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-recurring 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 revenue. 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.
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#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 accounting 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 expenses. The expense part is shown in the Profit & Loss, and accrual appears in the balance sheet 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 sheet. 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 issues for capitalization.
#5 – Net Profit
We arrive at EBITDA after deducting the operating expenses 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 statements 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 center 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 analysis 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 debtors 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 –