How to Prepare Profit and Loss Account?

Profit and Loss Account

A profit and loss account, also known as the income statement or statement of revenues and expenses, is prepared to ascertain the profit earned or losses suffered by the business entity.

We have already discussed the theoretical concepts about profit and loss account. Now here we shall discuss only practical aspects only.

Profit and Loss Account starts with gross profit on the credit side. In the case of gross loss, it will start from the debit side. All those expenses and losses, which have not been entered in the Trading Account, will be entered on the debit side of Profit and Loss Account. Incomes and gains, other than sales, will be entered on the credit side.

The expenses which are of personal in nature will not be charged to Profit and Loss A/c. Only those revenue expenses and losses which are related to the business for the current year are debited to Profit and Loss Account.

How to Prepare Profit and Loss Account?

Profit and Loss Account should be prepared in such a manner as will enable the users to form a correct idea of the profit earned or loss suffered by the entity.

The profit and loss account should represent the entity’s true and fair statement of affairs for the period. Too many details will prevent a person from knowing properly the factors leading to the profit earned.

Items should be entered in the profit and loss account according to suitable heads and functionalities such as administrations, selling and financing etc. following are the main expenses found in the profit and loss account:-

(1) Administrative expenses

(i)        Rent and rates for the office premises

(ii)       Salaries paid to the people working in the general office;

(iii)      Printing and stationery

(iv)      Lighting in the office.

(v)       Audit fees,

(vi)      Legal expenses.

(vii)     Postage, telegrams and telephone charges.etc.

(2) Selling and Distribution Expenses

(i)       Commission to agents

(ii)       Salesmen’s salaries and commission

(iii)      Advertising.

(v)       Packing expenses.

(vi)      Freight and carriage on sales.

Financing expenses usually include interest paid on the loan, discounts on discounted bills, and discounts allowed to customers. On the income side of the Profit and Loss Account, besides the gross profit, there may be interest received, discount received, rent from letting of premises, miscellaneous incomes such as from the sale of scrap etc.

Other Items

Other categories of income like interest on fixed deposits, interests or income from investments and other interest should be shown separately. Similarly, items which have to be debited/credited to the proprietor should be segregated from other items. Ex. Interest charged on drawings made by the proprietor, interest provided on capital and charges for services provided by the firm to the proprietor personally.

We shall now understand treatments of a few items individually:

Drawings

Drawings are not expenses for the firm and, therefore, should not be debited to the Profit and Loss Account. If the proprietor has taken some benefit personally, like the use of the firm’s car, a suitable amount should be treated as a drawing, and to that extent, the charge to the Profit and Loss A/c will be reduced. Drawings are debited to the proprietor’s capital account.

Income Tax

In the case of companies, the income tax payable is treated similarly to other expenses. But in the case of sole proprietorship, income tax is treated as a personal expense of the proprietor. Hence, It is debited to the Capital Account and not to the Profit and Loss Account. This is because the amount of the tax will depend on the total income of the partners or proprietor besides the profit of the firm.

In the case of partnership firms, the firm’s tax liability is to be debited to the

profit and loss account of the firm, but the partners’ tax liability is not to be borne by the firm.

Discounts received and allowed

Discount is of two types: trade discount and cash discount. Trade discount is allowed only when the order for goods is not below a certain figure. It is deducted from the invoice. Trade discount is not recorded separately. A cash discount is allowed to a customer if he makes the payment before a specific date. Discount received is really in the nature of interest received and similarly, discount allowed means the interest paid. Discount received is a gain and is credited to the Profit and Loss Account while discount allowed is debited.

Bad Debts

When a customer fails to pay the amount due from him and all hopes of recovering the amount are lost, it is said to be a bad debt. It is a loss to the firm.
Therefore, the bad debts account is debited, which is later on debited to Profit and Loss A/c. Since it is no use showing the amount due still as an asset, the customer’s account is closed by being credited. The entry

Bad Debts Account Dr.

To Debtor’s (by name) Account

If the amount is recovered later, it should be recognised as a gain. It should not be credited to the party paying it. The recovered amount should be credited to Bad Debts Recovered Account. It will be entered in the Profit and Loss Account on the credit side.