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Home > Accountancy Checklists > Preparing Financial Statements: Profit and Loss Accounts (P&Ls)

Accountancy Checklists

Preparing Financial Statements: Profit and Loss Accounts (P&Ls)


Checklist Description

This checklist outlines the ways profit and loss accounts (P&Ls), or income statements, are prepared in financial statements.

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Definition

A profit and loss account, also known as an income statement or a statement of revenue and expense, is a financial statement that indicates how revenue (money received from the sale of products and services before expenses are taken out) is transformed into net income (the result after all revenues and expenses have been accounted for). The important thing to remember about P&Ls is that they represent a period of time (usually a year or part of a year), rather than being snapshots. They should indicate to managers and investors whether a company made a profit or a loss during the period of time being reported. This contrasts with the balance sheet, which represents a single moment in time.

P&Ls can be broken into two groups: revenues and expenses. Both the revenues and expenses are recorded in the year (or other time period) that they are earned or accrued, not when the revenue is actually received or the expenses paid.

Revenues are the income the business receives in exchange for the products or services it provides. In most cases, revenues are associated with the sale of goods or services. Some of the more common sources of revenue are sales revenue, service revenue, and interest revenue.

The recorded expenses reflect the amount of resources used in earning the reported revenue. Some common examples of expenses are: salaries, research and development, bad debt, depreciation for the current year, and taxes.

For the investor, P&Ls also report earnings per share (EPS). This calculation shows how much money stockholders would receive if the company decided to distribute all of its net earnings for the period reported.

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Advantages

  • P&Ls should help investors and creditors to determine the past performance of the enterprise, predict future performance, and assess the enterprise’s capability to generate future cash flow.

  • P&Ls, along with balance sheets, are the most basic elements required by potential lenders, such as banks, investors, and vendors. Lenders will use the financial information contained in P&Ls to determine credit limits.

  • P&Ls can also track dramatic increases in product returns or the cost of goods sold as a percentage of sales. They can also be used to determine income tax liability.

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Disadvantages

  • Factors that might be highly relevant but cannot be reliably measured (for example brand recognition and customer loyalty) are not reported in P&Ls.

  • Some numbers depend on the accounting methods used. The use of current costs or exit prices leaves room for manipulation. Measuring and reporting give management considerable discretion and the opportunity to influence results.

  • Some numbers depend on judgments, estimates and interpretation.

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Action Checklist

  • Use financial ratios on the P&Ls to evaluate the overall financial condition. Financial-ratio analysis will gauge viability, liabilities, and projected future performance.

  • Carefully analyze any P&Ls for differences during the reporting period. Anomalies might be due to seasonal or other variations, or may indicate deeper problems.

  • Consult and question managers and key business stakeholders in the evaluation process for P&Ls.

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Dos and Don’ts

Do

  • Make sure that you have used the financial ratios when analyzing profit and loss accounts. If in doubt, consult an expert analyst.

  • Consider seeking the help of specialist consultants.

  • Check for any changes in accounting policies or anomalies that occurred during the period. Carefully examine any departures from industry norms.

Don’t

  • Don’t take shortcuts. Accounting can be a complicated process and remember that any undiscovered problems might cost more in the long run.

  • Don’t rely on accounting standards to protect you from fraud.

  • Don’t assume that P&Ls are a true reflection of a company’s financial position. Measuring and reporting permit considerable discretion and the opportunity to influence results.

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Further reading

Website:

  • American Accounting Association (AAA): aaahq.org

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