Mr. E’s best selling guide to constructing a profit and loss account
All businesses have to produce accounts, either for the taxman[1] or to be published so anyone (potential investors, for example) can see how the business has performed (limited companies.). They may also produce them as part of their internal management and control.
Like most financial documents the profit and loss account is set out in a particular way. Some of the terms mentioned below do have different names. The ones used here are the ones the IB will use in your exam. So get used to them.
This is not complicated, but it does involve a lot of new terms used in a very specific way. (and if you think this is bad, wait until we get to the Balance sheet).
The profit and loss account is an historical record of how the business has done (usually) in the last year. It is, technically, three different things:
The Trading account (What we sell and buy)
The Profit and Loss account (How much is left as profit)
The Appropriation account (What happens to the profit.)
They are usually lumped together, and collectively known as the profit and loss account.
They would usually be set out with using two (or three) columns. The left hand one is a description of what is being shown, and the other(s) show the value of it. They are usually annual, but certainly do not have to be.
Step 1 The Trading account
This is the record of what the business has sold, and the cost of buying the raw materials needed. So, it starts with the amount sold in the last year.
Sales revenue 105,000,000
Then we take off the cost of ‘buying in’ the materials that we added value to and then sold.
Sales revenue 105,000,000
Less Cost of Goods Sold (COGS) 65,000,000
This is usually shown as a final figure, but is calculated as follows….
Opening Stock (The stock you had left over from last year) 12,000,000
+ Purchases (The stock you bought through the year) 58,000,000
70,000.000
Less Closing Stock (The stock you didn’t manage to sell. 5,000,000
65,000,000
Finally we show the answer to the sum, which is called Gross profit.
Sales revenue 105,000,000
Less Cost of Goods Sold (C.O.G.S.) 65,000,000
Gross Profit 40,000,000
Step 2 The Profit & Loss account
This follows directly on from the trading account. It takes away all of the other expenses of the business. In published accounts these will be shown as one item ‘expenses’, but for internal use they will be shown as individual items. Why should this be? For published accounts it would look like…
Sales revenue 105,000,000
Less Cost of Goods Sold (COGS) 65,000,000
Gross Profit 40,000,000
Less expenses 15,000,000
Expenses include things like: advertising; heating; wages; insurance; office; transport. The list is endless. It does not include the purchasing of assets (These are capital expenditure and go in the balance sheet.) A good rule to use is “If I have to keep on paying for it to use it, then it is an expense, if I pay once and can keep using it, then it goes in the balance sheet.” So, for example, rent is an expense, but a building you own would appear in the balance sheet.
One of the things included in expenses is depreciation. This is profit put aside to replace old and knackered machinery. More on this anon.
Finally (again) we complete the sum.
Sales revenue 105,000,000
Less Cost of Goods Sold (COGS) 65,000,000
Gross Profit 40,000,000
Less expenses 15,000,000
Net Profit before interest & tax 25,000,000
Step 3 The Appropriation Account
This shows what happens to all of that lovely profit we made. There are several places profit can go to. First, we need to pay back interest on money we may have borrowed, and any tax to the Government. What’s left is called (unimaginatively!) profit after interest and tax.
Sales revenue 105,000,000
Less Cost of Goods Sold (COGS) 65,000,000
Gross Profit 40,000,000
Less expenses 15,000,000
Net Profit before interest & tax 25,000,000
Less Interest 4,000,000
Less tax 8,000,000
Profit after interest and tax 13,000,00
Nearly there! Next the owners take their slice (Drawings in an unlimited liability business, and dividend in one with limited liability.), and what is left is called retained profit. This is profit kept in the business to allow it to grow.
Sales revenue 105,000,000
Less Cost of Goods Sold (COGS) 65,000,000
Gross Profit 40,000,000
Less expenses 15,000,000
Net Profit before interest & tax 25,000,000
Less Interest 4,000,000
Less tax 8,000,000
Profit after interest and tax 13,000,00
Dividend 6,000,000
Retained Profit 7,000,000
Oh, and finish with a double underline to show me that you have actually finished!
[1] Yes I know tax officers can be women too, but the phrase is taxman, so get over it!