Profit and Loss Accounting Definition
Profit & Loss account, also known as the Income statement, is a financial statement that summarizes the revenue and costs incurred by an organization during the financial period and is indicative of the financial performance of the company by showing whether the company has made a profit or incurred losses in that period.
Components of Profit & Loss Statement
Various components of the profit loss account are as follows.
#1 – Revenue
Revenue, also known as Sales, is the total amount charged to customers for goods and/or services sold to them. While preparing Profit & Loss Account, the revenue is categorized as recurring revenue, non-recurringNon-recurringNon-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off. revenue, non-trade revenue, and others.
To understand these revenue types, let’s consider that X Ltd. is in the business of providing Internet – Monthly fees charged to customers is recurring revenueRecurring RevenueRecurring Revenue is a part of the Company’s total revenue or income constantly generated in the future at regular intervals (monthly or yearly). This type of revenue is relatively stable as you can predict its occurrence with reasonable confidence. . The amount charged for installation, repair, or occasional extra usage is non-recurring revenue. If X Ltd has invested in another company and received a profit share from there, it is called non-trade revenue, as this income is not directly related to the main business of X Ltd. Any other type of receipt is others.
#2 – Cost
Cost is the total expenses incurred by an entity in a given financial period. Cost is further divided into various categories. There is a Cost of Revenue, which are direct expenses incidental to revenue generation and customer-related expenses. The other costs are factory expenses, office expenses, selling & administration expenses, depreciation, and others.
#3 – Accrual and Prepaids
In most countries, the accrual basis of accountingAccrual Basis Of AccountingAccrual Accounting is an accounting method that instantly records revenues & expenditures after a transaction occurs, irrespective of when the payment is received or made. is followed, which states that the revenue and expenses of the current period only are to be shown in the Profit & Loss a/c of the current period. In this case, while finalizing the books of account, if we find out that we have not received invoices from any Vendor and taken the goods/services, we should accrue those expensesAccrue Those ExpensesAn accrued expense is the expenses which is incurred by the company over one accounting period but not paid in the same accounting period. In the books of accounts it is recorded in a way that the expense account is debited and the accrued expense account is credited.. The expense part is shown in the Profit & Loss, and accrual appears in the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. as a liability. In the same way, if we have paid for any expenses related to a future period, it should be shown as a current asset in the balance sheetCurrent Asset In The Balance SheetCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.. In every period, the cost related to the relevant period should be released to the Profit & Loss account.
#4 – EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
If we see the Profit & Loss account of any listed company, we will find the EBITDA shown as operating margin. The EBITDA, as the name goes, shows the amount of profit or loss after deducting the operational expenses but before deducting any interest, taxes, depreciation, and amortization. The EBITDA indicates if the business is making any profit from its day to day operations. Also, it shows the repayment capacity of obligations such as interest on loans, taxes, creditors, and other statutory dues. This EBITDA becomes a crucial aspect when the organization applies for a loan to any bank or goes for shares issuesShares IssuesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet. for capitalization.
#5 – Net Profit
We arrive at EBITDA after deducting the operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit. from Revenue. When taxes, depreciation, amortization, and other expenses are deducted from EBITDA, we arrive at net profit or loss for that period.
Profit and Loss for Individuals and sole proprietors
Profit and Loss For Listed companies
- Makes usage and comparison of financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. easier
- Easier to extract data for audits
- Provides month over month and year over year analysis of expenses to which helps the higher management in decision making
- It also helps to track cost centerCost CenterCost center refers to the company's departments that don't contribute directly to the corporate revenue; however, the firm has to incur expenses for keeping such units operative. It comprises research and development, accounting and human resource departments. wise expenses.
- The account code wise analysis helps in the accrual process and identifies any invoices paid twice or not received in a financial period.
- Indicator of the financial health of an organization
- It is a time-consuming process that needs a lot of human resources to be involved.
- Sometimes noncash expenses put a lot of burden on profit, which is not really payable to any outsider creditor.
Profit & Loss accounting is a vital part of the accounting process of any organization. When prepared carefully, it helps in timely tax filings and smooth audit facilitation. Also, the data extracted from the profit & loss account helps in making complex reports and variance analysisVariance AnalysisVariance analysis is the process of identifying and analyzing the difference between the standard numbers that a company expects to accomplish and the actual numbers that they achieve, in order to help the firm analyze positive or negative consequences. of different periods, which assists management in decision making and identification of areas to focus on.
So, while preparing a profit & loss account, the accountant should be cautious while bifurcating expenses. Any non-recurring or an expense that relates to a recent acquisition should not be coded to operating expenses. Instead, it should go to transition expense and should be deducted from EBITDA. Also, utmost care should be taken while calculating the provision amount for debtorsDebtorsA debtor is a person or entity that owes money to the other party in a transaction. The receiver is referred to as the creditor, and the payment terms vary for each transaction based on the terms and conditions agreed upon by the parties. and creditors.
This article has been a guide to what is Profit and Loss Accounting and its definition. Here we discuss what is P&L along with its key components, advantages & disadvantages. You can learn more about accounting from the following articles –