Creating Profit & Loss Accounts

A closer look at how to create a profit and loss account

This article covers how to create a profit and loss account.

For a basic overview of what a profit and loss account is and how it supports your business see our summary article which includes an example of a profit and loss sheet and free profit and loss templates to download.

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Who needs to create a profit and loss accounts or P&L

Limited Companies must produce a formal profit and loss account every year and submit it to HMRC. It is used to calculate the amount of corporation tax your company must pay.

If you are a sole trader or in a partnership, you don’t need a P&L for tax purposes but it is advisable to create one as it is a useful measure of your business performance.

A profit or loss statement will be required if you want to apply for a mortgage, take out a loan, or get other financing for your business.  See our introduction to small business accounts for more information.

What time period should a P&L cover

It's perfectly acceptable to use any 12 month period you choose but if you’re a sole trader or in a partnership it’s easier if your accounts follow the tax year, ie be made to 31 March or more specifically 5 April. If you're a limited company you may choose to have 31 December as your year-end date.  Your first set of accounts will therefore probably not cover a full12 month period.

Take advice from your accountant on what would be a good choice for your circumstances.

Keeping proper records

A profit and loss account records your income and your costs to show whether your business is making an overall profit or loss during the time covered by your accounting period. You must keep accurate records of all your income and expenditure. Essentially this means getting a receipt for everything you buy, and keeping a copy of every invoice you issue.

Keeping a record of your income

Business income falls into two categories for profit and loss reporting:

Keeping a record of sales income

The amount of money you earn from selling your goods or services in a trading year is known as your turnover and is the starting point for your profit and loss account. Decide how you are going to keep a record of all your sales so the information is all in one place.

You should keep:

• copies of sales invoices issued by you
• rolls of till receipts
• paying-in slips
• bank statements
• For cash payments you should note the transaction with the rest of your sales and be able to relate the income to your expenditure, cash in hand and bank statements.

Keeping a record of other income

Your business may have income from other sources, such as:

• interest on investments or bank credit balances
• sale of equipment you no longer need
• rental income
• For limited companies – any money you put into the business

You should keep:

• A record of any transactions with the rest of your sales.
• Paying-in slips and bank statements that account for the income 
  

Keeping a record of your costs

The basic records you will need to keep are:

• Details on all your expenditure, including day-to-day expenses and equipment
• A petty cash expenditure record
• Information on items taken for personal use (you should pay the business for these)
• For limited companies - a record of personal money taken out or paid into the business from personal funds

You should keep:

• copies of supplier invoices/receipts
• till receipts for items bought over the counter
• payroll and National Insurance records if you have employees
• cheque book stubs
• bank statements
• credit card statements and receipts

You should be able to cross-reference your records to your expenditure figures if asked. Expenditure that does not have a receipt must still be logged with the rest of your spending so there is a record of it.

Business expenditure classification

Business expenditure is classified into 2 or 3 key areas for the purpose of reporting your profit or loss account:

Cost of sales or direct costs

These are known as direct costs as the amount varies in direct proportion to the amount of goods or services sold, for example:

• stock bought for resale
• components and raw materials
• labour costs to create or manufacture the product
• production costs

Cost of sales does not usually apply if you supply a service only.

When you create your profit and loss account, your sales income minus your cost of sales = your gross profit.

Business expenses or indirect costs

These are all the ongoing expenses associated with running your business and are known as indirect or fixed costs as they do not vary according to the amount of sales. Examples are:

• employee costs
• rent or mortgage payments
• rates
• general administration
• marketing activity
• interest on loans 

If you have purchased or leased expensive items these are called "capital items" or "fixed assets". These might include:

• equipment
• machinery
• tools
• vehicles
• furniture
• premises

There is some flexibility and judgement in calculating a profit and loss account, such as how long these fixed assets should be depreciated over, and what adjustments you should make to cater for bad debts. A qualified accountant will advise you what is reasonable and acceptable.

Your gross profit minus your business fixed costs = your operating profit

Your net profit (or loss) is calculated by taking your operating profit adding in any other income or expenses and then subtracting the amount of tax due to the paid to HMRC.