Profit and Loss Account: Understanding the Bottom Line
What’s
there to understand? The bottom line is the last line on the Profit & Loss
(P&L) statement and it is either a profit or a loss. That’s all you need
to know, isn’t it? Yes, it is important to know whether you are making a
profit or losing money, but understanding how financial statements work is
knowing the nature of each account and how it fits into the scheme of
things. In other words, did you know that the entire P&L statement is just
an extension of one number in the Equity section of your Balance Sheet?
If you
have a set of business financial statements, take a quick look at them.
First look at the Net Profit or Loss line on your P&L statement. Let’s say
it reads $48,567.32. Now look at your Balance Sheet and find the Equity
section. You should see that same number $48,567.32 on a line called Net
Profit or Loss or something similar.
Why is
this? Net Profit means an increase (credit) in Equity and Net Loss means a
decrease (debit) in Equity. Equity is what is yours. Therefore, if you
have an increase in Equity (credit) then it makes sense to think that you
have an increase in Assets (debit), probably in the form of cash,
receivables, inventory or property. Or, you might have a decrease in
Liabilities (debit) indicating an increase in Equity since you now no
longer owe as much to creditors.
Similarly, it stands to reason that if you have a loss, indicating a
decrease in Equity, that you will be showing a decrease (credit) in your
Assets. In other words, you now own less. You may find it helpful to print
a copy of the Accounting Model which is the formula that explains how
transactions are recorded as debits or credits depending whether they are
an Asset, Liability, Equity, Revenue, or Expense item, and whether they
represent an increase or decrease. By using the Accounting Model to trace
through the above debits and credits you will begin learning how
accounting logic works. Use the following URL to access the Accounting
Model:
http://www.reallifeaccounting.com/
accounting_model.asp
It may
also help to think of the Balance Sheet as working the same way as a
reservoir of water. At any point in time you can measure how much water a
reservoir contains. In addition, there is always a river that flows into
and fills the reservoir and an outlet, such as a dam, where the reservoir
is drained. The reservoir level always reflects whatever water came in and
went out.
The
Balance Sheet, like the reservoir, is a reflection of the financial
activity of your business at a given point in time. This is usually
measured at the end of an accounting period, i.e., month, quarter, and
year-end. The P&L statement can be thought of as the river that flows into
and out of the reservoir. The P&L statement is a measure of the revenue
and expense activity that occurred during an accounting period, such as at
the beginning of a month to the end of the month, etc. The point to
remember is that a Balance Sheet always reflects the activity of revenue
and expense that has occurred in the past and current accounting periods.
Now that
we have that concept established, here is a tip: When your business is a
sole proprietorship, the way you pay yourself is through an account called
“Owner’s Draw”. This account is located in the Equity section of the
Balance Sheet and represents a decrease in Equity when you take a personal
draw. However, sometimes owners get mixed up as to whether they are taxed
on the draw amount or net profit so let’s clear up the confusion.
When a
draw is taken, cash is being decreased, but where did the cash come from
in the first place? Here are a couple of possibilities:
1) Maybe
you borrowed some money and put it in the business, but then decided to
use some of the money for personal purposes. You don’t have to pay tax on
borrowed money.
2) Or
maybe a while ago, you contributed some personal money that had previously
been taxed and are now paying back. You certainly wouldn’t have to pay
taxes on the same money twice. Because the money withdrawn from the
business may include previously taxed money, the rule is that you pay tax
on Net Profit because Net Profit relates to newly earned income not
previously taxed. If you keep your books on an accrual basis, then Net
Profit may be quite different than your cash draws. This is because your
revenue may include sales that haven’t yet been paid (Accounts Receivable)
and expenses you haven’t yet paid (Accounts Payable).
Even if
your books are recorded on a cash basis, your Net Profit may not relate
directly to cash. For instance, usually a business has some depreciation
that is a non-cash deduction. Or, you may have expenses charged on credit
cards that have not yet been paid.
Perhaps
you can now see that there are several reasons why the Owner’s Draw is
something different than Net Profit even though there is a loose
relationship between the amount of money available to the owner and Net
Profit.
John W. Day, MBA is the author of two courses in accounting basics:
Real Life Accounting for Non-Accountants (20-hr online) and The HEART of
Accounting (4-hr PDF). Visit his website to download for FREE his 3
e-books pertaining to small business accounting and his monthly newsletter
on accounting issues. Ask John questions directly on his Accounting for
Non-Accountants blog .John
Day may be contacted at
http://www.reallifeaccounting.com
jday@reallifeaccounting.com
