Profit and Loss Account (P&L Account), or an income statement, contains financial data which business stakeholder groups find extremely useful. It shows the Sales Revenue, all business costs and profit or loss of a business over a given period of time. It is one of the Final Accounts.
Profit and Loss Account (P&L Account) is produced both for internal use and external use. Internally, managers need timely access to as much financial information as possible to make important business decisions. Externally, current shareholders and potential new investors need information to assess the performance of their investment, or make decisions whether to invest in this company or not.
Commonly, there are three sections each Profit and Loss Account (P&L Account) has. Each of those sections gives a different profit figure:
- Trading Account
- Profit and Loss Account
- Appropriation Account
The content of Profit and Loss Account (P&L Account) is laid down by specific regulatory bodies in each country. But it can be easily assumed that there will not be much differences between Profit and Loss Account (P&L Account) regardless of the country where the business operates.
1. Trading Account
Trading account is the first section of Profit and Loss Account (P&L Account). It shows how much Sales Revenue the business made, what the cost of production was and how much Gross Profit, or loss, has been made from normal trading activities. Specifically, it shows the difference between a firm’s Sales Revenue and its costs of producing or purchasing products to sell.
Sales Revenue
Sales Revenue is the value of products sold to customers. It is calculated as follows:
Sales Revenue = Price x Quantity
Example: Calculating Sales Revenue In 2021, the hamburger restaurants sold 1,000 burgers at USD$3 each. Question: How much was Sales Revenue? Sales Revenue = Price x Quantity Sales Revenue = USD$3 x 1,000 Sales Revenue = USD$3,000 Answer: So, this business generated USD$3,000 in Sales Revenue.
Cost of Goods Sold (COGS)
This position in Profit and Loss Account (P&L Account) can very simply be referred to as the cost production – Direct Costs or Variable Costs (VC). The cost of producing all those goods and/or services that were sold to customers during the financial year.
In a manufacturing company, Cost of Goods Sold (COGS) is the cost of goods manufactured (e.g. raw materials, wages for production workers, packaging, etc.) plus the beginning finished goods inventory minus the ending finished goods inventory. In a retail business, Cost of Goods Sold (COGS) is the beginning inventory plus the cost of buying goods from the manufacturer minus ending inventory. In a service business, Cost of Goods Sold (COGS) is the cost of the employee services rendered.
Cost of Goods Sold (COGS) = Opening Stock + Purchases – Closing Stock
Only the goods used and sold during the year will be recorded in Cost of Goods Sold (COGS), or cost of sales.
Example: Calculating Cost of Goods Sold (COGS) If the hamburger restaurant opens trading on January 1, 2021 with USD$1,000 worth of inventory (bread bums, vegetables and meat) and receives a delivery of stock for which it pays USD$3,000, then the business has costs of stock valued at $4,000. At the end of the trading year on December 31, 2022, it has USD$2,000 worth of stock remaining. Question: Using the formula, how much was Cost of Goods Sold (COGS)? Cost of Goods Sold (COGS) = Opening Stock + Purchases – Closing Stock COGS = USD$1,000 + USD$3,000 - USD$2,000 COGS = USD$2,000 Answer: The Cost of Goods Sold (COGS) is USD$2,000. This means that the cost of production in 2021 for this restaurant was USD$2,000.
The above Cost of Goods Sold (COGS) can be further broken down into more details:
Gross Profit
The very end of the trading account shows Gross Profit. Gross Profit is calculated by subtracting Direct Costs, or Variable Costs (VC) of trading from Sales Revenue:
Gross Profit = Sales Revenue – Cost of Goods Sold (COGS)
So, Gross Profit is the difference between Sales Revenue earned from selling products and the cost of making those products.
Example: Calculating Gross Profit In 2021, the hamburger restaurants generated USD$3,000 in Sales Revenue. The Cost of Goods Sold (COGS) in 2021, or the cost of production, wasUSD$2,000. Question: How much Gross Profit did this restaurant earn? Gross Profit = Sales Revenue - Cost of Goods Sold (COGS) Gross Profit = USD$3,000 - USD$2,000 Gross Profit = USD$1,000 Answer: The hamburger restaurant generated USD$1,000 Gross Profit in 2021.
Let’s take a look what Trading Account would look like now:
2. Profit and Loss Account
Profit and Loss Account is the second section of Profit and Loss Account (P&L Account). It shows two different profits. First, Net Profit Before Interest and TAX, or the operating profit. Second, Net Profit After Interest and TAX, or the profit for the year.
Expenses
Expenses are all Indirect Costs, or Fixed Costs (FC), of day-to-day running of a business organization.
Operating expenses are generally divided into Selling Expenses (e.g. advertising, salespeople’s salaries, travel, etc.) and General Administrative Expenses (e.g. managers’ salaries, rent, insurance, etc.).
Net Profit Before Interest and TAX
Net Profit Before Interest and TAX, or operating profit, is the actual profit made from a firm’s regular trading activities. It is the surplus at the end of a trading period that is left from Sales Revenue. Knowledge about Gross Profit is needed to calculate it in the following way:
Net Profit Before Interest and TAX = Gross Profit – Expenses
Net Profit Before Interest and TAX is the profit earned after all costs of production and expenses have been deducted from Sales Revenue. But before any Interest has been subtracted and TAX paid to the government.
Example: Calculating Net Profit Before Interest and TAX The hamburger restaurant generated USD$1,000 Gross Profit in 2021. The restaurant also has to cover expenses of USD$400 to run the business – pay rent and salary to the manager. Question: How much was Net Profit Before Interest and TAX? Net Profit Before Interest and TAX = Gross Profit - Expenses Net Profit Before Interest and TAX = USD$1,000 - USD$400 Net Profit Before Interest and TAX = USD$600 Answer: The hamburger restaurant generated Net Profit Before Interest and TAX of USD$1,000 in 2021.
Interest
Interest charged on bank loans is a cost as it represents the charge that a business pays to its lenders for loans.
TAX
Corporate TAX is the levy payable on a company’s Net Profit After Interest has been deducted. Net Profit After Interest and TAX will be lower when TAXes are raised. Limited companies pay Corporate TAX on their profits before they pay out dividends to shareholders.
Net Profit After Interest and TAX
Net Profit After Interest and TAX, or profit for the year, is Net Profit Before Interest and TAX minus Interest and Corporate TAX. Interest charges and TAXes, despite being business expenses, are shown as separate items. This is because both rates change over time being beyond the business’s control. Interest rates are set by central banks while TAX rates are set by the government.
Net Profit After Interest and TAX = Net Profit Before Interest – Interest – TAX
By having information about Net Profit After Interest and TAX, managers can make historical comparisons of financial performance.
Example: Calculating Net Profit After Interest and TAX The hamburger restaurant generated Net Profit Before Interest and TAX of USD$1,000 2021. The h restaurant also needs to pay monthly Interest if USD$100 on a small bank loan. The Corporate TAX rate for small businesses in the country is 20% which must be paid to the government. Question: How much was Net Profit After Interest and TAX? Net Profit After Interest and TAX = Net Profit Before Interest – Interest – TAX Net Profit After Interest and TAX = USD$600 – USD$100 – USD$100 Net Profit After Interest and TAX = USD$400 Answer: The hamburger restaurant generated Net Profit After Interest and TAX of USD$400 in 2021.
Let’s take a look what Profit and Loss Account would look like now:
3. Appropriation Account
Appropriation Account is the third and final section of Profit and Loss Account (P&L Account). It shows how Net Profit After Interest and TAX, or the profit for the year, is distributed between the owners. This is done in the form of paying out dividends to company shareholders. Any remaining amount will be kept in the business as retained earnings for future business growth to fund new projects.
Dividends
Dividend is a part of the Net Profit After Interest and TAX paid to the owners of the company (shareholders) as a return for investing in the company. Dividends are allocated based on the decision of The Board of Directors which must be approved at the company’s Annual General Meeting. Most of the companies which pay dividends pay them quarterly, while some pay biannually and some even pay monthly such as many Real Estate Investment Trusts (REITs).
NOTE! The figures about Dividends are transferred to Balance Sheet and shown under the section Current Liabilities.
Retained Profit
Retained earnings is the amount of profit left after all costs, Interest, TAXes and dividends have been paid out from Sales Revenue. Retained Profit is ‘ploughed back’ into the company as an internal source of finance. The business will use it for internal purposes such as expanding the business.
NOTE! The figures about Retained Profit are transferred to Balance Sheet and shown under the section Shareholder’s Equity.
The owners of any profitable business usually decide to reinvest some of the profits back into the firm instead of paying out everything to themselves.
Example: Calculating Retained Profit The hamburger restaurant generated Net Profit After Interest and TAX of USD$400 in 2021. The owner of the hamburger restaurant decided to split Net Profit After Interest and TAX of USD$400 that the company earned in 2021. He will keep USD$100 for himself as Dividend. Question: How much is Retained Profit? Answer: The owner will keep USD$300 as Retained Profit to reinvest back into the business. He is planning to buy a pizza oven next year to also sell pizzas as some of his customers want to buy both hamburgers and pizzas.
Let’s take a look what appropriation account would look like now:
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Here is the complete Profit and Loss Account (P&L Account) for our famous hamburger restaurant.
Therefore, in reality, combining the three parts of the account will produce the final Profit and Loss Account (P&L Account).
