is a Statement for a given period. It shows the revenue of the entity and the costs incurred to earn that revenue, ultimately revealing whether the business is in Profit or Loss.
What are the types of Profit and Loss Account
In accounting parlance, the Profit and Loss a/c is a Nominal Account. Every Account is prepared using the double effect in ‘Debit’ and ‘Credit.’ That means one of the accounts is debited, and the other is credited considering the golden rules of accounting. Now let’s first understand the basics of accounting before proceeding.
Accounts are of three types as below based on their representation. Every account type has its own set of accounting rules described as follows:
|
Sr. No. |
Type of account |
Function |
Golden Rules of Accounting |
|
1 |
Personal Account |
This Account is for people. They may be debtors, creditors, or any other person to whom money is due or receivable. For Example, Ram A/c |
Debit: The receiver. Credit: The giver |
|
2 |
Real Account |
This account caters to objects. For Example, Cash A/c, Bank A/c, Furniture A/c. |
Debit: What comes in. Credit: What goes out. |
|
3 |
Nominal Account |
These accounts represent the revenue or expenses. For Example, Sales A/c, Loss on sale A/c, Bad Debt A/c. |
Debit: The expenses and Losses. Credit: The Incomes and Gains. |
According to the above rules, the Statement of Profit and Loss is prepared based on debiting the Expenses and Losses and Crediting the Incomes and Gains.
System of Accounting
Accounting revolves around two systems of accounting. One is the Cash System, and the other is the Accrual System.
- Cash System of Accounting:
Under this system, transactions are recorded as and when cash flow occurs. That means an expense is booked only when cash is paid, and an income is booked only when cash is received. Cash Flow matters to record the transactions, and accordingly, Profit and Loss for a given period are calculated. This may defer figures showing incorrect information in the financials.
- Accrual System of Accounting
Most of the entities, especially Public and Private Companies, entities performing Tax Audits, Entities to comply with GAAP and IFRS are required to follow the Accrual System of accounting. Under this system, transactions are recorded as and when they occur, irrespective of the timing of the cash flow. For example, if an invoice is issued, the transaction is recorded, even if a sale is made on a credit basis. This attributes the income and expenditure to given periods and avoids deferment of transactions. The Accrual System of accounting is the most widely used in current scenarios.
Components of Profit and Loss Account
The P and L account are based on two components:
- Trading Account
- Profit & Loss Account Statement
|
Sr. No. |
Item |
Explanation |
|
A |
Trading Account |
|
|
1. |
Debit Side |
|
|
a. |
Opening Stock |
This is the opening balance of the inventories lying with the entity at the start of the given period. The figure can be taken from the Balance Sheet of the earlier period where it is shown as Closing Stock. This may consist of the Raw Materials, Consumable stocks, Work-in-progress stock, and Finished Goods stock. |
|
b. |
Purchases |
It consists of Purchases made by the entity during the given period for selling purposes. These are the purchases of goods intended for sale during the period or shortly but not assets purchased for investment purposes. |
|
c. |
Purchase Return |
Purchase returns are the goods purchased but returned due to any damages or defects or rejected goods. Such are shown as a deduction from purchases in the Trading Account. |
|
d. |
Freight or Transport Expenses |
Any freight or Transport Expenses directly attributable to the Inventory are shown as a debit in the Profit and Loss account. |
|
2. |
Credit Side |
|
|
a. |
Sales |
Sales consist of the revenue earned through the sale of goods or services in the ordinary course of business. Any sale of assets or scrap that is not a regular trading activity is not considered here. |
|
b. |
Sales Return |
These are the goods that are rejected after the sale by our customers. They are shown as a deduction from Sales. |
|
c. |
Closing Stock |
This is the figure depicting the closing value of the inventories lying in hand at the end of the period. It is calculated as Opening Stock Purchases – Cost of Goods Sold. |
|
B |
Profit and Loss Account |
|
|
1. |
Debit Side |
|
|
a. |
Salaries and Wages |
These are the employment expenses paid to workers and administrative staff. |
|
b. |
Marketing Expenses |
Expenses relating to advertisement and Sales promotion are considered. |
|
c. |
Depreciation Expenses |
These are non-cash expenses showing the amount of wear and tear of assets attributable to its revenue capacity. These tend to reduce the value of assets. |
|
d. |
Outstanding expenses |
Any outstanding expenses that are incurred but yet to be paid are shown as an expense of the period. |
|
e. |
Rents and Royalties |
The rents paid for properties and equipment used for business and Royalties paid for patents and trademarks are also considered a cost to the company. |
|
f. |
Bad Debts |
Any amounts earlier shown as receivable and later couldn’t be recovered are written off by debiting the Profit and Loss a/c. |
|
h. |
Other Operating Expenses |
Along with the above expenses, other expenses like Repairs and Maintenance, Property Taxes, Interest on Loans and Debt Funds, Travel Expenses, Legal charges, Bank Charges. |
|
g. |
Non-Operating expenses |
These are one-time expenses incurred for the business. For Example, Preliminary Expenses, Loss on Sale of Assets, Loss on Fire or Theft, Loss of Foreign Exchange, etc. |
|
2. |
Credit Side |
|
|
a. |
Operating Income |
Income earned from core business activities is said to be operating income. |
|
b. |
Non-Operating Income |
One-time Incomes from Investments like Dividend, Interest, gains from the sale of assets, gains on Foreign Exchange. |
Also Read: What is Inventory Management Software System?
How is the Profit and Loss account prepared?
The traditional system of book-keeping consisted of some steps to prepare the financial statements:
- Journal: A journal entry was recorded to represent the transaction showing the Debit and the Credit accounts and the amount involved and a short narration to describe the transaction. Each entry was numbered manually for reference called a Folio number which was used to track the transaction.
- Ledger: A ledger is a T-shaped account consisting of the Debit side on the left half and the Credit side on the Right half. Entries in the journal are posted in the ledger accounts. Each separate account has a separate ledger. The ledgers are closed at the end of the given period. The Real and Personal Account Balances are reflected in the Balance Sheet, and the Nominal Accounts are transferred to the Profit and Loss account.
- Trial Balance: A Trial balance is a statement showing all the debit and credit balances as a list to ensure that each entry has been recorded correctly. Here, the sum of the debits must match the credits.
- Balance Sheets: All the Personal and Real Accounts aren’t closed, and their balances are shown in the Balance Sheet. Unlike, Profit and Loss Account, a Balance Sheet is prepared as on a given date. Also, the balance of the Profit & Loss Account is transferred to the Balance Sheet. A Balance Sheet consists of Assets presented on the right side and Liabilities presented on the left.
All nominal Accounts are closed and transferred to the Profit and Loss Account. They do not consist of any carrying balances to be carried forward to the next period. These are settled by transferring balances to the P & L Account. The net Balances show the profits or losses.
In ERP systems of book-keeping and accounting, only journal entries are required to be recorded. The rest of the entries are done automatically by the system. All reports are generated by the system in the most efficient manner.
Regarding the structure of the P&L Account, the credits represent the income, and the debits represent the expenses. Where there is a credit balance, it shows a profit. That means, Income over Expenditure. Where there is a debit balance, it offers a loss. That means, Expenditure over Income.
Refer to two Sample Profit and Loss Statements below to know the format and structure.
A]
|
ABC Company |
|||||
|
Prop.: XYZ |
|||||
|
PAN: CLFOT5412B |
|||||
|
Address: 12/8D, Secunderabad, Telangana, 500060 |
|||||
|
Profit and Loss Account for the year ended 31/03/2020 |
|||||
|
AY 2020-21 |
|||||
|
Particulars |
Amount (in Rs) |
Particulars |
Amount (in Rs) |
||
|
To Opening Stock |
50,000 |
By Sales |
50,200 |
||
|
To Purchases |
134,540 |
By Service Charges |
424,010 |
||
|
To Direct Costs |
4,800 |
By Closing Stock |
52,973 |
||
|
To Transport |
550 |
By Discount Received |
740 |
||
|
To Gross Profit c/d |
338,033 |
||||
|
527,923 |
527,923 |
||||
|
To Bank Charges |
240 |
By Gross Profit b/d |
338,033 |
||
|
To Petrol Charges |
6,580 |
By Dividend Income |
1,200 |
||
|
To Rent Paid |
66,000 |
||||
|
To Depreciation |
9,835 |
||||
|
To Repairs & Maintenance |
4,000 |
||||
|
To Telephone Charges |
1,600 |
||||
|
To Electricity Charges |
3,600 |
||||
|
To Miscellaneous Charges |
3,900 |
||||
|
To Net Profit c/d |
243,478 |
||||
|
388,033 |
388,033 |
||||
|
As per information on a given date, |
|||||
|
ABC Company |
|||||
|
XYZ |
|||||
|
Date: 10/01/2021 |
(Proprietor) |
||||
|
Place: Secunderabad |
|||||
B]
|
DEF Technologies Limited |
||
|
Statement of Profit and Loss for the year ended 31st March 2020. |
||
|
(‘000) |
||
|
2019-2020 |
2018-2019 |
|
|
Sales and revenues: |
||
|
Revenues from Operating Activities |
9,624 |
8,520 |
|
Total sales and revenues |
9,624 |
8,520 |
|
Operating costs: |
||
|
Cost of goods sold |
4,126 |
3,512 |
|
Selling and administrative expenses |
612 |
452 |
|
Research and development expenses |
926 |
984 |
|
Interest expense of Financial Products |
250 |
120 |
|
Other operating (income) expenses |
154 |
98 |
|
Total operating costs |
6,068 |
5,166 |
|
Operating profit |
3,556 |
3,354 |
|
Interest expense excluding Financial Products |
342 |
465 |
|
Other income (expense) |
287 |
169 |
|
Consolidated profit before taxes |
4,185 |
3,988 |
|
Provision for income taxes |
1,256 |
1,196 |
|
Profit attributable to common shareholders |
2,930 |
2,792 |
|
Profit per common share |
4.8825 |
4.6526667 |
These statements are presented along with Notes to Accounts to explain every line of Item in detail or to add any relevant explanations.
Objectives of PL account
The primary purpose of a Profit and Loss account is to check whether the business earns a profit or a loss for a given period. It is a crucial part of any financial statement; the figures depicted therein are used for calculating various ratios for analysis purposes. Investors, other stakeholders, etc., require this statement to consider their decision-making. Many reports for the management’s analytical study are prepared by taking this account as the base. Future strategies are framed based on the performance of the entity that is revealed through this statement.
Advantages and Disadvantages of Income Statement
- Advantages:
- Assists in easy comparison of financial statements to make quick decisions.
- It helps to track the cost centres and expenses related to the cost centres.
- The accrual system of accounting helps relate data to specific periods and keep track of financial transactions periodically.
- It makes it easy to extract data for various tax and statutory compliances and audit purposes.
- Various accounting analyses like the operating leverage, Financial leverage, Operating margins, Interest coverage ratios, Earnings per share, diluted earnings per share, etc., can be calculated.
- Disadvantages
- It is a time-consuming process.
- It includes cash and non-cash expenses. Hence, a Cash Flow statement and a Fund Flow Statement are to be studied simultaneously to better picture the entity profitability.
Also Read: What are Debit, Credit Note and their Formats?
To Conclude
Profit and Loss Account or Income and Expenditure Statement shows the performance of an entity for a given period in a nutshell. It shows the number of costs borne by the entity to earn the stated revenue over that period. It is the most sought-after statement that the higher management considers to formulate strategies and evaluate actions plans in the past. The Credit Balance reveals a profit, whereas; a debit balance reveals loss. Various analyses like variance analysis, ratio analysis, financial management decisions, costing decisions, pricing decisions, budget controls, etc., are prepared out of these statements. When viewed in conjunction with the Balance Sheet and Cash Flow Statement, the Profit and Loss Account can give tough insights into the profitability of any entity.