Making the Profit and Loss Account

In the previous chapter, "How to Make a Trading Account", we learned how to calculate a business's Gross Profit. We did this by matching the direct costs of buying or making goods against the revenue from selling them.

But if you buy a phone cover for ₹100 and sell it for ₹150, is that ₹50 Gross Profit actually yours to take home?

Not even close. To run that phone cover business, you probably had to pay rent for your shop, pay a salary to your helper, pay the electricity bill, and maybe spend some money on Instagram ads. All of these extra costs eat into your Gross Profit.

This is where the Profit and Loss Account (often just called the P&L Account) comes in. It picks up exactly where the Trading Account left off. Its entire job is to subtract all those everyday running costs from your Gross Profit, and add any side incomes, to reveal the final, ultimate truth of the business: the Net Profit.

Let us break down exactly how to build it, step by step.

The Big Picture: Trading vs. Profit & Loss

To understand the P&L Account, you need to understand how it splits the world of expenses with the Trading Account.

Think of a traditional manufacturing business. It has two main areas: the noisy, dusty factory where goods are made, and the quiet, air-conditioned office where the administration happens.

• The Trading Account is the factory. It only cares about direct expenses. These are costs tied directly to purchasing goods or bringing them into the factory (like raw materials, factory wages, and freight inward).
• The Profit and Loss Account is the office and the showroom. It cares about indirect expenses. These are the costs of running the business, managing the staff, and selling the goods to the customer (like office rent, manager salaries, advertising, and delivery charges).

In practice, the Trading Account and the P&L Account are usually prepared together on the same page as one continuous ledger account, called the "Trading and Profit & Loss Account". The top half is Trading; the bottom half is P&L.

Step 1: The Starting Line (Bringing Down the Gross Profit)

Because the P&L Account is the second half of the process, it cannot start from zero. It must start with the result of the Trading Account.

If the Trading Account resulted in a Gross Profit, this amount is transferred to the Credit side (the income side) of the P&L Account. You will write it as:

• By Gross Profit b/d (brought down)

If the Trading Account resulted in a Gross Loss (meaning the direct costs were higher than the sales), this amount is transferred to the Debit side (the expense side) of the P&L Account. You will write it as:

• To Gross Loss b/d

Once the Gross Profit is sitting safely on the credit side of our P&L Account, we are ready to record the rest of the year's activities.

Step 2: The Debit Side (Recording Indirect Expenses)

The Debit side (the left side) of the P&L Account is where all the indirect expenses and losses go.

To make sense of them, accountants usually group indirect expenses into four main buckets. Let us look at what goes into each.

1. Office and Administrative Expenses

These are the costs of keeping the business running day-to-day, regardless of how much you sell.

• Office Salaries: Paying your manager, accountant, or receptionist.
• Office Rent, Rates, and Taxes: The monthly rent for your office space or showroom.
• Printing and Stationery: Paper, pens, printer ink, and bill books.
• Postage and Telephone: Internet bills, phone bills, and courier charges for documents.
• Insurance: Premiums paid to insure the office building or the business against fire and theft.

2. Selling and Distribution Expenses

These are the costs incurred to find customers, convince them to buy, and deliver the goods to them.

• Advertising: Newspaper ads, billboards, or digital marketing.
• Commission Paid: Money paid to sales agents for bringing in orders.
• Discount Allowed: When you allow a customer to pay less than their bill amount to encourage quick payment, that discount is an expense (a loss of potential revenue) for you.
• Bad Debts: When a customer buys goods on credit but runs away or goes bankrupt without paying, the money you lost is a bad debt. It is a loss debited to the P&L.
• Carriage Outward (or Freight Outward): The cost of delivering finished goods out to the customer's location.

3. Financial Expenses

These are the costs of borrowing money or using banking services.

• Interest Paid: If the business took a bank loan, the monthly interest paid is an indirect expense.
• Bank Charges: Fees deducted by the bank for maintaining the account, issuing cheque books, or processing transactions.

4. Depreciation and Other Losses

• Depreciation: When you buy a computer for the office, its value drops every year due to wear and tear. This drop in value is called depreciation. It is a non-cash expense, but it must be debited to the P&L Account to show the true cost of using that asset.
• Loss by Fire or Theft: If goods or cash are stolen or destroyed, and the insurance company does not cover the full amount, the uninsured loss is debited here.

Step 3: The Credit Side (Recording Indirect Incomes)

A business's main source of income is selling its goods. That main income (Sales) is already recorded in the Trading Account.

But businesses often make a little extra money on the side. These side incomes are called Indirect Incomes, and they are recorded on the Credit side (the right side) of the P&L Account, right below the Gross Profit.

Common examples of indirect incomes include:

• Discount Received: When you buy goods from a supplier on credit, and they give you a discount for paying your bill early. This saves you money, acting as a gain.
• Commission Received: If your business acts as an agent for someone else and earns a commission.
• Rent Received: If your business owns a large building, uses half of it, and rents out the other half to a tenant, the rent you collect is indirect income.
• Interest on Investments: If the business has spare cash sitting in a bank fixed deposit, the interest earned on it goes here.
• Bad Debts Recovered: If a customer who previously defaulted (and was written off as a bad debt last year) suddenly walks in and pays you, it is treated as a sudden gain.

Step 4: The Balancing Act (Calculating Net Profit)

Once you have listed all your indirect expenses on the Debit side and all your indirect incomes on the Credit side, it is time to balance the account. This is exactly like balancing any other ledger.

Step A: Total both sides on a rough piece of paper.

• Find the total of the Credit side (Gross Profit + all indirect incomes). Let's call this Total Income.
• Find the total of the Debit side (all indirect expenses and losses). Let's call this Total Expenses.

Step B: Compare the two totals.

Scenario 1: Credit is heavier than Debit (Income > Expenses) If your Total Income is ₹1,50,000 and your Total Expenses are ₹90,000, you have money left over.

• The difference (₹60,000) is your Net Profit.
• To make both sides equal, you write this difference on the shorter side (the Debit side) as: To Net Profit (transferred to Capital A/c).

Scenario 2: Debit is heavier than Credit (Expenses > Income) If your Total Expenses are ₹1,20,000 but your Total Income is only ₹1,00,000, you spent more than you made.

• The difference (₹20,000) is your Net Loss.
• To make both sides equal, you write this difference on the shorter side (the Credit side) as: By Net Loss (transferred to Capital A/c).

Step 5: The Final Destination (Transfer to Capital)

Why do we write "(transferred to Capital A/c)" next to the Net Profit or Net Loss?

Because of the Business Entity Concept. In accounting, the business and the owner are two separate people. The owner invested money (Capital) to start the business. Therefore, any profit the business makes does not belong to the business—it belongs to the owner.

• If the business makes a Net Profit, it owes more money to the owner. The Net Profit is added to the owner's Capital.
• If the business makes a Net Loss, the owner's investment has shrunk. The Net Loss is deducted from the owner's Capital.

This transfer is the final bridge between the Profit and Loss Account and the Balance Sheet (which we will cover in the next chapter). The P&L Account is now closed for the year, and its final result lives on in the owner's Capital balance.

Worked Example: Building a P&L Account

Let us put all this theory into practice. Imagine you are preparing the final accounts for Sharma Electronics for the year ending 31st March.

The Trading Account has already been prepared, and it shows a Gross Profit of ₹1,20,000.

You look at the Trial Balance and find the following indirect items:

• Salaries: ₹30,000
• Rent Paid: ₹12,000
• Advertising: ₹8,000
• Discount Allowed: ₹2,000
• Discount Received: ₹5,000
• Carriage Outward: ₹3,000
• Interest Received from Bank: ₹4,000
• Depreciation on Furniture: ₹5,000

Let us build the Profit and Loss Account.

Credit Side (Incomes & Gains) - The Right Side We start by bringing down the Gross Profit, then list the indirect incomes.

• By Gross Profit b/d: ₹1,20,000
• By Discount Received: ₹5,000
• By Interest Received: ₹4,000
• Total of Credit Side on rough paper = ₹1,29,000

Debit Side (Expenses & Losses) - The Left Side We list all the indirect expenses.

• To Salaries: ₹30,000
• To Rent Paid: ₹12,000
• To Advertising: ₹8,000
• To Discount Allowed: ₹2,000
• To Carriage Outward: ₹3,000
• To Depreciation: ₹5,000
• Total of Debit Side on rough paper = ₹60,000

The Calculation:

• Total Income (Credit) = ₹1,29,000
• Total Expenses (Debit) = ₹60,000
• Difference = ₹1,29,000 - ₹60,000 = ₹69,000

Since the Credit side is heavier, this ₹69,000 is a Net Profit. We write it on the Debit side to balance the account.

Final Debit Side Entry:

• To Net Profit (transferred to Capital A/c): ₹69,000

Now, both the Debit and Credit sides total exactly ₹1,29,000. The account is balanced, closed, and the ₹69,000 profit will be added to Mr. Sharma's capital in the Balance Sheet.

Quick Revision

• Purpose: The P&L Account calculates the Net Profit or Net Loss of a business by deducting indirect expenses from Gross Profit.
• Starting Point: It always starts with the balance brought down from the Trading Account (Gross Profit on the Credit side, or Gross Loss on the Debit side).
• Debit Side: Records all indirect expenses (office, administration, selling, distribution, financial costs, and depreciation).
• Credit Side: Records all indirect incomes (rent received, discount received, interest earned, commission received).
• Carriage Rule: Carriage Inward is direct (Trading A/c). Carriage Outward is indirect (P&L A/c).
• Salaries Rule: "Wages and Salaries" goes to Trading. "Salaries and Wages" goes to P&L.
• Balancing: If Credit total > Debit total, the result is a Net Profit. If Debit total > Credit total, the result is a Net Loss.
• Final Destination: The Net Profit or Net Loss is transferred to the owner's Capital Account, closing the P&L Account for the year.