Profit and Loss Accounts

1. Introduction
2. Coverage of a Profit and Loss Account
3. Key Terms in a Profit and Loss Account
4. Useful Tips
   
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1. Introduction
A profit and loss account shows what happened in a business, in terms of income, sales and expenditure, during a specific period. All businesses have to prepare a profit and loss account as part of the annual accounts. However, profit and loss accounts can be prepared at any stage during the financial year, covering any length of time.

2. Coverage of a Profit and Loss Account
The Profit and Loss Account shows:

• The turnover or sales for the period.
• The expenditure for the period.
• How much profit there was.
• How the profit has been divided.
• Profit and loss accounts are generally set out in the way illustrated in the example.

3. Key Terms in a Profit and Loss Account

Sales Figure
The sales figure shows the actual sales for the period, excluding VAT. It does not reflect the cash received from customers, since some payments may still be outstanding. A basic principle in accounting is to match costs against the revenues generated by those costs, so it is important that the sales figure is correctly calculated. It should be the sum of all invoices received rather than paid during the period.

Direct Costs
The direct costs, i.e. those costs directly attributable to the sales, reflect raw materials and sub-contract costs in the product or service actually sold during the period. In most businesses (except retail), employee costs can also be directly attributed to the product sold. There may be stock purchased during the period which was not consumed, i.e. stock in hand at the balance sheet date; this will be shown on the balance sheet but not charged to the profit and loss account. Conversely, raw materials may have been consumed which were bought in a previous period. The cost of those materials will be included in the direct costs. Materials purchased but not consumed will be shown in the stock figure on the balance sheet. It is important to watch out for purchases of materials or sub-contract work which have gone into sales made during the period or included in stock at the period end, but for which the business has not been billed. This applies to any costs incurred where invoices have not been received. Ideally, the business will not prepare the accounts until all bills have been received. However, when producing management accounts, an estimate of these costs may have to be made in order to give a profit figure which is as accurate as possible.

Profit
The direct costs are deducted from the sales figure to give gross profit. This allows the business to calculate its gross profit margin. The overheads are deducted from the gross profit to give the net profit. It is important to keep an eye on both the gross profit margin and the net profit margin. Dramatic reductions in either could be a sign of trouble.

Depreciation
The depreciation element in the Profit and Loss Account does not involve a movement of cash. Depreciation is charged to cover the wear and tear of fixed assets. The amount charged therefore is an allocation of the cost of fixed assets over their useful life. If depreciation is high relative to payroll costs, the business is capital intensive; if the payroll costs are high relative to depreciation, the business is labour intensive.

4. Useful Tips
If there is concern regarding excessive overhead charges, it is useful to refer to the Profit and Loss Account as it gives a breakdown of each individual type of expense.

By drawing up a Profit and Loss Account, it is possible to see whether corrective action is needed to maximise profit. For example, it may show that the percentage of raw materials as a proportion of sales is too high.