Profit and Loss Accounting

Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Profit and Loss Accounting Meaning

Profit and loss (P&L) accounting is the process of creating a profit and loss statement to help companies have a clear view of the revenues and expenses over a period. The segregated view of the financial inflows and outflows enables organizations to track their financial performance and implement ways to keep up the same or improve it.

what is profit and loss accounting

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A profit and loss statement is one of the most important financial documents as it assesses whether a company has made profits or incurred losses in a fiscal quarter/year. The report, in turn, lets investors and other stakeholders decide whether to invest and involve in the organizations’ initiatives and operations.

Key Takeaways

  • Profit and loss accounting is when companies prepare the profit and loss statements to figure out their financial performance for a fiscal quarter or year.
  • These statements let creditors and investors make well-informed decisions on whether to involve with or invest in a company.
  • Revenue, cost, accrual and prepaid, EBITDA, and net profit are some of the components that help format a standard P&L statement.
  • To ensure accurate P&L accounting, the professionals prepare separate ledgers first and then create a trial balance and profit and loss statements.

Profit and Loss Accounting Explained

Profit and loss accounting generates a profit and loss statement, also referred to as an income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more, that becomes a ready reference for creditorsCreditorsA creditor refers to a party involving an individual, institution, or the government that extends credit or lends goods, property, services, or money to another party known as a debtor. The credit made through a legal contract guarantees repayment within a specified period as mutually agreed upon by both parties. read more and investors. These stakeholders refer to the document to track the financial performance of the organizations and make well-informed, smart investment and business decisions. Going through the P&L accounting records thoroughly enables them to determine the level of risk involved in collaborating with these ventures.

There are two methods by which the accounting professionals prepare the P&L statement. The first step is the single-step method in which professionals calculate the business’ total revenue, subtracting the expenses for that period from it to derive the amount remaining with the company.

profit and loss accounting approach

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A second method is a multi-step approach. The total revenue is calculated in this process, and 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.read more are subtracted from it first. It helps obtain the operating incomeOperating IncomeOperating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business. It doesn’t take into consideration non-operating gains or losses suffered by businesses, the impact of financial leverage, and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business.read more, which further adds to the remaining non-operating figures, including revenues, expenses, investment gains, or losses. The figures obtained show the pre-tax income for the period. Then, the applicable income taxes are deducted, and the net incomeNet IncomeNet income for individuals and businesses refers to the amount of money left after subtracting direct and indirect expenses, taxes, and other deductions from their gross income. The income statement typically mentions it as the last line item, reflecting the profits made by an entity.read more is found.

Preparing P&L Statement

Preparing a statement of profit and loss accounting involves generating other sets of statements first. These 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.read more help accounting professionals assemble the required data before creating the final income statement. The first step to preparing the profit and loss statement is to create ledger accounts. Here, the professionals prepare a statement for each ledger to figure out the closing balance.

profit and loss accounting preparation

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Next is creating a trial balanceCreating A Trial BalanceTrial Balance is the report of accounting in which ending balances of a different general ledger are presented into the debit/credit column as per their balances where debit amounts are listed on the debit column, and credit amounts are listed on the credit column. The total of both should be equal.read more, which summarizes the data obtained from the ledger accounts and their respective closing balance. Finally, the trading and profit and loss statement are prepared. The accounting professionals record the ledger accounts, along with the type of sales, purchase, direct and indirect expense, and income in this statement.

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Components

Five components offer a standard profit and loss accounting statement format to the organizations. These include:

Revenue

It is the amount that marks a business or organization’s income generated over a period by selling the goods and services to customers. For example, in the P&L accounting, revenue figures might enter in different forms, including 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. read more (monthly fee), 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.read more revenue (repair or one-time additional charge), and non-trade revenue (income not directly linked to the main business), etc.

Cost

Cost or expense is the total expenditure an entity makes for profits at the end of production and sale of goods and services in a fiscal yearFiscal YearFiscal Year (FY) is referred to as a period lasting for twelve months and is used for budgeting, account keeping and all the other financial reporting for industries. Some of the most commonly used Fiscal Years by businesses all over the world are: 1st January to 31st December, 1st April to 31st March, 1st July to 30th June and 1st October to 30th Septemberread more. The cost incurredCost IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. read more can be the cost of revenueCost Of RevenueThe costs directly attributable to the production of the goods that are sold in the firm or organization are referred to as the cost of sales.read more, which indicate direct expenses related to boosting the revenue. Other expenses include office expenses, depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more, selling & administration expenses, etc.

Profit and Loss Accounting Components

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Accrual and Prepaids

Most countries follow accrual accountingAccrual AccountingAccrual Accounting is an accounting method that instantly records revenues & expenditures after a transaction occurs, irrespective of when the payment is received or made. read more which only summarizes the revenue generated and the cost incurred in the current period. The P&L accounts or statements reflect these pieces of information. In this case, while finalizing the books of account, if it is found that a few invoices have not been received, accounting professionals must 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.read more. Such expenses are recorded in the liability column of the balance sheet.

On the contrary, the future expenses already paid are recorded as a current assetCurrent AssetCurrent 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.read more on 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.read more.

EBITDA

It stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. As the name implies, it marks the earnings of any business before applicable deductions. The operational cost is subtracted from the total revenues, and the amount obtained becomes the EBITDAEBITDAEBITDA refers to earnings of the business before deducting interest expense, tax expense, depreciation and amortization expenses, and is used to see the actual business earnings and performance-based only from the core operations of the business, as well as to compare the business's performance with that of its competitors.read more. It indicates if an individual or firm is making profits from the daily operations it conducts. It also marks an entity’s capacity to repay its financial obligations.

Net Profit

Net profit is the amount obtained after all deductions, including taxes, depreciation, amortization, etc., are made from the revenue.

Examples

Let us consider the following profit and loss accounting examples to understand its function:

Example 1 – For Individuals and Sole Proprietors

Profit and Loss Accounting Example 1

Example 2 – For Listed companies

Profit and Loss Accounting Example 2

Pros & Cons

Profit and loss accounting advantages are many, but the process is not devoid of limitations. So, let us have a quick look at the pros and cons of P&L accounting:

BenefitsLimitations
Comparing financial statements becomes easyTime consuming
Summarizing and data retrieval is smoother and fasterThe accrual method of accounting is used, which burdens profits with non-cash expense settlements.
Helps track performance month-wise or year-wise as recorded 
Makes performance analysis easier 

Frequently Asked Questions (FAQs)

What is profit and loss accounting?

P&L accounting involves the creation of reliable profit and loss statements to assess the financial performance of an individual or business. These statements provide a clear picture of the company’s profits and losses incurred during a specific period. Based on the same, the creditors and investors decide whether to collaborate with the business or look for other entities in the market for fruitful investments.

How to calculate profit and loss in accounting?

Profit and loss figures are calculated by deducting the total expenses from the revenue generated from different sources in a fiscal quarter or year.

What is the difference between a profit & loss accounting statement and a balance sheet?

The P&L statements include income, expenditures, and profits made within a specific period. On the other hand, a balance sheet separates the assets and liabilities up to a particular date. While the former assesses the financial performance of the companies or individuals, the latter reflects how strong a company is in terms of the finances and resources it possesses. In addition, a balance sheet is normally presented on the last day of the fiscal year, whereas the P&L statement may be presented at the end of a quarter or year.

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This article is a guide to what is Profit and Loss Accounting and its definition. Here we explain how to prepare it, its format, components along with examples. You can learn more about accounting from the following articles –

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Comments

  1. Ibrahim Hamza Saleh says

    Good

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