Understanding a Business’s Profit & Loss Account/Statement

Completing a Profit & Loss Statement is a highly charged activity at the end of the financial year. It is what shareholders and prospective investors anxiously wait for as it determines the division of profit amongst shareholders. This article will examine the nature of the Profit & Loss Account and its presentation as a statement.

The parameters of the Profit & Loss account

Unlike the Balance Sheet which presents the state of affairs of the business at a given point in time, the calculation of profit/loss is based on the activities of the organization over a given period of time, this being the financial year of the business. It is thus labeled as The Profit & Loss Statement for the Year Ending 31/12/XX.”

How is Profit/Loss determined?

A business engages in a particular activity to generate profit. This may be in the form of delivering a service such as car washing or selling products that are either purchased or manufactured by the business. The selling price reflects the revenue received.

Profit is calculated by deducting the expenses incurred in earning that revenue. These could include costs such as wages, fuel, and motor expenses, rent of premises, electricity, and so forth. These are the everyday running costs of the business and very different from the set up costs of starting a business where assets are purchased.

Revenues and expenses relating to the business are recorded on a daily basis and totaled monthly. The monthly figures are collated at the end of the year to assess the performance related to that year.

The Profit & Loss (P&L) Account

p&l account

This account is only used periodically for the calculation of profit/loss. The revenue accounts such as Sales and revenues are closed and their balances are credited to the P & L account. All the expense accounts are closed and their balances are debited to the P & L account.

A credit balance on the P & L account indicates a profit whilst a debit balance means a loss for the period. The profit /loss amount is transferred to the balance sheet clearing the P & L account and leaving it with a nil balance for the next period’s calculation. The above process also leaves the revenue and expense accounts with nil balances for the new financial period.

Gross Profit & Net Profit Before Tax

A business that only offers a service does not have a gross profit figure to calculate. It simply sells the expertise, skills, and knowledge that it possesses. The client does not buy a product but has walked away with something that they value such as a new hairstyle.

If we look at a business that sells a product, we have the added step of having to purchase that product in the first place. It is then marked up for resale. The calculation of gross profit now enters the picture and this is the difference between the selling price and purchase price of the product. The price of purchase must be deducted before we deduct the everyday expenses of the business which provide us with the figure of net profit before tax.

Breaking the process down into each stage is important in ensuring that the markups are sufficient to cover all costs and provide an adequate profit for the business to sustain itself. Each type of expense is recorded separately. This enables the business to identify overspending in certain areas where controls may need to be implemented. Image 2 is the Profit & Loss Statement of a trading firm; it clearly identifies gross profit from net profit.

P & L Account vs. P & L Statement

p&l statment
Image source by Gusto

The information present in both is exactly the same. The accountant works with the account which is in T-format or three-column format. It speaks the language of the accountant and may look confusing to the layperson. Shareholders could be baffled if presented with an accountant’s version and as this account is of such importance to the shareholders, the same information is presented in a format that a layperson can understand, the P & L Statement.

The P & L Statement

For the going concern, the Profit & Loss Statement is perhaps the most important tool that the organization has in terms of monitoring its success, keeping shareholders happy and attracting new investors to enable further growth and prosperity for the future.
The overarching reason behind running a business is intrinsically linked with making profit.