The management of any business is most interested in knowing the net income or net profit, as this will increase owners' equity. If the business incurs a loss, owners' equity will be decreased. However, it is a business practice, that no company shows gross and net profit separately, but shows them in a continuing computation, vide "Divisible Profits" later on.
The Trading Alc reveals gross profit. The excess of gross profit and other revenue gains over sales expense including sales costs and other expenses and any losses gives the figure of net profit. Other expenses considered are to be the ones that are essential to the conduct of the business. These are called INDIRECT EXPENSES and are not shown in the Trading Alc. These revenue gains and indirect expenses (which do not get a place in the Trading A/c) are (now) shown in the P & L A/c.
The debit side shows various expenses and losses as shown in the Trial Balance. The credit side shows the gross profit transfered from the Trading A/c and other incomes like commission, interest received, dividend received, discount earned from suppliers, etc. which will be found in the Trial Balance with (or, through) respective credit balance.
As in every other case, if the total on the debit side happens to be more, it would be net loss by the amount of the excess, and if the total on the credit side is more, this excess shows the net profit.
In respect of both incomes and expenses, the matching principle must invariably be kept in mind. In this respect, the following two points are highlighted :
- Only the incomes and expenses relating to the period concerned are to be shown. Items relating to past or future periods are excluded. This necessitates separation of pre-paid expenses as well as expenses relating to the previous year from expenses relating to the current year. Likewise, income received in advance (but due only next year) and income received in respect of previous year (but received late and thus in this year) too are to be separated from that relating to the current year.
- All the expenses and incomes relating to the current year will have to be brought into books even if settlement in cash is yet to be made. For this, outstanding or accrued expenses on one hand and incomes not yet received have to be considered and added, respectively, to expenses or'incomes already settled in cash.
Instances of losses need some deliberation. Any loss resulting from trading operations, and speculation in particular, must be wholly charged to the current year's P & L A/c. Other types of losses are called accidental. Small amounts of accidental losses may be absorbed into the year's P & L A/c. If accidental loss is heavy, only a part of it may be charged as a loss in this year's P & L A/c and the balance may be canied forwared to be charged off in future years.
An essental adjustment is occasionally needed and will be inevitable. Often clauses exist in business agreements for revision of prices with retrospective effect; these may affect prices payable for raw materials, salaries payable to staff, amounts receivable for finished goods, etc. The current year's transactions may thereby include amounts paid or received which should in fact be related to respective previous years. Such items should be bifurcated and shown explicitly separately in the P & L A/c and not lumped with current year's figures. "Arrears", "Adjustments due to pricelsalary refixation", or any such terminology should be inserted to highlight the same. If not done so, the current year's profit or loss (or gross income) will stand out quite differently from that of the previous year(s) (and may be, also future years), It is to be remembered that profits should be arrived at on a comparable basis with the figures of the previous year.
Expenditure not to be shown in P & L A/c
- Expenses relating to the owner or partners are not to be accounted for in the P & L A/c of the company. Being personal expenses and not business expenses, these are transferred to the DRAWINGS A/c of the owner or partners. They include : Life Insurance premia, Income tax, Household and personal expenses. These should be deducted from Capital at the Liabilities side of the BS.
- Income tax charged from salaries of employees as "Tax Deducted at Source" (TDS) is neither an income nor an expense. Hence, it is neither debited or credited to the P & L A/c. This amount will be debited with the full salary amount paid to them.
- All expenditure incurred in acquiring fixed assets, or improving the existing ones by increasing their efficiency or effecting economy in operation of existing assets, being capital expenditure, should go to the Assets side of the BS and should not be included on the Debit side of P & L A/c.
- Direct Expenses : All direct expenses (are said to) add to the cost of goods purchased or manufactured. Thus, they belong to the Debit side of the Trading A/c. They shall not be debited to the P & L A/c.
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