The profit and loss account forms part of a business’ financial statements. It summarises the trading results of a business over a period of time (typically one year). In contrast, the balance sheet is a ‘snap shot’ of the assets and liabilities of the business at a particular point in time.

So you could think of the profit and loss as a video of what has happened over the year; and the balance sheet as a still photograph.

The financial statements are very important. Key business decisions taken by the owners/managers are often based on the financial statements. Furthermore, the figures are included on documents such as tax returns and finance applications, and can affect relationships with investors, customers and suppliers.

Preparation of the profit and loss account

If you are VAT registered, your income and expenses are likely to be shown ‘net’ of VAT, i.e. any VAT charged/ incurred is not included in the profit and loss account.

Also, the profit and loss account only shows ‘revenue’ transactions that are connected with the commercial activity of the business. This means income such as grants, cash injected by the owners and bank loans received are generally not shown here, and any purchases of significant equipment, loan repayments, drawings, HM Revenue & Customs payments etc won’t be shown either. Such items will affect the balance sheet instead.

The financial statements needn’t be 100 percent accurate, but they should be free from ‘material’ errors. There is no absolute measure of materiality, but loosely speaking, a material error is defined as an error that would affect decision making.

The trading account

The top section of the profit and loss account up to and including the gross profit, is referred to as the ‘trading account’. This is because it shows only the direct trading activities of the business.