Profit and Loss Account

The profit and loss account is a primary statement in the financial statements. It calculates profit or loss for a specified period. The profit or loss for the period is added to the accumulated profit or loss balance in the balance sheet. All the amounts in the profit and loss account are for a specified period such as twelve months. Because companies are able to change their year ends, they could have a shorter or longer period than twelve months, but no longer than 18 months in UK.

The profit and loss account usually has two columns, one for the current accounting period and one for the prior accounting period. To assess how a business is performing, and whether the figures in the profit and loss account appear reasonable, a detailed comparison is perfromed on a line by line basis. Accountants will raise questions about the accounts and attempt to identify errors in the accounts from such a comparison. HMRC will do the same, and raise queries and investigations based on this comparison.

Financial statements often include the statutory profit and loss account and the detailed profit and loss account contained in the management pages, which do not form part of the financial statements. The statutory profit and loss accounts is the minimum information that must be filed at Companies House made available for public viewing. Small companies are required to publically disclose less information than large companies of public companies. For an accurate analysis of business performance, the detailed pages included for management information are the most beneficial to use. Don't file these pages, as they disclose information that can be used by competitors.

The analysis reveals how accurate the accounts are and tell the story of what has happened in the year.

For instance, if rent was £50,000 for the 12 months to December 2006 and £70,000 for the 12 months to December 2007, the question will be asked why. The answer may be that the business has expanded and moved to new premises that are more expensive. Based on this answer, the accountant may ask for the new lease agreement to ensure it has been correctly accounted for.

Potential investors use the profit and loss account to value the expected future growth of the business. They may look at a period longer than two years to establish a pattern. Because the balance sheet shows the cumulative position, the best indicator about the state of the health of the company is the net asset position. Profits increase the net asset position whilst losses decrease it.

The profit and loss account does not include only cash flows. It includes accounting entries that do not affect cash flow, such as the depreciation of assets. The cash outflow of purchasing an asset is recorded in the balance sheet, whilst a depreciation charge is shown in the profit and loss account to spread the cost of using the asset of a number of years. this is intended to show a more accurate reflection of real profit or loss, but can also lead to a great deal of manipulation. Watch out for companies who base bonuses to management on the profit for the year. The accounting policies in the notes to the accounts are required to show how the non cashflow entries have been calculated, so be sure to read them to get a full understanding of how profit or loss has been calculated.

Download the financial statements template to see how the profit and loss account is created from the trial balance and view a working example. The figures feed through from the bank statement summary, to the extended trial balance and finally to the financial statements. It is during the creation of the extended trial balance that the non cash entries are calculated and fed into the accounts. The extended trial balance is then fed into the accounts. There are detailed notes in the spreadsheets that explain what the final figures mean, so that it becomes easier to analyze the final profit and loss account and balance sheet.

Below briefly explains the procedure:

List all income and expenses from your trial balance on a page called "Income Statement".
Calculate the gross profit as income less direct expenses (directly incurred to bring goods to the point of sale). Remember to include opening and closing stock values.
Calculate the net profit as gross profit less administrative expenses (for general running of the business). You can list the administrative expenses on the face of the income statement or in a note to the accounts.
Remember to include depreciation on fixed assets.
Include interest paid that was included in your loan repayments. The capital portions of the loan repayments are not included in the income statement, but reduce liabilites in the balance sheet.
Salaries are posted to the profit and loss account, whilst loans taken from the company or made to the company are recorded in the balance sheet.
Add accrued expenses and deduct your prepaid expenses. These are invoiced costs that have to be allocated to the accounting periods according to the dates that services are performed as opposed to the dates that payments are made (called the accruals concept in preparation of accounts).
Remember to include the cost of preparing the accounts.
List the prior year income and expenses in a second column, obtained from the accounts prepared in the previous year.
How well has your business performed compared with the prior year?
Do you see anything that looks unusually large or small?
Trace it back to the detail to see why it has changed.
Prepare a tax computation and include the tax charge that will be due if a taxable profit has been made. By looking at the tax computation of the previous year, it is possible to estimate what expenses will be disallowed for the current year. An accountant needs to verify the final position as tax rules change year on year.

Useful ratios

P/E Ratio = current price per share/earnings per share

Dividend Yield = dividend per share/current market price per share

Dividend Cover = earnings per share/net dividend per share

Earnings per share = net profit(loss) attributable to ordinary shareholders/weighted average number of ordinary shares outstanding during the period

GP% = gross profit/sales x 100

NP% = net profit/sales x 100

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