What is a profit and loss account?

This simplest formula for calculating profit is: total revenue – total expenses = profit.

Profit is calculated by deducting direct costs, such as materials and labour and indirect costs (also known as overheads) from sales. Under normal accounting rules, sales and expenses are included in profit when they occur, not when they are actually paid so profit will include credit sales and purchases, even when they are yet to be paid.

Here is an example. A business buys £3,000 of stock in January and agrees to pay for it in three months’ time. It sells the stock in the month in which it purchased it (January) for £5,000 cash. The profit for the month is £2,000. The fact that the stock wasn’t paid for immediately is not relevant when calculating profit. The profit that is calculated will derive from the ‘profit and loss’ account and will be calculated for a set period, usually a year.