Profit and Loss Account: Definition

A profit and loss (P&L) account shows the annual net profit or net loss of a business. It is prepared to determine the net profit or net loss of a trader. The P&L account is a component of final accounts.

Explanation

A profit and loss account is prepared to determine the net income (performance result) of an enterprise for the year/period. This is the most significant information to be reported for decision making.

Net income or net profit is calculated by charging all operating expenses and by considering other incomes earned in the form of commission, interest, rent, discounts, and fees.

In fact, the profit and loss account is prepared by following the accrual system of accounting, in which gross profit and other operating incomes are credited and all operating expenses are debited.

The resulting effect is either net profit or net loss. If the total amount of gross profit and other operating incomes exceeds the operating expenses, the difference is treated as net income or net profit.

By contrast, if the total amount of gross profit and other operating incomes is less than the operating expenses, then the difference is treated as a net loss.

The following items usually appear on the debit and credit side of a profit and loss account.

On the debit side:

  1. Gross loss (transferred from trading account)
  2. All indirect expenses

On the credit side:

  1. Gross profit (transferred from trading account)
  2. All indirect revenues

Net Profit or Net Loss

Net profit or net loss is the difference between the total revenue for a certain period and the total expenses for the same period.

A company reports net profits when its total revenues exceed its total expenses. If the value for total revenues is less than the total expenses, a net loss is incurred.

The resulting balance at the bottom of a profit and loss account (see below) represents either a net profit or net loss that will be transferred to the capital account.

Format of Profit and Loss Account

Profit

If it is prepared in the form of a statement, it appears as shown below.

Income

Notes:

  1. In a partnership, net profit or net loss should be transferred to the partners’ capital accounts in accordance with the agreed profit sharing ratio.
  2. When preparing an income statement, it is customary to prepare one single statement combining trading A/c and profit A/c items, including the respective stages, to ascertain gross profit/gross loss and net profit/net loss.

How Are Related Items Transferred to the Profit and Loss Account?

When preparing a profit and loss account, it is important to remember that closing entries are made at the end of each accounting period. The aim is to transfer the indirect expenses and indirect revenue accounts to the profit and loss account.

These closing entries are made in the general journal (journal proper). After making closing entries, the balances of these accounts disappear from the ledger. This is because they are closed and transferred to the profit and loss account.

Closing Entries to Transfer Different Items in Profit and Loss Account

1. For debit side items:
Closing

2. For credit side items:

Closing

3. For net profit:

Closing

4. For net loss:

Closing

Note: In the case of a partnership enterprise, the net profit or net loss is shared according to the partner’s profit-sharing ratio. Therefore, the amount of profit or loss associated with a partner will be transferred to their capital account.

Example

From the following trial balance of John and Co., prepare the trading and profit and loss accounts for the year ended 31st December 2019.

John

The closing stock was valued at $32,000.

Solution

John

Example 2

From the following ledger balances extracted from the books of Mr. Bharath, prepare a profit and loss account as on March 31, 2019.
Mr

Solution

Profit and Loss Account for Mr. Bharath
for the Year Ended 31st March 2019

Mr

Statement of Profit and Loss Account for Mr. Bharath for the Year Ended 31st March 2019

Mr

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