The Purpose of a Trading Profit & Loss Account
A trading profit and loss account is a summarised report that indicates a company's revenues, expenses and net profit during a period, as well as significant accounting policies and calculation assumptions that a company uses in preparing this report. Also known as an income statement, this report informs top management and investors about business trends.
A trading profit and loss account serves two purposes: computing net income for the period and identifying major revenue and expense items that affect net income. An accountant computes net income by subtracting expenses from revenues. For example, if John Doe Inc. has £6 million in monthly revenues and £4.9 million in expenses, net income for the month is £1.6 million. The company also may review revenue and expense accounts to identify major customers and suppliers.
An accountant records corporate transactions by debiting or crediting in ledgers (i.e., accounting records). Debits increase expense accounts (e.g., salaries or cost of goods sold), while credits decrease them. The opposite is true for revenue accounts (e.g., sales or interest income). For example, an accountant may record sales to Customer A by crediting sales (revenue account) and debiting accounts receivable.
There are several tools a company uses to gauge business performance and analyse trading profit and loss accounts. A firm may use trend analysis by comparing current versus historical data. For example, an accountant may contrast current year sales with last year data to evaluate percentage changes. Alternatively, a trading profit and loss account specialist may perform vertical analysis by comparing current year sales to cost of goods sold and assessing whether gross margin levels (i.e., sales minus cost of goods sold) are adequate.
A financial manager may perform income statement account analysis at any time during the year to gauge profit levels and recommend improvements in operations. For example, a finance manager at a Queens, New York-based pizza delivery company may analyse customer orders every month, study sales trends in pizza varieties and detect whether customers prefer cheese pizza or mushroom pizza. An accountant also may perform an income statement evaluation to identify "bad debt," i.e., customers who may be unable to pay for goods delivered, due to bankruptcy.
An accountant does not record financial transactions involving a company's investors or shareholders in a trading profit and loss account because those payments are not revenues or expenses. Those transactions (e.g., dividend payments, stock issuance or bond sales) are recorded in a corporation's retained earnings statement.