All of us know that a company can make a profit or a loss. So why is this statement (account) called Profit and Loss account? the Americans call it the ‘Income statement’.
Simple. This account summarizes all the financial activities – so if you made a loss by selling a car, and profit by selling a piece of land apart from business operations all those transactions are reflected in this statement. Hence ‘and’ and not ‘or’.
A Profit and Loss account (income statement) is a reflection that shows how much revenue a company earned over a specific time period (usually for a quarter, half year or one year. It also shows the costs and expenses incurred to create that income. The number at the top (aka gross revenue) is also called the “Top Line” or the total revenue of the company. This top line is often referred to as gross revenues or sales. It’s called “gross” because expenses have not been deducted from it yet. So the number is “gross” or unrefined. From the ‘gross’ sales the discounts, and returns are deducted – what you now get is the ‘Net’ sales – i.e. what is left in the net after all the returns, discounts, etc. have been reduced. Now we have to still deduct all the expenses incurred to create that sales.
Come to the bottom of the statement and you will see whether the company made a Profit or a Loss at the end of the reporting period. This, obviously is called the “bottom line” of the company. This tells you how much the company earned or lost over the period.
Let us see how the whole thing is constructed….
You start at the top (top line?) with the total amount of sales made during the accounting period. This could be sales of goods, consulting services, premium received, fees received,…then you go down, one step at a time. You then go to the other side (expenses) and you make a deduction for certain costs or operating expenses incurred for creating that revenue. Expenses are arranged in order of their importance. So for a steel manufacturer it has to be raw materials, then labor expenses, factory expenses, factory assets depreciation, etc.
Moving down from the net revenue line, there are many lines that represent different kinds of operating expenses. Top expense is the cost of good sold, and then the other major expenses are recorded and reported. This number tells you the amount of money the company spent to produce the goods or services it sold during the accounting period.
The next section deals with operating expenses. These are expenses that go toward supporting a company’s operations for a given PERIOD OF TIME – for example, salaries of administrative staff, costs of researching new products, etc. Marketing expenses, sales expenses, rent, etc. are also things that you will find in this statement.
Depreciation is also an important item of expense and has to be reduced from the gross profits. Depreciation takes into account the wear and tear on assets, such as machinery, tools, cars, and furniture, which are used over time. Companies have to spread the cost of these assets over the periods they are used. This process of spreading these costs is called depreciation or amortization. The “charge” for using these assets during the period is a fraction of the original cost of the assets. In India there are 2 types of depreciation – one the minimum depreciation as recommended by Company Law – without which you cannot declare dividend and the other the maximum that you can charge as an expense before your tax is computed.
After all the current expenses for the accounting period are deducted from gross profit, you arrive at operating profit before interest and income tax expenses. This is often called “income from operations.” Also called EBITA = Earnings before Interest tax and ammortization expenses.
Companies must account for interest expense. Interest expense is the money companies paid in interest for money they borrow. Most income statements show interest income and interest expense separately.
Finally, income tax is deducted and you arrive at the bottom line: net profit or net losses.
This tells you how much the company actually earned or lost during the accounting period. Did the company make a profit or did it lose money?
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