January 24, 2018 Profit and loss account explained As a director of a limited company, you are responsible for filing accounts with Companies House and with HMRC each year (along with a corporation tax return). Although most people appoint an accountant to handle this, it’s still important to have a basic understanding of how your accounts are put together. You may think that if you put all your receipts and payments through your company bank account, you can add them up to see what profit you’ve made over a period of time and that the balance left in your account shows how much profit your business has made. However, it’s not quite that simple. One of the key components of your company accounts is your Profit and loss account. This shows your company performance (profit or loss) over a period of time – generally one year (your accounting period). When you file your accounts with Companies House and HMRC it is usually only the accounts that are filed with HMRC that have to include a profit and loss account. Profit and loss account example: The profit and loss account starts with the total value of your sales for the period. If you’re VAT registered, you will usually ignore the VAT and only show the net value of your sales. This is because the VAT is something you just collect on behalf of HMRC. It doesn’t belong to your company, and so you don’t include it in your profit and loss figures. There are some exceptions to this, such as if you are on the VAT flat rate scheme, but we’ll keep it simple for this article. After sales, you show the direct costs you’ve incurred in making those sales. This could be items of goods you’ve bought to sell to your customers, or it could be payments you’ve made to a subcontractor (again, you don’t usually include the VAT if you’re VAT registered.) The important point is that the costs must relate to the sales you’ve included on the line above. For example, if you’d bought goods to sell to a customer, but hadn’t actually sold the goods before the end of your accounting period, you would not include it in your direct costs figure (instead these unsold goods would sit on your balance sheet). You then deduct your direct costs from your sales to give a figure for your gross profit. For many businesses the gross profit will be a key indicator of how well it is doing – however if you are simply a freelancer or contractor the gross profit is not likely to be a useful figure and you should rely on net profit instead, discussed below, as you are unlikely to have many direct costs. After direct costs come overheads. Most of these are the type of costs you’re stuck with, even if you don’t make any sales. Your own salary is included here as well as items such as rent, travel and subscriptions. Sometimes you will have income or costs that don’t relate or only partially relate to the accounting period in question – adjustments will need to be made to your profit and loss account for these – this is because the profit and loss account only includes income and costs for a specific period of time. For example, if you paid for a year’s business insurance in advance one month before the end of your accounting period, only 1/12th of the amount you paid would be included in your profit and loss account (the rest would be included on your balance sheet as a prepayment and would then get released to the following years profit and loss account) – we have another article which explains these year end timing adjustments. Another item in the overheads section that often causes confusion is depreciation. If you buy a computer for your business you normally expect it to last for a few years. Therefore, you only include part of the purchase cost of the computer on your profit and loss account each year. The remaining unused cost is included on your balance sheet. Deducting your overheads cost from your gross profit gives your net profit before tax. The next figure shows the amount of corporation tax payable on the profit (if any) for the period. For the 2017/18 & 2018/19 tax years corporation tax is charged at 19% of taxable profits – there are usually tax adjustments which mean that a company’s taxable profit is often different from the accounting profit. Finally, the corporation tax is taken away from the net profit before tax figure to give you the after tax profit (or loss). Retained profits and dividends Your profit and loss account shows how much profit (or loss) you’ve made over a set period of time (usually a year). The next step is to add this to the profit or loss remaining from earlier years, and deduct any dividends you’ve taken so far, this final figure gives you your retained profit carried forward at the period end. One of the key items that affect a company’s retained profits are dividends. Dividends are paid to shareholders out of post tax profits – they aren’t treated as a business expense and don’t attract tax relief – and you must ensure that there are always sufficient retained profits to support the dividends paid. The table below shows how our example profit and loss account affects retained profits – the figures in this are again just example figures for illustration purposes only.