Profit and Loss Account

Profit and Loss Account

The profit and loss account is a financial statement which represents the revenue that the business has received over a given period of time, and the corresponding expenses which have been paid.

It also shows the profit that the business has made over a period of time (usually 12 months) and the uses to which the profits have been put.

Revenue is the inflow of money to the business in the course of the ordinary activities of the enterprise.

There are a number of different sources of revenue;

  • cash sales
  • credit sales (i.e. where the business has sold goods to customers, but has not yet received the cash)
  • interest
  • royalties
  • dividends that the business receives on its investments or
  • fees for hiring-out the resources of the business to a third party.

Revenue is recognised at either the receipt of the cash OR at the point of sale (if the goods are sold on credit).

Expenses are expired costs (i.e. costs from which all benefits have been extracted during an accounting period). Examples include wages, raw materials, and utility bills -often known as revenue expenditure.

It must be remembered that expenses are not necessarily the same as costs.

For example, if a business purchases a new fixed asset (such as a machine) then it will clearly incur the monetary cost of purchasing the machine (say £50,000).

However, this £50,000 will not be written-off as an expense, since the benefits from the machine will last for more than a single accounting period (i.e. for more than 12 months). Instead of writing-off the total cost of the machine, a portion of the £50,000 will be written-off as an expense each year over the useful life of the machine -this is known as a 'depreciation charge'.

The usual layout for a profit and loss account is as below:

Profit & Loss Account (01/04/99 - 31/03/00)

£000 £000
Sales Revenue 1,000
Cost of Sales:
Materials 300
Direct labour 200
Production overheads 100
Gross profit 400
Less selling expenses 100
Less administrative expenses 120
Trading [Operating] Profit 180
Add non-operating income (10)
Profit before interest and tax 190
Less interest expense (30)
Profit before tax [Net Profit] 160
Less taxation (60)
Profit after tax 100
Less dividends (20)
Retained Profit 80

The first line gives the Sales Revenue for the business from selling its goods and services.

From this, we deduct the "Cost of goods sold" (costs directly associated with the production of the goods and services - such as the cost of the raw materials, the labour charges associated with the production, and the production overheads. These are sometimes referred to as direct materials, direct labour and direct overheads).

Sales revenue less C.o.G.S. is known as Gross profit.

However, we have not yet accounted for selling and administrative expenses (such as advertising costs, distribution costs, salaries, utility bills, etc.).

When these are deducted from the Gross Profit, the result is known as trading or operating profit. These refer to the profit made from normal trading activities.

The next adjustment is to add on any income from other activities, known as non-operating income (e.g. renting out premises). The resulting figure is known as profit before interest and tax.

We then deduct a figure for interest charges. The resulting figure is known as profit before tax or net profit.

The final part of the account is known as the appropriation account. It provides information on the way in which the profit is dispersed.

Some is taken in corporation tax and goes to the Inland Revenue, some is drawn from the business as dividends to be distributed to the shareholders and the remainder is retained within the business for re-investment.

This is a form of creative accounting and it basically involves manipulating various figures in the financial accounts of a business, so to flatter its financial position.

There are two key variables that a business may like its shareholders (and other stakeholders) to believe are stronger than they really are:

  • liquidity (the ease with which a business can raise cash quickly)
  • profitability.

If a business is experiencing a deteriorating liquidity situation, then it can temporarily improve this figure either by selling off fixed assets, or by using a 'sale and leaseback' scheme. This involves a business selling a fixed asset (often land and buildings) to a third party, and then paying a sum of money per year to lease it back.

The business still retains the use of the asset, but no longer owns it.

The cash from the sale of the asset will improve the liquidity of the business, and it will imply to the readers of the accounts that cash is readily available. However, there are two drawbacks to this:

  1. The 'fixed asset' figure on the balance sheet will have fallen after the sale of the land and building.
  2. The business is not tackling the cause of the liquidity problem.

Profitability can be improved by bringing some of the revenue for the next financial year's confirmed orders into the current financial year.

This artificially boosts the 'sales revenue' figure for the current financial year and, therefore, also boosts the profit figure for the business. Again, however, there are two drawbacks:

  1. The business will not be able to count the money again for the next financial year when the orders are dispatched -therefore the profit figure for the following year will be depleted of this revenue.
  2. The business is not tackling the cause of the low profit figure.