In order to properly finalize an annual financial statement, most corporations must include a profit and loss (P&L) account, which, as its name already suggests, breaks down their profits and losses for a given financial year. However, we must ask what a P&L statement should really look like. We explain the procedure surrounding P&L statements so that you stay on top of all laws, methods, and...
The Financial Accounting Standards Board (FASB) establishes the US-GAAP (Generally Accepted Accounting Principles adopted in the United States) and regulates commercial accounting for any commercial activities, or in other words, all enterprise forms pursuing commercial operations. Merchants systematically record their transactions in accordance with the requirements of the accounting principles on a double-entry basis. This entails creating an annual financial statement for each fiscal year, which includes a balance sheet as well as a profit and loss account.
The article “Double-entry accounting simply explained” provides closer insight into commercial accounting as well as introduces the idea of balance sheets and profit and loss accounts.
The profit and loss account (P&L account) is central to this accounting concept, as it splits expenses from income (nominal accounts) with the aid of two columns, namely the debit and credit sides. It is a sub-account of a company’s equity account, which has the power to validate the success of a company. It forms an informative basis not only for external parties such as investors or suppliers, but also notifies the company itself about its current economic position. For example, limited liability companies are obliged to inform their supervisory boards about respective profits and losses. Tax authorities value clear and, above all, correct information. The successful completion of your profit and loss account brings you one step closer to a correctly executed annual financial statement. Here, with the aid of some examples, we present the manner in which you should close your profit and loss account.
Profit-and-loss accounts (P&L accounts for short) form part of external financial statements, which demonstrate the financial situation of a company over a given time by listing the origin, nature, and scope of changes in its equity capital. P&L accounts are therefore sub-accounts of equity accounts and are a core component of annual financial statements.
First basis: expense and income account
Over the course of a company’s financial year, at least one expense and one income account is created. Account balances of both the former and the latter form the basis for profit and loss accounts. These so called T-accounts are made up of two opposing sides, namely the "debit" and "credit" sides. Both are nominal accounts, which can be closed by means of a P&L account.
Nominal accounts record business transactions that affect net income, or in other words, have a direct influence on the profit or loss figures of a company. Such accounts have no opening balance. On the contrary, stock accounts record non-profit business cases and provide information about company stocks.
Expense accounts reduce the value of equity capital. Since expenses are otherwise known as payments for temporary assets and services, they do not enable the acquisition of assets. They include:
- Shortterm acquisitions (raw materials, commodities)
- Consumption costs (water, sewage, energy)
- External services (advertising, maintenance)
- Personnel costs (wages and salaries, social benefits)
- Fees and charges
Expense account are treated as asset accounts with no opening balance and are mainly used for payments to third parties. You should therefore record earnings on the debit side, and losses on the credit side. If the total of the former is greater than that of the latter, insert the account’s balance on the credit side, as shown below. What is visible in the following example are various monthly expenses, the figures of which are intended as an example. The list of expenses has been shortened for reasons of clarity.
Purchase of goods: $9,000
Account balance: $20,880
The debit and credit side totals must always remain equal to one another. The difference between the two sides is evened out by the account balance. "Debit balance" is always interpreted as a loss, and the "credit balance" as profit.
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You are in greater control over your expenses when you create multiple expense accounts for different expense types. Please keep in mind that each expense account requires a separate balance to be made.
Payments from third parties are recorded in income accounts. Their totals rise when you sell your own products or services, which subsequently adds to equity capital. Examples of incomes include:
- Sale of goods or services (product sale, rental income)
- Interest on financial investments
- Legal claims (compensation, overdue fees)
- Sale of fixed assets
Just like with expense accounts, income accounts are also created without any opening balance. Any increase in income is noted on the credit side, while returns and other reductions to income are not settled immediately, but rather noted on the debit side. Balance visible on the debit side represents profit. The following figures also serve as an example and the list of possible incomes is also shortened.
Rental income: $900
Interest earned: $30
Sale of goods : $22,300
Account Balance: $22,430
You can also create multiple income accounts for different income types. However, you also have to create a separate balance for each of these accounts.
Second basis: sample structure of a profit and loss account
Closing P&L accounts is a mandatory when creating annual financial reports. Profit and loss accounts can also be presented by means of T-accounts. The Generally Accepted Accounting Principles indicate the preferable structure and order of every P&L account. Since both the nature of the expense and the cost of sales methods achieve the same end result, it is up to you to decide which one to assess your account with.
The following example shows a P&L account for the purpose of completing an annual financial statement, which is used to close nominal accounts. The debit column includes balances of expense accounts for a given financial year, whereas the credit column lists the balances of income accounts.
Profit and loss account | Table 1a
(Balances of expense accounts)
(Balances of income accounts)
Rental costs: $54,000
Sales revenue: $1,900,000
Wages and salaries: $1,260,000
Intrest earned: $55,000
Operating taxes: $60,000
Sale of fixed assets: $30,000
Account balance: $611,000
In this example, the total value of the debit side amounts to $1,985,000. Since it is the highest of the two values, it is also considered the sum of the overall account. However, the calculation does not end here. Firstly, the difference between the two sides must be determined in the following manner:
$1,985,000 (total of the credit side)
- $1,374,000 (rental costs, wages and salaries, operating costs)
$611,000 (account balance, i.e. the difference)
The difference is therefore recorded under “account balance” on the debit side. This, on the other hand, signifies that the credit side is greater, which creates a credit balance. The annual net profit therefore amounts to $611,000.
Profit and loss account | Table 2a
(Balances of expense accounts)
(Balances of income accounts)
Rental costs: $70,000
Sales revenue: $1,623,000
Wages and salaries: $1,638,000
Interest earned: $50,000
Operating taxes: $55,000
Sale of fixed assets: $25,000
Account balance: $65,000
In this example however, a total of $1,763,000 appears on the debit side, which exceeds the sum of $1,698,000 on the credit side. What results from this is a debit balance of $65,000. This is a so-called net loss.
Closing P&L accounts – here’s how it works
P&L accounts are sub-accounts of equity accounts. Tables 1a and 2a show not only their structure but also the manner in which they are used to determine the annual balance. The corresponding expense and income accounts have therefore been closed. However, in order to close the P&L account in full, all that remains is to complete an equity account. Since this is a liability account, losses from P&L accounts must be recorded under “outflows” on the debit side, and profits under “inflows” on the credit side.
Example of annual net profit
Equity account | Table 1b
Opening balance: $1,400,000
P&L account balance: $611,000
Closing balance: $2,093,000
In order to close the P&L account, the last step involves entering corresponding balances into an equity account. Table 1b includes the balance from table 1a under "P&L account balance." This closing entry of the profit and loss account increases the value of credit side’s equity capital. Together with other deposits and withdrawals, which had no influence on the success of the company, what results is the final equity capital value of $2,093,000. In other words, a profit has been made.
Annual closing entry: The P&L account balance of $611,000 is entered directly into the equity account (previously, income account balances were recorded in P&L accounts).
Example of annual net loss
Equity account | Table 2b
Opening balance: $1,400,000
P&L account balance: $65,000
Closing balance: $1,417,000
In this example, the P&L account has recorded a loss. Equity in Table 2b is greater than the debit balance of $65,000. Together with the remaining inflows and outflows, what results is a final equity capital value of $1,417,000.
Annual closing entry: $65,000 are contributed from the company’s equity capital toward the P&L account (in other words, the sum of $65,000 is then recorded in the expense accounts).
When preparing your annual financial statement, you must first close your P&L account. Only then do you finalize your equity account. Simply put, the profit and loss account breaks down the amount, type, and sources of your company's success. The process of closing is therefore a matter of entering respective balances in the equity account.