Companies prepare four types of financial statements every quarter and every year: the balance sheet, profit and loss statement, cash flow statement and the statement of retained earnings. In the profit and loss statement, also referred to as the income statement, the company lists out all its expenses and revenue. When revenue exceeds expenditures, the company is said to have made a profit. When the expenditures are more than the revenue, the company has incurred a loss.
A significant disadvantage of the profit and loss statement is that it uses the accrual method of accounting. The company accounts for expenses and revenue as and when they occur, rather than waiting for the physical exchange of cash to take place. The reality may be far different from the picture in the profit and loss statement.
For example, the company may have placed an order for inventory with a supplier. The company treats this money as an expense immediately. On the due date, the vendor may not supply the inventory, in which case the company will not incur the expenditure. Similar is the case with accounts receivable. The company treats the money owed by the debtor as revenue even though, on the due date, the debtor may not pay.
Companies prepare financial statements at the end of a stipulated period. Many times, the company conducts a comparative analysis using these statements. The company compares the present period’s profit and loss account with the profit and loss account of a previous period. This way, the company is able to ascertain the progress or deterioration in performance.
Companies also compare the profit and loss accounts of companies operating in the same industry. A major glitch is that the companies may be following different fiscal calendars. In such cases, comparisons are difficult, if not impossible.
Companies prepare financial statements for their external stakeholders, like creditors and shareholders, and for federal regulatory authorities. Unfortunately, it is simple enough for the company to manipulate the statements. The management may choose to over-inflate profits to lure prospective shareholders into investing in the company or to deflate profits to avoid paying taxes. Not all companies indulge in such practices, but less scrupulous companies can take advantage of loopholes to manipulate their profit and loss accounts.
Companies follow some accounting principles while preparing their financial statements. With the profit and loss accounts, the company may choose to adopt the matching principle. The matching principle says that every revenue item must be matched with a corresponding expenditure item, and vice versa. This principle works well when income and expenditures match up neatly, but when they do not, matching can make the profit and loss statement more difficult to analyze.