The trial balance is used by accountants to produce the Profit and Loss Account and the Balance Sheet.
The Profit and Loss Account, which is also known as an Income Statement in international accounting standards, essentially records the income of a business throughout an accounting period minus expenses incurred in that period, to end up with a profit or loss figure for that period. It is therefore a summary of the fortunes of a business over a passage of time. This is why it is vital to note the period to which the Profit and Loss Account relates in order to understand it. The accounting period is recorded in the heading for the account, always with the words “for the period ending on [last day of the period]”.
As a general rule, only the income and expense entries from the trial balance are transferred into the Profit and Loss Account. For example, ‘Commission’ in the trial balance is an income account and this appears at the top of the Profit and Loss Account. In contrast, ‘electricity bill’ is a business expense and appears in the expenses section of the Profit and Loss Account. ‘Cash at bank’, on the other hand, is an asset account and does not appear on the Profit and Loss Account.
There are standard formats for presenting the layout of the Profit and Loss Account and all Profit and Loss Accounts for UK businesses follow a similar structure.
Below is an example Profit and Loss Account for ABC Trading, together with notes to explain its format.
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Notes for the Profit and Loss Account
1. All income entries from the trial balance are put at the top of the Profit and Loss Account (e.g. sales).
2. You will note there is a separate entry labelled ‘Gross profit’ in the top part of the Profit and Loss Account. This figure is not itself taken from the trial balance but is calculated using some entries that are shown on the trial balance.
The ‘Gross profit’ calculation represents all the income of the business less the ‘cost of sales’, that is, costs directly attributable to how the business earns money (e.g. the cost of purchasing stock). The ‘Gross profit’ figure shows the reader how much money the business has made during the accounting period before other expenses are taken into account.
3. The formula for ‘cost of sales’ is:
Opening stock + purchases – closing stock = cost of sales
The calculation must be shown in full on the Profit and Loss Account in the format shown in the example.
‘Cost of sales’ includes figures for ‘opening stock’ and ‘closing stock’. These accounts represent the value of unsold stock held by the business at the start and end of the accounting period respectively. (They are asset accounts, so these two accounts are exceptions to the general rule that a Profit and Loss Account shows only income and expense accounts). The figure for closing stock never appears on the trial balance but would be provided separately.
4. All expenses excluding purchases (which have already been deducted in the cost of sales calculation) are deducted from the Gross profit. Such expenses are, broadly speaking, the ‘overheads’ of the business.
5. The resulting figure is the Net Profit and this figure will appear as ‘profit for the year’ in the bottom half of the Balance Sheet