Trading and Profit and Loss Accounts are an accounting document used to calculate and display a number of key figures that a business generates in each financial year. They are a legal requirement for companies in the U.K. The Account is split into two component parts: the Trading Account, which calculates the gross profit (or profit on trading activities) of the company, and the Profit and Loss Account, which calculates the net profit (which is profit after nondirect, sales-related expenses).
Trading Accounts are used to calculate gross profit. These accounts take the revenue from sales that the company generated and then subtracts the cost to the company of generating these revenues. First subtracted is the value of stock owned at the beginning of the year, then the value of stock purchases made during the year are subtracted, and then the value of closing stock at the end of the year is added back on. This gives the final figure, which represents how much money the company made from direct trading activities, i.e., the amount of sales made minus the cost directly associated with those sales.
Profit and Loss Account
Companies use a Profit and Loss Account to go from the gross profit to an actual net profit figure, and then on to a retained profit figure. This is done by taking the gross profit figure, and taking away the expenses incurred by the company, such as salaries, rent and utilities. Once this is done, the company has a net profit figure, which is then used to calculate taxes due. The final part of the Profit and Loss Account is to take the post-tax profits and use this figure to calculate a dividend to shareholders. Once this figure is subtracted, the account ends with a final retained profit figure.
Positive Attributes of Trading and Profit and Loss Accounts
Trading and Profit and Loss Accounts have a number of uses. Firstly, they are used for a number of useful margins for the business, one of which is the return on sales; by calculating the percentage of revenue, which ends up as gross profit, the company can see whether it is paying too much for stock, or if its sales price is too low.
Trading and Profit and Loss Accounts are also useful for comparing year-on-year figures for companies, as a company should calculate these figures the same way each year.
Negative Attributes of Trading and Profit and Loss Accounts
Trading and Profit and Loss Accounts also do have a number of pitfalls. They are only half the picture of the company. They only take into account a current year's trading activities and not the general state of the company. For these figures, a Balance Sheet is required, too.
Also, companies are able to manipulate these figures by using certain accountancy tools. By changing the value of the figure for the end-of-year stock, which an accountant can do quite arbitrarily, a company can alter its gross profit, and therefore net profit figures, thus changing how much tax it pays in a given period.