How to Prepare 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 of profit and loss accounts. Now here we shall discuss only practical aspects only.

The 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 the Profit and Loss Account. Incomes and gains, other than sales, will be entered on the credit side.

The expenses which are 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 the 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.

Items should be entered in the profit and loss account according to suitable heads and functionalities such as administration, selling and financing etc. The following are the main steps to prepare a profit and loss account:

1. Start with Revenue: Begin by listing all the revenues earned by the company during the specified period. This includes sales revenue, service fees, interest income, and any other income generated from core business operations.

2. Deduct Cost of Goods Sold (COGS): Subtract the cost of goods sold from the revenue to calculate gross profit. The COGS includes direct expenses incurred in the production or purchase of goods that are directly related to revenue generation.

3. Subtract Operating Expenses: Deduct operating expenses such as selling and distribution expenses, administrative expenses, research and development costs, and depreciation from gross profit. These expenses are indirect costs incurred in running the business.

4. Calculate Operating Profit or Loss: The result after deducting operating expenses from gross profit will be either an operating profit if revenues exceed expenses or an operating loss if expenses exceed revenues.

5. Account for Non-Operating Income or Expense: Include any non-operating items such as interest income or expense, gains or losses from investments or asset sales, and extraordinary items separately in this section.

6. Net Profit or Loss Calculation: Add or subtract non-operating income/expenses from operating profit/loss to calculate net profit before taxes.

7. Taxes: Deduct applicable taxes (e.g., corporate tax) to arrive at a net profit after taxes.

Following are clarifications of the treatment of certain items in the profit and loss account.

(1) Administrative Expenses

Administrative expenses are costs incurred by a company that is not directly attributable to the production of goods or services. These expenses include salaries, rent, utilities, office supplies, and other general operating costs.
In the profit and loss account (also known as the income statement), administrative expenses are typically grouped together with other operating expenses under a specific heading such as “Selling, General and Administrative Expenses” (SG&A) or “Operating Expenses.”

To properly account for administrative expenses in the profit and loss account, companies follow standard accounting practices. This involves recording these expenses in the period in which they are incurred. Following are examples of some administrative expenses:

• Rent and rates for the office premises
• Salaries paid to the people working in the general office;
• Printing and stationery
• Lighting in the office.
• Audit fees,
• Legal expenses.
• Postage, telegrams and telephone charges etc.

(2) Selling and Distribution Expenses

Selling and distribution expenses are costs incurred by a company that are directly related to the marketing, selling, and distribution of its products or services. These expenses include advertising, sales commissions, transportation costs, packaging materials, and other costs associated with delivering goods to customers.

• Commission to agents
• Salesmen’s salaries and commission
• Advertising.
• Packing expenses.
• Freight and carriage on sales.

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 a 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.

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. The discount received is a gain and is credited to the Profit and Loss Account while the 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.