Profit and Loss Account: Importance and Guidelines for Preparing A P&L Account

The Profit and Loss Account is a statement of income and expenditure for a given period, and the net amount of these two elements is known as the profit or loss for that company. It is prepared to assess whether the company has generated profit or loss through its activities. 

Normally, Profit and Loss Statements are prepared at the end of each accounting year. The accounting year, as defined by our accounting standards, starts on the 1st of April each year and ends on the 31st of March of the next year.

Importance of Profit and Loss Account

• Profit & Loss statements must be prepared under the Companies Act rules and regulations.
• It is a part of the Balance Sheet.
• The financial health and achievements of your business are assessed with this statement. You will know whether your business is earning profit or incurring losses through this statement. 
• It is the preliminary stage for preparing your Balance Sheet. 
• One should first arrive at the Profit or Loss figure before preparing the Balance Sheet of any company, as that figure is to be shown in assets or liabilities as the case may be.
• The Profit and Loss Statement is to be submitted along with the Balance Sheet for filing your tax returns and for Income-Tax assessments.
• Banks require this statement along with the Balance Sheet while sanctioning loans to business.

How to Prepare Profit and Loss Account

It is very simple to prepare a profit and loss statement. It is a summarised statement of expenses and incomes to derive the net result.

1. First of all, you need to balance each account in the Main Ledger or General Ledger of your business and copy them to the Trial Balance Sheet.
2. Then tally your Trial Balance.
3. On the basis of that trial balance, you can easily prepare a profit and loss statement. Enter all expenses in the expenditure column and all income in the income column. The net result will give you the profit and loss.
4. There are two types of preparation. One is horizontal P&L a/c, and the other is vertical P&L a/c.

Horizontal Profit and Loss Account Sample

              Income                                                   Expenditure

Sales                       5,000,000                        
                                                              Goods purchased            37,50,000

                                                              Freight/transportation         2,50,000

                                                              Labour charges                    50,000

                                                              Godown rent                       30,000

                                    _______                                                 _________      

                                    50,00,000                                                  40,80,000                                                                                                      
                                                             Gross/Trading Profit           9,20,000

                                         1) Staff salary                        1,80,000

                                                             2) Electricity         50,000

                                                              3) Stationery        30,000

                                                              4) Package charges  30,000

                                        5)  Sales promotion                    30,000

                                                            6) Other expenses      20,000

                                                                  Total (1 to 6)                   3,40,000

                                                                                   
                                                         Profit before interest/depreciation 5,80,000  

                                                             Interest on loans                      100000    

                                                             Depreciation of assets              180000

                                                                                                            2,80,000
                                                             NET PROFIT                         3,00,000    

The above is a sample format of profit and loss account prepared in horizontal format.

In a vertical format, you will start with sales income, and below it, all the expenses are mentioned in the same manner as in the above format. The three elements of Gross profit, Profit before Depreciation and Net profit will be calculated in the same manner and in the same column under income.

All expenses directly related to the production of goods are taken for calculating the Trading profit of the company. Then salaries and administrative expenses and sales promotion are taken to arrive at the net profit before interest and depreciation. Then, you can separately calculate profit after depreciation and profit after interest, if you want them separate, to get separate statistics for each element of cost.

It is customary to provide the figures of the previous year also in the profit and loss statements, to enable comparison with previous achievements.

Bank Reconciliation Statement- How to Tally Your Cash Book with Passbooks

Bank Reconciliation Statement

Bank reconciliation means reconciling your account book entries with the bank's records. Reconciliation is the process of tallying and aligning the records.

Every business keeps a bank account to make transactions easy. You can make transactions online, including receiving payments, making payments, and transferring funds, with the click of your mouse or a tap on the phone. Now, you are expected to record all these transactions in your books of account. Banks will automatically update your accounts with each transaction. But your entries are based on the vouchers prepared at your end. So, there can be slips in your entries.

Due to the enormous workflow, some omissions or commissions may occur at both ends in recording these transactions. Because even banks can make mistakes. 

So, you need to tally the entries from your books with your bank. This tallying of accounts is known as Bank reconciliation.

Importance of Bank Reconciliation Statements 

The need for a Bank Reconciliation statement arises due to the fact that at any particular point of time, the balances in your books may not tally with the Bank statement, as there can be time gaps.

 

Under such circumstances, you should prepare to explain the reasons for the differences at both ends. This is for your own balance confirmation and for explaining to the Board of Directors and auditors who check your accounts each year. 

So, it is important to prepare bank reconciliation statements regularly.

Reasons for Differences in Bank Books

There can be various reasons for differences in your Bank balance and the balance as per Bank Books. The most common reasons are:

1. You may have issued a cheque to one of your parties but not yet presented to the bank by the receiver of the cheque.
2. You deposited some drafts or cheques received from others into your account, but the bank did not collect those amounts and so not credited to your account.
3. Banks might have charged some bank charges, and the entries were not done in your books.

Above are common features which affect your bank balances. 

When you account for all these things, then only your balances tally with the bank passbook.

A Sample Format of Bank Reconciliation Statement

Generally, a typical bank reconciliation statement will project only cheques issued but not presented and deposits made but not collected as the only differences. 

All other discrepancies get sorted out and corresponding entries made in your books before closing your books.

• If the Bank debits any charges to you, you will account for them in your expenses and credit the Bank A/C. 
• If any interest is credited to your account, you will credit your income and debit the bank in your books.

But, there will be no corresponding entries for cheques issued but not presented or deposits made but not credited to your account. 

You can not reduce your expenses by reversing the cheques or reduce your receipts by reversing the deposits made into the bank. So these two items will stand in the Bank Reconciliation Statement as reasons for the differences between your Books and the Bank Books.

So a typical Bank Reconciliation Statement will be like this:

Balance as per our Books                  (say)         10,000 Dr.

Add:

Cheques issued but not presented     (say)           5,000

                                                 Total                  15,000 Dr.

Less:

Drafts deposited but not collected    (say)           3,000    

Balance as per Bank statement or PassBook     12,000 Dr.

In the reconciliation statement above, we are adding back the amounts of those checks issued by us (but not presented to the bank) because we already reduced our balance when we issued the checks. Similarly, we already increased our bank balance when the drafts were deposited into the bank. Therefore, we have to decrease the amount in the bank reconciliation statement (if the draft is not collected by the bank) to match the bank balance.

This is the general procedure for preparing a Bank Reconciliation Statement.

Trial Balance and its Importance in Accounts

A trial balance is a list of your account book balances mentioned in two columns- as debits and credits; the totals of which should tally.

The Trial Balance is named so because it is a trial to test whether you have entered your account books correctly. If the sheet tallies, you can confidently prepare your Profit & Loss and Balance Sheet Accounts.

Normally, trial balances are prepared each month to verify whether you entered your accounts correctly during that month. It is a kind of preliminary exercise. Though at times, your entries could be wrong, such as when you might have made a credit or debit entry correctly, but the corresponding entry might have been posted to the wrong account heads.

How to Prepare A Trial Balance

At the end of each month, you will draw the closing balances for each and every account in the primary accounting book known as the General Ledger or Main Ledger. When you do this, each account will show either a debit balance or a credit balance at the end of each month. Now, you can prepare a Trial Balance by writing down those balances on a sheet of paper, debits in one column and credits in the other.

You should depict the columns as below:

Particulars(Head of Account)        Ledger Folio                   DEBITS               CREDITS        

Now, enter all the balances of your accounts from the General Ledger into this sheet accurately, mentioning all the debit balances in the debit column and credit balances in the credit column. Enter the cash balance also on this sheet (taking it from the cash book) and then total both columns.

The totals of both debit and credit columns should tally. This is because, for each debit entry, there will be a corresponding credit entry in your books of accounts. 

If the totals do not tally, then you should know that there is some mistake either in your account books or in the balancing of the Ledger accounts, or maybe you have made a mistake while copying the balances from each page into the trial balance statement. So, you need to check all these points.

Importance of Trial Balance   

• Trial balance confirms the accuracy of all your debit and credit entries.
• It serves as a quick picture of your accounts.
• You can know the amount spent or incurred under each expenditure head or the amount received under each income head by looking into this trial balance statement for any particular period.    
• It is the preliminary stage for preparing your financial statements. You can prepare your Profit & Loss statement or Balance sheet statements with the help of this Trial Balance.  
• Other important documents, like Budget and Cost Sheets, are also prepared with the help of this trial balance.
• It serves as a managerial information statement for having a quick look at revenue, expenses, and income during any period.

What to Do if Trial Balances Do Not Tally 

If the Trial Balance does not tally, you should check the following factors.

1. Check/recheck the totals of both columns in the trial balance.
2. Compare the amounts of balances entered in the trial balance with your ledger and ascertain whether they were entered accurately.
3. Check whether the debit balance is entered correctly in the debit column and credit balance in the credit column of the sheet.
4. Check the balancing of each head in your General Ledger- whether it is correctly done or not.
5. If, in spite of all these verifications, the trial balance does not tally, then there can be mistakes in your original postings of accounts while entering them from your original bills and vouchers. 
6. So you need to check each and every entry done in your Main Ledger with their corresponding vouchers, which can take many days to locate the mistake.

Here is "A Smart Tip"

One simple trick, which may or may not work, is to take half of the amount (half of the difference between Debit and Credit side totals in the Trial Balance) and check for that half amount in your accounts. Whether any entry was done for such amount in your books. If there is an entry equal to that half amount, whether it has been wrongly entered on the debit side instead of the credit or vice versa. 

This method sometimes works and can save a lot of time and energy in locating the mistake. But it only works if you made one simple mistake of that kind. If you made many mistakes, it will not help much.                                             

Basic Records or Documents Needed for Building Your Accounts

Some fundamental records must be maintained to build any type of account, whether it is your Individual Account, Business Account, or any other field that attracts income tax. 

You cannot create or maintain an account without basic records that support your transactions. At least, you need to remember the nature and purpose of your payments and receipts. A scrap book where you note down as and when you bought something or received some money.

These basic records and documents 9for example, bills and receipts) are the most essential and important foundations for an accountant or auditor to create or maintain accounts and verify their authenticity.

Some of the essential documents are discussed below:

Purchase Bills

Bills for any purchases, whether you pay cash or credit, are to be safely maintained as your primary record. You make entries from these bills by preparing vouchers. I will discuss vouchers at a later stage. So, these bills should be kept safely either pinned to the vouchers or in separate files. 

If kept in files, you should maintain separate files according to the nature of transactions and the account head of that purchase and mark the files with their identity/nature. Or, you can simply arrange your bills and documents chronologically and mention the period on the file cover. 

In either case, you may pin the duplicate copies or xerox of the bills along with those vouchers. Keep original bills for record-keeping in their respective topic files for any urgent reference in the future.

Sales Bills

When you make sales, you should prepare sale bills to your customers.  It helps buyers understand the details of the payments made or to be made by them for those purchases. Additionally, it serves as the document for their accounting purpose. 

There may be cash and credit bills. Credit bills refer to Credit Sales. 

In either case, a copy of the bill is to be retained by you for record and for preparing your accounting entries. Cash bills may be enclosed with your sale vouchers. But credit bills are to be kept separately in files, and copies of them are to be enclosed with the voucher (you will be preparing a Debit Voucher debiting the receiver of the goods/items). 

If transactions are too many, you cannot enclose all bills with vouchers. In that case, you can give the bill number and date in your vouchers and keep the bills in files.

Asset Purchase and Sale Records:

You should maintain these bills as well to calculate the value of assets that are of significant value in your possession. If you sell any of them, keep a record of the sale value and date of sale, with supporting evidence. You can maintain an Assets Register if you are holding or selling too many assets.

Vouchers

Vouchers can be either Cash or Bank (voucher), or Journal voucher according to the nature of transactions.

• Cash vouchers are made for cash transactions when you purchase in cash or sell against cash. You can keep the cash bills enclosed with the vouchers. But if you make any big purchases, like assets or equipment, keep the bills in secured files, and only copies may be attached to vouchers.
• Bank vouchers are prepared for entering bank transactions. If you purchase by giving cheques or sell by receiving cheques or drafts, these bank vouchers are prepared. Here also, tiny payment bills may be enclosed with the vouchers, and big payment bills need to be kept in relevant files for a safe record.
• Journal vouchers are prepared for transactions other than cash or bank payments. These can be prepared for monthly total entries against sales or purchase day books or for any internal transfer accounts and adjustments or for salaries and wages sheets and depreciation accounting, etc.

Business Property Documents

Whatever property you hold in the name of your business requires proof of the holder, its authenticity, and valuation. You should be able to justify your property and its valuation and its holdings duly certified or verified by some legal authority.

Passbook

If you hold Bank or Post office accounts, you should keep the passbooks properly updated from time to time, for verification purposes and making entries in your account books. Your entries should always be tallied with the passbook entries, and keep everything updated.

Liabilities: Meaning and Classification of Liabilities

Liability is something which a person owes to another. It is an obligation that should be met by the liable party as a result of any activity or transaction entered into by the two parties.

At times, a liability can be merely a responsibility or sense of feeling shown by one person to another in place of sheer love or gratitude. For example, performing the marriage of a daughter or donating money to some social cause periodically, or even frequently, can be felt as a liability.

But, for accounting purposes, a liability is to be defined as an obligation or responsibility of a person or any business entity to the other party as a result of a transaction or contract. 

It is an unavoidable obligation to be fulfilled by the party concerned to his creditors or other parties on the maturity of a certain period, or on the occurrence of an event, or the achievement of a certain goal or target.

Liabilities, in accounts, are mostly monetary and expressed in money values. Though goods can be exchanged between parties to meet out liabilities, they should be evaluated and expressed in the books in money values.

Classification of Liabilities

Liabilities are generally classified into three major groups:

1) Current Liabilities

2) Long-Term Liabilities

3) Contingent Liabilities

Now let us take a look at the nature and identification of these three classes of liabilities.

Current Liabilities

Current liabilities are also known as short-term liabilities due to their short duration. A current liability signifies the priority involved in the clearance of the liability. Such a liability is considered to be cleared within a specific short period, say within 3 months or 6 months. You will have to clear them within that short range of period. Some of them may even become due within days, say within 3 days, 7 days, or a month like that. 

Any type of borrowing or credit taken to meet your daily needs of business falls under this category, and they are to be cleared first. Salaries and taxes payable are such urgently payable short-term liabilities. Besides, bank overdrafts, short-term credits, like credit cards, and credit purchases are also examples of this category.

Long-Term Liabilities 

From the name itself, you are able to see that these liabilities are of long-term or for longer durations. Normally, such liabilities are cleared in many years, and the terms of repayment are set forth at the time of obtaining the funds or during execution of the contract. Bank loans for long periods, mortgages, etc. fall under this category.

Contingent Liabilities 

This category of liability depends on the occurrence of a contingency. That is, its settlement is tied to the occurrence of an event or incident. If the specified event occurs, it becomes due and payable immediately upon that happening. If the stated incident does not occur at all, it is not required to be settled.

So, a contingent liability means that it shall be met only on the occurrence of a certain incident. The time of that occurrence is neither known nor certain. 

There can be other unexpected incidents like a breach of contract, damage due to accidents, and/ or court cases which are also treated as contingent liabilities.

For accounting purposes, only current liabilities and long-term liabilities are considered in the Balance sheets. 

Contingent liabilities are merely mentioned in the notes as a supplement to the Balance Sheet for the information of the Board of Directors and Shareholders.

Definition of Assets and Types of Assets

What is an Asset?

Any goods of significant value that are durable and saleable in the market may be treated as Assets.

But sometimes, from an ordinary layman's perspective, anything considered very important to him can be treated as an asset, even though it is not saleable. 

This means that his child is his asset. Or a gift received from his sweetheart can be a great asset for him. His hands, legs, or brain can be treated as assets by him, which are of great importance for his earning and sustenance.

But, as we are currently dealing with Accounts, an asset is something with significant importance and monetary value, and lasts for a durable period and can be easily sold in a market or be exchanged for other goods.

Definition of Asset

Different definitions have been proposed describing an asset. But the essence of all definitions is more or less the same.

"So an asset may be any goods or resource or property having value for some durable period and which generates income or aids in the production of other goods and services which generate income to the holder of that asset."

So from the above definition, you can see that-

• An asset has to be of some value. 
• It should be marketable or exchangeable for other items. 
• It should be of some considerable duration. 
• And finally, it can be anything that generates income for a certain duration of the period.

Types of Assets

The above definition revealed that assets have different qualities. That means there are multiple characteristics of any asset that refer to their durability and exchangeability. Assets have been classified according to their nature and tangibility.

Classification of Assets Based on Liquidity or Convertibility:

One classification of assets is into Current Assets and Fixed Assets based on their convertibility into easy money or hard money.

• Current Assets are more easily convertible into cash or other goods within a short span of time with no legal barriers and procedures. Goods in stock or trade, cash and bank balances, and other sundry advances or deposits fall in this category of Current Assets. Current assets are mostly of a shorter time span and may become obsolete after a certain period.
• Fixed Assets are more of a fixed nature and last for many years, like Land, Roads, Building, Plant, and Machinery, etc. Further, they can not be easily sold or converted. They require adequate legal formalities and considerable time to dispose of. 

Classification of Assets Based on Usage or Utility:

Another classification based on the utility or use of the assets divides the assets into Operating and Nonoperating Assets.

• Operating Assets are those which are required for daily operations of the business, as well as for use in various production processes enabling the business to generate income. So naturally, the working capital like Cash and Bank balance, inventory in use, a stock of semi-finished and finished goods, and Plant and machinery, etc., used for running the business are all termed as operating assets.
• Non-Operating Assets are assets not of much importance for running the business but still held for future plans or disposal. The business production and activities do not get hindered by disposing of those assets. Such assets can include any excess land or buildings kept for future plans and extra cash or funds invested unnecessarily. Inventory of old and obsolete items no longer used for production and inoperative dead balances lying for long periods can also be treated as non-operating assets.

Classification of Assets Based on Tangibility or Physical Nature:

Based on their physical or non-physical existence, assets are classified into Physical and Non-physical assets.

• Physical or Tangible Assets are those which have physical quality and can be seen and felt. All fixed assets, cash, and bank balances, inventory items, debtors, are all tangible assets.
• Intangible Assets can be anything that can not be touched or felt, like a company's Brand name, patent, copyrights, logo, goodwill, and trademark, etc. Even though not physical, these are very useful and important as they promote business and help in increasing sales and profits.

Three Branches of Accounting: Costing. Financial, and Management Accounting

Any business or trade needs to maintain records for various purposes.

The owner of a business wants to know how much profit is being made and what the assets and liabilities are at any time. 

The government requires proper record-keeping and tax payments. 

The manager is concerned about how to control costs and increase the company's profit. 

Therefore, accounting principles must provide accurate information to satisfy all these people. 

To meet the above-stated needs of different groups of people, multiple branches of accounting have developed according to their basic purposes. 

The three most important branches of accounting are Cost Accounting, Financial Accounting, and Management Accounting.

Let us now discuss these branches one by one.

Cost Accounting

Cost accounting deals with the segregation of costs. It analyses the cost of the finished product through various intermediary and final output stages. 

For example, it deals with the cost of the raw material, semi-finished goods, and finished goods one-by-one and side-by-side. Finished product cost includes other costs also, like administrative, marketing costs, and selling expenses, and elements like interest and depreciation. So all the required information needs to be kept accurately to determine the cost at each stage. This is possible through cost accounting records.

The total costs incurred, like salaries, wages, and administrative expenses, are maintained product-wise and stage-wise for each process and product. This facilitates calculating costs at different stages and for each product individually. Only then can their management control the costs at each level and determine the price for selling their products.

Financial Accounting

This branch is responsible for maintaining accounting records such as the Cash Book, Bank Book, Main Ledger (General Ledger), Customer and Sales Books, Purchase Ledger, etc. These records must be maintained accurately to prepare the company's Profit & Loss Account and Balance Sheets, which enable the Taxman to verify whether the tax is being properly calculated and deposited. It also enables the management and Board of Directors to understand the company's financial position.

Management Accounting

This is also an important accounting branch. This branch deals with the preparation of various monthly, weekly, and yearly reports, like Cash Flow, Funds Flow, and Budget. They are compared with actual expenses. These reports provide information to management regarding the progress of the company, its financial status, and enable them to take important decisions for the efficient running of the business.

Other Branches of Accounting:

Besides these main branches of accounting, there are other branches like Government accounting, Tax accounting, Audit accounting, Fiduciary accounting (dealing with accounts on behalf of minors), and Fund accounting, and other branches