Methods for Preparing Profit and Loss Account

This article throws light upon the top two methods for preparing profit and loss account. The methods are: 1. Percent of Sales Method 2. Projected Expenses Method.

Method # 1. Percent of Sales Method:

In this method, the basic assumption is that there is no change in business, its policies etc. Everything continues to take place as before. All the ratios to sales in future will be similar to the previous ones. For example if cost of sales to sales was 80% in the previous year, the ratio will remain same in the current year.

We simply calculate the ratios of all the expenses to sales and prepare the profit and loss account. But this is not very accurate method. So for better results we take the figures of profit and loss account for last two years and take the average of all the ratios.

In this way percentage of every item to sales is calculated and proforma or projected profit & loss account for current year is prepared. But some projections cannot be made like distribution of profits, retained earnings etc. because these are based on managerial policies.

Method # 2. Projected Expenses Method:

It is also known as budgeted expenses method. While preparing proforma profit and loss account, it is assumed that every expense is some percent of sales and there is no change. It is not practical because some development always takes place. The projected expense method is an improvement over the previous method.

Under this method, every expense is to be based on the expected developments in future. For the projections, greater effort is required by the management because if the expected developments do not take place, the proforma P/L A/c may not give a true picture.

We can say that of the above two methods for preparing proforma P/L A/c, no method, if used in isolation, is correct. The proforma P/L A/c will be correctly projected if both the methods are used simultaneously. Some expenses which are directly related to sales may be projected by percent of sales method.

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For other expenses which frequently change with change in market development and policies of management, the budget/ projected expense method may be used.

Illustration 1:

The following is the Income Statement of ABC Ltd. for the year ending 31 Dec. 2007. Prepare Projected Income Statement for 2008: