The Profit and Loss Account

1. The Profit and Loss Account Geoff Leese Sept 1999 revised Sept 2001, Jan 2003, Jan 2006, Jan 2007, Jan 2008, Dec 2008 (special thanks to Geoff Leese)

2. Profit and Loss Account • A profit and loss account is a summary of business transactions for a given period - normally 12 months. By deducting total expenditure from total income, it shows on the "bottom line" whether your business made a profit or loss at the end of that period. • A profit and loss account is produced primarily for business purposes – to show owners, shareholders or potential investors how the business is performing. But most of the information is also used by the Inland Revenue to work out your tax bill.

3. Trading Account • That part of the profit and loss account where the cost of goods sold is compared with the money raised by their sale to arrive at the gross profit • This gives a view of the business in terms of sales and viability of profit

4. Retail trading account for Nov £ £ Sales 50 000 Opening stock 12 000 Purchases 30 000 42 000 Less closing stock 15 000 Cost goods of sold 27 000 Gross profit 23 000

5. Yearly Profit and Loss • By law, if your business is a limited company or a partnership whose members are limited companies, you must produce a profit and loss account for each financial year • Self employed sole traders and most partnerships don’t need to create a formal profit and loss account - the information they complete on the self assessment tax return form amounts to the same thing • However, there are key benefits to producing formal accounts. If you are looking to grow your business, or need a loan or mortgage, for example, most institutions will ask to see three years’ accounts

6. Keeping accurate records • By law business must keep accurate records of income and expenditure. Keep self-employment records for five years and limited company/partnership records for six years after the latest date your tax return is due • Accurate record keeping has important benefits. It: • gives information to manage your business and make it grow • enables reporting on profit/loss easily and quickly when required • will improve your chances of getting a loan or mortgage • makes filling in your tax return easier and quicker • helps you or your company avoid paying too much tax • provides back-up for claims for certain allowances • helps you plan and budget for tax payments • prevents interest or penalties for late tax payments • helps reduce accountant fees - your annual accounts will be far easier to produce

7. The basic records you will need to keep are: • a list of all your sales and other income • a list of all your expenditure, including day-to-day expenses and equipment • a separate list for petty cash expenditure if relevant • a record of goods taken for personal use and payments to the business for these • for limited companies: a record of money taken out for personal use or paid in from personal funds • back-up documents for all of the above • You will need the information above to create your profit and loss account

8. The Profit and LossAccount The profit and loss statement shows the trading performance of the business and the distribution of profit. Profit is not equivalent to cash in bank Income Customer sales, profit/loss from sale of tangible fixed assets, “non operating” income, investment income Expenses Variable (direct) costs, Fixed (overhead) costs, interest paid, depreciation allowance on tangible fixed assets Distribution Drawings/dividends, retained profit

9. Profit and Loss accountMeasuring profit Income Expenses The profit and loss statement shows the trading performance of the business and the distribution of profit. Net Profit Drawings or dividends Increase in assets Retained profit

10. Or measuring loss Turnover Costs Net Loss Drawings or dividends Decrease in assets Retained loss

11. SIMPLE COMPANY LTD - Profit and loss account for year ending 31.12.08 £ Turnover 950,000 Cost of sales (Direct costs) 525,000 Gross profit 425,000 Expenses (Overheads) 325,000 Other Costs (Depreciation) 10,000 Operating profit 90,000 Non-operating income 24,000 Interest payable 15,000 Profit on ordinary activities beforetaxation/Net profit 99,000 Corporation tax 22,500 Profit after tax 76,500 Dividends 30,000 Retained profit for the period 46,500 Trading account Profit and LossAccount AppropriationAccount

12. Cost of sales (Direct costs) £ £ Production wages 110,000 Material costs Opening stock 01.01.08 110,000 Plus purchases during the year 500,000 610,000 Less closing stock 31.12.08 195,000 415,000415,000 Cost of Sales 525,000

13. Expenses (overheads) £ £ Wages and salaries (admin) 140,500 Heating and lighting 35,500 Rent and rates 40,000 Telephone 10,000 Advertising 16,000 Car expenses 42,000 Printing and stationery 17,000 Accountant fee 5,000 Insurances 10,000 Provision for bad debts 9,000 325,000 Other Costs Depreciation 10,000 335,000

14. Depreciation • Fixed assets such as cars, computers, and machinery are not treated the same as other expenses. • Instead of being offset against revenue in the year of purchase, a proportion of the purchase value is allowed as an expense each year over the life of the asset. • At the end of the useful life of the asset, it is disposed of (scrapped or sold) and added into the P&L account as non operating income Typical example Computer £ 1100, life of 3 years, expected to make £50 at disposal Depreciation (£1100-£50)/3 = £350 per year

15. Interest and charges £ £ • Non-operating income • Interest on bank accounts 24,000 • Other investment income 0 • 24,000 • Interest payable • Loan interest 12,000 • Overdraft charges 3,000 • 15,000

16. Taxable amount for inland revenue returns Simple Home Trader P&L Accountfor year ending March 31st 2008 Consultancy fees £17,700 Overheads Depreciation £2150 Overdraft cost £80 Car expenses £1500 Other transport £550 Telephone £430 Stationary £700 Insurance £350£5,760 Net Profit £11,940 Drawings £7,000 Net profit retained in business£4,940

17. Financial Ratios (Profitability) Monitoring direct costs (manufacturing companies) • Gross profit margin = Gross profit / sales • Cost of materials (%) = materials costs / sales • Cost of labour (%) = labour costs / sales Monitoring overhead costs • Net profit margin = Net profit / sales • Overhead cost (%) = Overhead costs / sales

18. Simple Company Limited profit ratio analysis Year 2008 2007 2006 • Turnover 950,000 800,000 700,000 • Cost of sales (Direct costs) 525,000 500,000 450,000 • Gross profit 425,000300,000 250,000 • Expenses (Overheads) 325,000 200,000 150,000 • Other Costs (Depreciation) 10,000 12,000 15,000 • Operating profit 90,000 88,000 85,000 • Non-operating income 24,000 20,000 20,000 • Interest payable 15,000 16,000 17,000 • Profit on ordinary activities beforetaxation/Net profit 99,000 92,000 88,000 • Corporation tax 22,500 20,000 18,000 • Profit after tax 76,500 72,000 70,000 • Dividends 30,000 28,000 30,000 • Retained profit for the period 46,500 44,000 40,000 • Gross profit margin 44.7% 37.5% 35.7% • Overhead cost 34.2% 25% 21.4% • Net profit margin 10.4% 11.5% 12.6%

19. Further Reading • Dyson, J.R. (2001); Accounting for Non-accounting Students (5th edn); Prentice-Hall (other editions exist) • Chapter 3 (Covers book-keeping) • Chapter 4 (Covers Profit and Loss and Balance Sheet) • Chapter 5 (Covers adjustments) • Chapter 6 (covers all of these in a company context) A substantial amount of reading – some 100 pages in all. But necessary.