Profit & Loss Account (P&L A/c)

Q. What is a Profit & Loss Account? Explain P&L A/c objectives and importance.

According to Prof. Carter, "A Profit and Loss account is an account into which all gains and losses are collected in order to ascertain the excess of gains over the losses or vice versa".

It must be remembered that expenses relating to the owner or partners are not to be accounted for in the Profit and Loss A/c of the firm. They are personal expenses and hence are transferred to the Drawings A/c of the owner or partners. These expenses are usually (i) Life insurance premium, (ii) Income tax, and (iii) Household or personal expenses.

Objectives of preparing Profit & Loss P&L A/c

1. Provides information about Net Profit;
2. Comparison of current year's income with that of the previous year's can be made;
3. Concrete steps may be taken to increase the net profit in future through analysis of expenses.
4. Proper allocation of net profit can be made among partners and provision for various types of Reserves as also for Research and Development programs can be made.

Importance of Profit & Loss (P&L A/c) Account

The purpose and importance of preparing Profit and Loss Account is as under:

1. The purpose of preparing profit and loss account is to ascertain the amount of net profit or net loss. This is the actual profit available to the proprietor and credited to his capital account. In case of net loss his capital account will be debited. The net profit is calculated after charging all indirect expenses.
2. It is an index of the profitability or otherwise of the business. The profit figure disclosed by the profit and loss account for a particular period can be compared with that of the other period. Thus, it helps in ascertaining whether the business is being run efficiently or not.
3. An analysis of various expenses included in the profit and loss account and their comparison with the expenses of the previous periods helps in taking steps for effective control of the various expenses.
4. The net profit is matched with the net sales to calculate net profit ratio'. This ratio is compared with the desired ratio and if there is any short-.coming, that will be removed. Similarly expenses ratio to sales is calculated. It will always be in the interest of the firm that the expense ratio should be the minimum.
5. Allocation of profit among the different periods or setting aside a part of the profit for future contingencies can be done. The amount of provisions, reserves and funds to be maintained depends upon net profit earned by the firm.
6. We can adopt effective future line of action on the basis of information available from profit and loss account regarding net profit and other expenses.

Last but not the least, we compare our actual performance with our planned and desired performance, identify weaknesses and try to remove them.

Trading and Profit & Loss Account
for the year ended ---

Q. What are the basic requirements of preparing Profit & Loss Account?

Profit and loss account should be prepared in such a manner as to clearly disclose the results of the working of the company during the period covered by the account. It should also disclose every material feature including credits or receipts and debits or expenses in respect of non-recurring transactions or transactions of an exceptional nature. It should also disclose various items relating to income and expenditure of company under proper headings. And where need be the detailed information of certain items can be given in separate schedules, which then form part of the profit and loss account. As in the case of the balance sheet, figures for the immediately preceding financial year for all items shown in this account have also to be given. In short the following principles govern the preparation of Profit & Loss Account:

1. Materiality: It means the relative importance of an item or amount in a given situation. Thus all significant points, which are likely to influence the investment, decisions or otherwise of various users of this statement must be disclosed. For example, if large quantities of raw materials are sold resulting in the considerable profit or loss, such a sale should not be included in the Sales Account. Instead, profit or loss on this item must be shown separately. What is material or not will depend on individual case.
2. Prior-period items: They may be defined as material charges or credits which arise in the current accounting period as a result of errors and omissions in the preparation of financial statements of one or more prior periods. As a rule the profit and loss account should disclose the working of the company during a particular year. It is therefore imperative that items of income and expenditure must pertain to that year only. When the provision for expenses made during the previous year is less than the actual expenditure during the year, the excess of expenditure over the provision made during the previous year, should be disclosed in the profit and loss account separately, if it is material in natures. For example salaries of the University employees have been revised with effect from January 1996 but the decision was taken only in March 1998. The increased salaries for 1997-98 can certainly be absorbed in the 1997-98 salaries but the increased salaries for three months of 1996-97 will also have to be accounted for and instead of clubbing them with the salaries of the current year, they should be shown separately. ICAI opines that prior period items should be stated in the profit and loss appropriation' section when profit and loss account is prepared in a horizontal (account) form. In the case 6f profit and loss account prepared in the vertical form, the same purpose can be achieved by arriving at current year's result and thereafter adding or deducting therefrom, as the case may be the prior year items. [Compendium of Opinions 2nd Ed. p. 29]
3. Extra-ordinary items: AS-5 defines such items as gains or losses which arise from events or transactions that are distinct from the ordinary activities of the business and which are both material and expected not to recur frequently or regularly. For example, profit or loss from the sale of fixed assets or speculation gains or losses are unusual items not connected with the ordinary activities of the business. Though such items should be shown in the profit and loss account as a part of net income but the nature and amount of each such item should be disclosed separately in a manner that their relative significance and effect on the current operating results can be easily seen.
4. Change in accounting policies: A change in accounting policy such as method of inventory valuation or change in rate or method of depreciation should be disclosed with its effect on profit or loss resulting from such a change. AS-5 recommends that a change in accounting policy should be made if the adoption of a different accounting policy is required by the statute or for compliance with an accounting standard or if it is considered that the change would result in a more appropriate preparation or presentation of the financial statements of an enterprise.
5. Accrual basis of accounting: Section 209 (3) requires every company to keep its books of account on accrual basis and follow the double entry system of accounting popularly known as mercantile system of accounting which alone discloses a true and fair view of the state of affairs of a company. The accrual basis of accounting records the financial effects of the transactions, events and circumstances of an enterprise in the period in which they occur rather than recording them in the periods in which cash is received or Raid by the enterprise. The main objective of the accrual basis of accounting is to relate the accomplishments (measured in the form of revenues) and the efforts (measured in terms of cost) so that the reported net income reflects the performance of the enterprise during a period rather than being a mere listing of its cash receipts and payments [ICAI: Guidance Note' on Accrual Basis of Accounting

Main contents of profit and loss (P&L A/c) account

1. Turnover or Sales: The aggregate amount for which sales are affected by' the company and connected items with the turnover such as commission paid to sole-selling agents [Section 294];- and other selling agents and brokerage and discounts on sales other than usual trade discount.
2. Cost of sales, stocks and work-in-progress: The details in respect of these items are to be given as : (a) the purchase of raw materials and the opening and closing stock of the goods produced for a manufacturing concern;(b) in the case of trading concerns, 'the purchases made and the opening and closing stocks. The term raw materials would include materials, which physically enter into the composition of the finished goods. Monetary and quantitative information regarding opening and closing stocks have to be given in respect of each class of goods. In addition, the opening and closing balances of work-in-progress are also to be given.
3. Stores, power, rent, repairs, salaries etc.: These are to be stated separately as the consumption of stores; power and fuel, rent, repairs to building, machinery; salaries, wages and bonus; contribution to provident fund and other funds-staff and workmen welfare-rates and taxes etc.
4. Depreciation: The amount provided for depreciation, renewals, diminution in the value of fixed assets and the method adopted for such a provision, where no such provision is made and the details regarding arrears of depreciation as per Section 205(2) shall be disclosed by way of foot note.
5. Interest on loans and debentures: Interest on different types of loans and company's debentures has to be stated separately. It will include the amount of interest paid as well as payable.
6. Miscellaneous expenses: This head includes items such as rent, rates and taxes, insurance premium etc., which must be stated separately. It is provided that in case an item exceeds one per cent of total revenue of the company or Rs. 5,000, whichever is higher, such an item should be shown as a separate and distinct item in the profit and loss account.
7. Managerial remuneration: The payments made to directors or managers of the company have to be stated in the profit and loss account in the form of managerial remuneration, other allowances and commission, directors' fees, pension, gratuities, etc.
8. Payments to auditors: The payments made to auditors as auditors and in any other capacity must be stated separately. This will include audit fees, consultancy fees for taxation matters, company law matters, and management services and in any other matter etc.
9. Payment of-interim relief: Interim relief is normally given to employees till the final settlement of wages. At the time of final settlement, the amount of interim relief is absorbed or merged with the final regular wages. Thus the interim relief granted to the employees is normally not in the nature of an advance, as the said amount is not deducted from the wages of the employees after final settlement. Accordingly the amount in respect of interim relief should be treated as an expense in the year in which it is paid under the appropriate head and is not to be treated as an advance.
10. Premium paid on insurance covering gratuity liability: The premium of LIC policy taken for covering the gratuity liability is worked out by the actuarial valuation of increase in gratuity liability during the year; it is not based on time factor. As the premium is not based on time factor, the premium paid may be debited to the profit and loss account for the year. There IS no question of prepaid premium.

Dividends remitted in foreign currency: According to ICAI, the disclosure of dividends remitted in foreign currency during the year should be made on cash basis.