A profit and Loss Account is the second financial statement prepared by an organization. This account is prepared to ascertain the net results of a firm in form of net profit earned or net loss incurred during an accounting period. Similar to the Trading Account, the Profit and Loss Account is also a nominal account in which all the expenses or losses are debited and all the incomes or gains are credited. This account begins with a recording of the gross profit (or gross loss) depicted by the Trading Account. After this, all the indirect expenses are debited and all indirect incomes are credited to this account. Indirect expenses are those expenses that are not directly related to the manufacturing and production of goods and services. These are incurred for making the finished goods ready for sale. While on the other hand, indirect incomes are those incomes that are not directly earned from the operating activities of business operations. The excess of credit side over its debit side of Profit and Loss account is regarded as Net Profit. In contrast, excess of debit side over its credit side is regarded as Net Loss.
Characteristics of Profit and Loss Account
- It is the second financial statement prepared by an organization.
- It is a nominal account.
- It is prepared on an accrual basis.
- It depicts the net profit or net loss during the year.
- The net result of this account is added to (in case of net profit) or subtracted (in case of net loss) from the Capital on the Liabilities side of the Balance Sheet.
Purposes of Profit and Loss Account
- To calculate net profit or a net loss.
- To ascertain the net profit ratio and to compare this year’s net profit ratio with that of the desired and proposed target in order to assess the efficiency and effectiveness.
- To measure the adequacy and reasonability of indirect expenses incurred by ascertaining the ratio between indirect expenses and net profit.
- To compare the current year’s actual performance with desired and planned performance.
- To provide various provisions and reserves to meet unforeseen future conditions and to toughen the financial position of the business.
Explanation of Items recorded in Profit and Loss Account
Items recorded on the Debit Side of Profit and Loss Account
We know that all the indirect expenses are recorded on the debit of the Profit and Loss Account. The following are some categories under which indirect expenses are grouped:
Administration and Office Expenses: These are the expenses that are incurred for making and implementing the plans for the efficient running of the business and maintenance of the office. These expenses are considered as indirect expenses and recorded on the debit side of the Profit and Loss Account. The following are some examples of administration and office expenses.
- Office Salaries
- Office Rent
- Postage, Printing, and Stationery
- General/Trade Expenses
- Telephone or Internet Charges
- Insurance
- Maintenance of Office Equipments
- Lighting
- Audit Fees
- Consultation Fees
- Legal Charges
Selling Expenses: These are the expenses that are incurred in connection with promoting the sales and maintaining the existing customers. These are also indirect expenses and are recorded on the debit side of the Profit and Loss Account. The following are some examples of selling expenses.
- Advertisement Expenses
- Salaries to Salesman
- Commission to Salesman/Agents
- Bad Debts
- Free Samples
- Postage, Printing, and Stationery related to Sales
- Free Samples
- Royalty on Sales
- Other sales department expenses
Distribution Expenses: These are the expenses that are incurred in relation to distributing and transporting the goods. In simple words, these expenses are incurred for executing the orders of the business. It also includes the expenses incurred for maintaining the warehouse of the finished goods. As these are indirect expenses and therefore, are shown on the debit side of the Profit and Loss Account. The following are some examples of distribution expenses.
- Warehousing or Storage Charges
- Packing Costs
- Carriage or Freight Outward
- Carriage on Sales
- Transportation Costs
- Vehicle Maintenance Costs (used for delivering the goods)
Financial Expenses: These expenses are incurred for raising the funds required by a business which means that these expenses are incurred in connection with arranging the finance for the business. Being indirect expenses, these are shown on the debit side of the Profit and Loss Account. The following are some examples of financial expenses.
- Interest on Loans
- Interest on Capital
- Interest on Overdraft
- Cash Discount Allowed
Abnormal Losses: It includes all the losses that are accidental to a business enterprise. In simple words, these losses are not frequently incurred by the business. These losses are debited to the Profit and Loss Account. The given below are some factors that result in abnormal losses to a business.
- Loss of Goods/Stock or Assets by Fire or Theft
- Loss on Sale of Fixed Assets
- Cash Embezzlement
- Loss of Goods due to Accidents
Other Expenses: These expenses include the following and are shown on the debit side of the Profit and Loss Account.
- Depreciation
- Charity
- Donations
- Repairs and Maintenance of Assets or types of equipment
Items recorded on the Credit Side of Profit and Loss Account
Gross Profit: The first item recorded on the credit side of the Profit and Loss Account is the Gross Profit transferred from the Trading Account.
Financial and Other Incomes/Gains: All the incomes or gains to a business enterprise are shown on the credit side of the Profit and Loss Account. It includes the following
- Rent Received
- Commission Received
- Interest Received
- Dividend Received
- Discount Received
- Income from Investments
- Profit on Sale of Assets
- Bad Debts Recovered
- Insurance Claim Received
- Interest on Drawings
- Tax Refunded
- Other Miscellaneous Incomes
Procedure to Prepare Profit and Loss Account
First of all, this account begins with transferring the gross profit or gross loss from the Trading Account. Gross profit is transferred to the credit side of the Profit and Loss Account. On the other hand, Gross Loss is transferred to the debit side of this account.
Secondly, all indirect expenses and losses are recorded on its debit side. After this, all the indirect incomes and gains are recorded on the credit side of the account.
Lastly, if the credit side exceeds the debit side then the balancing figure is shown as net profit and added to the capital account of the proprietor in the Balance Sheet. On the other hand, if the credit side falls short of the debit side then the balancing figure is regarded as net loss and deducted from the capital in the Balance Sheet.
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