The profit and loss account is a record of earnings, expenditures and profits for a business entity in a given period also known as the accounting period.
A profit and loss account is to be prepared every year based on the financial information of the previous financial year. This report is prepared using the books of accounts, balance sheet, and statement of change in equity.
Before preparing a profit and loss account, a bookkeeper has to finish several tasks and close nominal accounts.
So let’s dive in to understand how to proceed with preparing the profit and loss account after making adjustments to accounts and books of accounts.
Salaries are considered an expense, they are recorded as part of the operating expenses section of the profit and loss account. This is because salaries are typically incurred to support the overall operations of a business and are not directly related to the production or sale of a specific product or service.
Salaries are paid for the services of employees and are debited to the profit and loss account as an indirect expense. If any salary has been paid to proprietors or partners, it should be shown separately because it requires special treatment during income tax assessment.
Salaries are usually attributed to individuals in executive positions or those with fixed remuneration, while wages typically encompass compensation for non-executive employees who are paid by the hour or on a daily basis.
When the wages account is included with salaries, it is treated as an indirect expense and is taken into the profit and loss account.
Rent of the office shop showroom or godown is an indirect expense and is debited to the profit & loss account. However, the rent of the factory is debited to the trading account. When a part of the building has been sublet, the rent received should be shown on the credit side of the profit and loss account as a separate item.
4. Rates and Taxes
The treatment of rates and taxes in a profit and loss account is similar to that of salaries. Rates and taxes are usually considered indirect expenses incurred by the business in order to carry out its operations. These costs are necessary for the maintenance of a property or business premises.
Therefore, rates and taxes incurred during the accounting period are recorded as expenses in the profit and loss account. This reduces the net income or profit of the business for the period, which is often used to calculate various financial ratios such as return on investment (ROI), earnings per share (EPS) or operating margin.
The company is responsible for paying interest on loans, overdrafts, and past-due bills. Because it is an indirect item, it is recorded as a debit to the profit and loss statement. Depositor interest earned on loans granted by the business is a source of revenue for the firm and is recorded as a profit in the company’s profit and loss statement.
Suppose the business has paid any interest on capital to its proprietor or partners. In that case, it should also be debited separately in the profit and loss account because this item needs special treatment at the time of income-tax assessment.
In business, agents are sometimes appointed to effect sales, who are paid commission as remuneration. So this being a selling expense is shown on the debit side of the profit and loss account. Sometimes a commission is also paid on purchases of goods; such expenses should be debited into the trading account.
Sometimes the firm can also act as an agent to other business houses, and in such cases, it receives a commission from them. Commission so received is shown on the credit side of the profit and loss account.
7. Trade Expenses
They are also termed as ‘sundry expenses. Trade expenses represent expenses of such a nature for which it is not worthwhile to open separate accounts. Trade expenses are not taken into the trading account.
Repairs to the plant, machinery, and building are indirect expenses that are treated expenses and are debited to profit and loss accounts.
9. Travelling Expenses
Unless mentioned otherwise, travelling expenses are treated as indirect and debited to profit and loss accounts.
10. Bad debts
It is the amount that could not be recovered by the trader on account of credit sales. It is a business loss, so it is debited into the profit and loss account.
11. Insurance Premium
If the insurance premium account appears in the trial balance, it stands for the business’s insurance. This is taken to profit and loss accounts. Insurance premiums on goods purchased, factory building, and factory machines are treated as direct expenses and are taken to the trading account.
12. Income Tax
In the case of merchants, income tax paid is treated as a personal expense and is shown by way of deduction from the capital account. Income tax, in the case of companies, is treated differently.
13. Discount allowed and Received
A discount is a reward for prompt payment. It is believed to show discounts received, and discounts allowed separately on the credit and debit side of the profit and loss account, respectively, instead of showing the net balance of this account.
When a company uses fixed assets during its operations, it incurs a loss known as depreciation. In most cases, it is deducted from the profit and loss account at a predetermined proportion. Regarding the pace of depreciation, the pupils should take extreme caution. If the rate is expressed without the words “per annum,” the rate will be applied regardless of the accounting period. When the term of accounting is shorter than a year, this is crucial to remember.
For example, if the depreciation rate is ‘per annum,’ the depreciation on the assets must consider how long the asset has been in use throughout the year when computing the depreciation on the assets. If assets are added throughout the year, it is recommended that depreciation on the additions be ignored if the dates of the additions are not specified. The same rule will apply to any assets that are sold throughout the year.
15. Stock at the end appears in the trial balance
It is important to emphasise that the balance appearing in the trial balance is taken to one and only one place. It may be a trading account, profit and loss account, or balance sheet. Since stock at the end is an asset, it will be taken to the balance sheet. On the other hand, so long as there is stock in trade, account for that must be kept open and thus be taken to the assets side of the balance sheet.