Understanding the Profit and Loss (P&L) Account

You Need This To Successfully Run A Business

The P&L account is obviously the financial statement that business people are most interested in. Reason: it shows the 'bottom-line' which is the profit (or loss) made by the business over a given period. The Profit and loss account summarises the trading operations of the business over a stated period (month, quarter, year, etc) and shows the net result of those activities by way of what profit was achieved or the loss incurred by the business.

Multiple Benefits
Given that profit is a strong motive for most businesses, getting to see the outcome of operations in terms of profit or the absence of it is of major interest. The P&L is however more than a net result: it classifies and summarises the components of earnings and expenses, in a manner that gives useful insight into the basis of the final result. With such information, it becomes possible to evaluate and work on individual elements of that performance.

Contrasted With The Balance Sheet
While related to the balance sheet, the P&L account focuses on revenue and costs while the former captures assets and liabilities. The P&L outlines the sources of revenue and the amount from each source and the components of operating expenses, classified by type. The P&L account shows a flow, over a period, unlike the balance sheet which shows a snapshot as at a particular date. Consequently, the P&L account title includes the definer " for the (period) ended (date)".

Basic Accounting Principles Are Observed
Some basic accounting principles are applied in capturing transactions and generating the P&L account. These include:

1. Accrual of Income And Expense:
This implies that income is recoginised in, and expense charged to, the period they relate to and not necessarily when received or paid. When sales are made, revenue is taken as earned and will be captured in the P&L account, even if payment has not been received. For instance, if rent income is received, covering the next two years, only the portion relating to the current financial year is taken as income to current year's P&L account. The same principle applies to expenses. If insurance premium is paid for one year from the last quarter of the current year, only the portion for that quarter is charged to the P&L account for the current year.

2. Revenue Recognition
This defines the point of realisation of revenue, for clarity. Revenue is defined to be realised at the point of delivery of goods or services to the other party, irrespective of when payment is made. In certain transactions where progressive certification of work done is applied (construction contracts, for instance), revenue is recognised once a certificate of completion of any portion is issued.

3. Matching of revenue and expenditure:
This is the matching principle which insists that expenditure incurred in earning revenue is matched with that revenue in reporting the results. It will therefore be wrong to capture revenue in a particular period but fail to recognise all the costs that have been incurred in earning it, irrespective of when they are settled. If goods are produced in the current accounting period but sold in the subsequent period, the cost of production can only be charged to that period when sales are recognised.

4. Consistency
Businesses may exercise some discretion in adopting accounting policies and procedures from the body of "generally accepted accounting principles" to apply in accounting for their operation. The principle of consistency however requires that arbitrariness is excluded by applying the adopted principles on a consistent basis, to make results comparable over different periods.

Structure Of a P&L Account
The P&L account has two major categories of items: (1) the revenue items (2) the expenditure items. Revenue items include proceeds from the sale of goods or services, fees, interest income, commissions and discounts received and other items of income accruing to a particular business. Expenditure on the other hand includes the cost of goods sold or direct costs of providing a service, overhead expenses, the expired cost of capital assets and any other expense of non-capital nature. By subtracting expediture items from revenue, the net result of operations in the period is determined. Below is a specimen structure of a profit and loss account:

X- Company Limited
Profit & Loss Account
For the year ended 31st December, 1900

SALES
Electronics	4,530,500
Accessories	605,500
Total Sales		5,136,000
Less DIRECT COSTS
Materials	3,054,000
Stock at start of year	250,000
Total	3,304,000
less stock at end of year	520,000
Total Direct Costs		2,784,000
GROSS PROFIT		2,352,000
Miscellaneous Income		528,366
Less EXPENSES
Wages	586,000
Rent & Rates	240,800
Telephone Expenses	52,500
Insurance	60,000
Advertising	180,000
Transport Expenses	10,900
Stationery & Printing	10,350
Professional Fees	40,000
Electricity	35,000
Bank charges	20,400
Depreciation	22,000
Total Expenses		(1,257,950)
NET PROFIT BEFORE TAX		1,094,050
Tax provision (say @30%)		328,215
Dividend Provision		520,000
Retained in business		245,835

The profit and loss statement not only helps you to see the final outcome of your business activities in a given period, it also shows the income and expenditure items that produced that result. As a business manager, this places you in a position to decide what aspects of your income or expenditure profile you can work on to improve your overall results. By evaluating the relationship between various key components, critical parameters for managing your business can be established and monitored over time. The result, all things being equal, will be a business that is more efficient and more profitable.

You therefore need to ensure that a system is available in your business to generate this and other lkey financial statements which are critical to the proper management of your business. More importantly, there is need to understand these statements, so that they become effective tools for business success.