The profit and loss account is fundamentally a summary of the trading transactions of a business and shows whether it has made a profit or loss during a particular period of account. Indeed, by deducting the total expenditure from total income the profit or loss of a business can be calculated. Along with the balance sheet, it is one of the key financial statements that make up a company’s statutory accounts.
Basically, this type of account shows the following information for a business:
- Sales revenue earned by business
- Cost of sales that the business has incurred
- Other operating costs incurred by the business
- Profit/Loss earned by business.
The profit and loss account usually has two columns: one for the current accounting period and one for the previous accounting period. Any costs directly associated with generating sales and also any other operating costs represent debits in the profit and loss account. Furthermore, the other operating costs are usually allocated to categories such as selling or administrative expenditure. The sales income for the business represents a credit in the account.
The basic construction is as follows:
Net Sales = Gross Sales – (Allowances + Discounts + Returns)
Cost of Goods Sold = Opening stock + Purchases – Closing stock
Gross Profit = Net Sales – Cost of Goods Sold
Net Profit = Gross Profit – Other operating costs
The profit and loss account is often seen as a key indicator of how well a business is doing. However, when interpreting the figures it is important to look at them in conjunction with the balance sheet and other financial information included in the accounts. Lastly, you should also bear in mind that the information in the profit and loss account is historic and therefore budgets, forecasts and other management accounting information is likely to be crucial in helping you to make any future financial and/or business decisions.