i n t r o d u c t i o n t o t h e p r o f i t a n d l o s s a c c o u n t

Richard Bowett introduces the important concept of the profit and loss account:
Introduction - the Meaning of Profit
The starting point in understanding the profit and loss account is to be clear about the meaning of"profit".
Profit is the incentive for business; without profit people wouldn'tt bother. Profit is the reward for taking risk; generally speaking high risk = h igh reward (or loss if it goes wrong) and low risk =
low reward. People wont take risk s without reward. All business is risky (some more than others) so no reward means no business. No business means no jobs, no salaries and no goods and
services.
This is an important but simple point. It is often forgotten when people complain about excess ive profits and rewards, or when there are appeals for more taxes to pay for eg more policemen on
the streets.
Profit also has an important role in allocating resources (land, labour, capital and enterprise). Put simply, falling profits (as in a business c oming to an end eg black-and-white TVs) signal that
resources should be taken out of that business and put into another one; rising profits signal that resources should be moved into this business. Without these signals we are left to guess as to
what is the best use of societys scarce resources.
People sometimes say that government should decide (or at least decide more often) how much of this or that to make, but the evidence is that governments usually do a bad job of this e.g. the
Dome.
The Task of Accounting - Measuring Profit
The main task of accounts, therefore, is to monitor and measure profits.
Profit = Revenue less Costs
So monitoring profit also means monitoring and measuring revenue and costs. There are two parts to this: -
1) Recording financial data. This is the book-keeping part of accounting.
2) Measuring the result. This is the financial part of accounting. If we say profits are high this begs the question high compared to what? (You can look at this idea in more detail when
covering Ratio Analysis)
Profits are spent in three ways.
1) Retained for future investment and growth.
2) Returned to owners eg a dividend.
3) Paid as tax.
Parts of the Profit and Loss Account
The Profit & Loss Account aims to monitor profit. It has three part s.
1) The Trading Account.
This records the money in (revenue) and out (costs) of the business as a result of the business trading ie buying and sell ing. This might be buying raw materials and selling finished goods; it
might be buying goods wholesale a nd selling them retail. The figure at the end of this section is the Gross Profit.

2) The Profit and Loss Account proper
This starts with the Gross Profit and adds to it any further costs and revenues, including overheads. These further costs and revenues are from any other activities not directly related to trading.
An example is income received from investments.
3) The Appropriation Account. This shows how the profit is appropriated or divided between the three uses mentioned above.
Uses of the Profit a nd Loss Account.
1) The main use is to monitor and measure profit, as discussed above. This assumes that the information recording is accurate . Significant problems can arise if the information is inaccurate,
either through incompetence or deliberate fraud .
2) Once the profit(loss) has been accurately calculated, this can then be used for comparison ie judging how well the busines s is doing compared to itself in the past, compared to the managers
plans and compared to other businesses.
3) There are ways to fix accounts. Internal accounts are rarely fixed, because there is little point in the managers fooling themselves (unles s fraud is going on) but public accounts are
routinely fixed to create a good impression out to the outside world. If you unders tand accounts, you can usually (not always) spot these fixes and take them out to get a true picture.
Example Profit and Loss Account:
An example profit and loss account is provided below:
'000 '000
Revenue 12,500 10,000
Cost of Sales 7,500 6,000

Gross Profit 5,000 4,000
Gross profit margin (gross profit / revenue) 40% 40%

Operating Costs
Sales and distribution 1,260 1,010
Finance and administration 570 555
Other overheads 970 895
Depreciation 235 210
Total Operating Costs 3,035 2,670

Operating Profit (gross profit less operating costs) 1,965 1,330
Operating profit margin (operating profit / revenue) 15.7% 13.3%

Interest (450) (475)

Profit before Tax 1,515 855

Taxation (455) (255)

Profit after Tax 1,060 600

Dividends 650 400

Retained Profits 410 200


The proflt und loss uccount (P & L), culled the lncome stutement ln the US, shows
the proflt or loss u compuny hus mude over u perlod of tlme. The rutlos lnvestors
look ut most often, such us the PE und yleld, ure culculuted uslng numbers from the
P & L.
In u slmple cuse the proflt or loss equuls the lncreuse or decreuse ln the compuny's
ussets us shown on the bulunce sheet. Thls ls rurely exuctly true und the stutement
of totul recognlsed gulns und losses reconclles the P &L to the chunges
ln equlty shown on the bulunce sheet
The P & L cun be mlsleudlng und there ure u number of uccountlng technlques thut
cun shlft losses (or gulns, ulthough thut ls rurer) from the P & L to the bulunce sheet.
The P & L should be looked ut ln con|unctlon wlth the notes, the cush flow
stutement (whlch ls hurder to munlpulute) und the other uccountlng stutements.
The shortest posslble P & L would be: sules less costs = totul proflt.
In uccordunce wlth the uccruul prlnclple, costs und revenues ure mutched so thut, for
exumple, sules und purchuses mude on credlt durlng u yeur, but perhups not yet puld
for, wlll be lncluded ln the P & L for the yeur.
The proflt und loss uccount ls structured to provlde u reusonubly conclse breukdown
of costs und, to u lesser extent, revenues. Thls leuds to the generul form of u P & L
thut looks somethlng llke thls:
Sales
Also called revenues. Not always synonymous with turnover. Revenue
recognition is not always simple.
Cost of sales The direct costs of things sold
Gross profit Sales minus cost of sales
Other operating
expenses
Depreciation, admin, marketing etc.
Operating profit Gross profit less other expenses
Interest costs Interest payable less receivable
Pre-tax profit Operating profit less interest
Tax

Profit after tax Pre tax profit less tax
Dividends

Retained profit Profit after tax less dividends
Earnings per share


The most detulled proflt und loss uccount ls glven ln the unnuul report, but UK llsted
compunles ure requlred to muke unnuul und hulf yeur results unnouncements us
well. The full yeur results unnouncement ls shorter und covers the sume perlod us
the unnuul report, but lt ls releused eurller.
0uny compunles muke quurterly unnouncements, us compunles ln the US und muny
other countrles ure requlred to. Unsurprlslngly, UK llsted compunles thut ulso huve
u secondury or duulllstlng ln u country thut requlres quurterly unnouncements.
As cun be seen, the P & L contulns severul proflt numbers. Euch of these glves us
dlfferent, und useful, lnformutlon. In uddltlon, the P & L (perhups together wlth other
lnformutlon) usuully glves us enough lnformutlon to culculute severul other proflt
numbers such us EBITDA und EBITA
0uny compunles wlll show exceptlonuls sepurutely. If there were uny dlscontlnued
buslness, or pluns to dlspose of u buslness wlthln u short perlod, these ure ulso
shown sepurutely.
These cun glve lnvestors u better ldeu of the underlylng buslness (the |ustlflcutlon
for dolng lt). For exumple, lf the compuny hus declded to sell u purtlculur operutlo n
und the prlce hus been ugreed, shureholders do not reully need to worry too much
ubout thut operutlon's performunce.
A group P & L wlll need to be consollduted, whlch requlres extru llnes such us those
for shure or proflt ln ussoclutes und |olnt ventures, und the deductlon of mlnorlty
lnterests.
As well us the vuluutlon rutlos, the P & L provldes the numbers for meusures of the
performunce und efflclency of the buslness, such us murglns, ROCE, und some
meusures of flnunclul stublllty such us lnterest cover.
The P & L ls buckwurd looklng und lnvestors wlll need to conslder correctlng some
ltems such usumortlsutlon thut ure not useful for modelllng future cush flows. From
un lnvestor's polnt of vlew the P & L ls essentlul, but cun be mlsleudlng und should
not be looked ut ln lsolutlon.
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