Set up a profit and loss account for your business
A profit and loss account is a summary of business transactions for a given period - normally 12 months. By deducting total expenditure from total income, it shows on the 'bottom line' whether your business made a profit or loss at the end of that period.
A profit and loss account is produced primarily for business purposes - to show owners, shareholders or potential investors how the business is performing. But most of the information is also used by HM Revenue & Customs to check your tax calculations. See profit reporting: how, when and where?
This guide tells you about the basic financial records you need to keep to enable you to report your profit or loss each year. The information should help you decide whether you need the services of an accountant or bookkeeper, or whether you can do it yourself.
Do all businesses have to produce formal profit and loss accounts?
By law, if your business is a limited company or a partnership whose members are limited companies, you must produce a profit and loss account for each financial year.
Self-employed sole traders and most partnerships don't need to create a formal profit and loss account - but they do need to keep adequate records to complete their Self Assessment tax return fully and accurately.
However, there are key benefits to producing formal accounts. If you are looking to grow your business, or need a loan or mortgage, for example, most institutions will ask to see three years' accounts.
Profit reporting: how, when and where?
Profit and loss reporting requirements vary according to how the business is set up.
For example, if your business is a limited company, the company will report its profit (or loss) through annual accounts and a Corporation Tax return. You also need to report your own personal income from the business, for example as a company director, on your Self Assessment tax return.
If you are a sole trader, you report your business income as part of your own Self Assessment tax return.
If your business is a partnership, the nominated partner must complete a Self Assessment tax return for the partnership. In addition, you need to report your own personal income from the business on your own Self Assessment tax return.
Find further information on Self Assessment.
Records for producing a profit and loss account or completing a tax return
Whatever your business type, you must keep accurate records of your income and expenditure. You need to keep self-employment records for five years after the 31 January deadline - and you may need to keep them for longer if you file your return late or if HM Revenue & Customs starts a check. You need to keep limited company or partnership records for six years after the latest date your tax return is due.
Accurate record keeping has important benefits. It:
- gives you the information you need to manage and grow your business
- enables you to report on your profit or loss easily and quickly when required
- will improve your chances of getting a loan or mortgage
- makes filling in your tax return easier and quicker
- makes completing VAT Returns straightforward - if you are registered for VAT
- helps you or your business pay the right tax
- provides back-up for claims for certain allowances
- helps you plan and budget for tax payments
- reduces the risk of interest on late payments or late-filing penalties
- helps reduce fees if you use an accountant - your annual accounts will be far easier to produce
The basic records you will need to keep are:
- a record of all your sales and takings
- a record of all your purchases and expenses
You may also need to keep:
- a separate list for petty cash expenditure if relevant
- a record of goods taken for personal use and payments to the business for these
- a record of money taken out for personal use or paid in from personal funds - this applies to limited companies
- back-up documents for all of the above
You will need the information above to create your profit and loss account and to complete your tax returns.
For detailed information on the records you must keep, see record-keeping and tax.
Sales and other sources of business income
Business income falls into two categories for profit and loss reporting:
- sales or 'turnover'
- other income
Business sales or turnover
Your business' total sales of products and/or services in a trading year is referred to as turnover. This is the starting point for your profit and loss account.
How you record sales will vary according to your business type, size and whether you are VAT-registered. You may use a simple list or 'ledger' in a book, a tailored spreadsheet, or a computer software program.
Sales records back-up
The back-up records for your sales ledger fall into two categories, and will vary according to your business type:
- copies of sales invoices issued by you
- rolls of till receipts
- records of money you pay into the business when taking goods out for personal use
Proof of income relating to the above:
- paying-in slips
- bank/building society statements and similar
If you operate on a 'cash only' basis you must keep detailed records of your income in your sales book or ledger and be able to relate these to your expenditure, cash in hand and bank statements.
Business income: other than sales
As well as reporting sales income, you need to report income to the business from other sources, for example:
- interest on business bank accounts
- sale of equipment you no longer need
- rental income to the business
- money you put into a limited company from personal funds
Recording other income
- Record equipment sales in your sales ledger, or on a separate schedule of assets if you prefer.
- Keep a record of any rental income, for example if you sub-let part of your office to someone else.
You must keep paying-in slips and/or bank statements to account for your additional business income.
Recording business expenditure
Business expenditure falls into three key areas for the purpose of reporting your profit or loss. You can save yourself, or your accountant, time by grouping your costs accordingly in your purchase list or 'ledger'. The three key areas are:
- cost of sales - the base cost of obtaining or creating your product
- business expenses
- cost of equipment you have bought or leased for long-term use
If your business is VAT-registered, you will need to record details of any VAT included in your expenditure - see accounting for VAT.
Business expenditure back-up
The back-up records for your business expenditure fall into two categories. As with sales records, they will vary according to your business type.
1. Purchase/expenditure documentation
- copies of supplier invoices/receipts issued to you
- till receipts for items bought over the counter
- payroll and National Insurance records if you have employees
2. Proof of expenditure relating to the above
- cheque book stubs
- bank statements
- credit card statements and receipts
It is important for you to be able to cross-reference your records to your expenditure figures if asked. If you mislay a receipt for a small item, make sure you enter it in your purchase or petty cash book ledger and make a note that you have lost the receipt.
Cost of sales
The cost of sales is the cost of obtaining or creating your product.
This might include:
- the cost of stock you buy for resale
- components/raw materials to make your product
- labour to produce the product
- machine hire
- small tools
- other production costs
When you create your profit and loss account, you deduct your cost of sales from your overall sales, or turnover, to arrive at your 'gross profit'. This is your profit before deduction of expenses.
Cost of sales does not usually apply if you supply a service only.
These are all the ongoing expenses associated with running your business that you can deduct from your 'gross profit' figure on your profit and loss account to calculate a figure of 'profit before taxation'.
Legitimate business expenses for accounting purposes are:
- employee costs
- premises costs
- general administration
- motor expenses
- bad debts
- legal/professional costs
- other finance charges
- depreciation or loss - profit - on sales of equipment
- any other expenses
Note that some elements of these expenses are not allowed for tax purposes and are added back before your taxable profit is calculated.
Apportioning expenses - self-employment and partnerships
Where expenses apply partly to business and partly to non-business or personal use, you need to exclude any expenditure that relates to non-business use. For example, if you use your car for both business and private purposes, you normally work out the allowable business and non-allowable private proportions based on the mileage covered for each.
When filing invoices, remember to note any apportionment on them.
Read more on expenses if you're self-employed.
Cost of equipment
Any items of equipment you have bought or leased for long-term use are called 'capital items' or 'fixed assets'. These might include:
- computer equipment
- cars or vans necessary for the business
Depending on the size of your business, you can record the cost of equipment you buy in a separate register of equipment, the 'fixed asset register', or you can include it in your general expenditure records and show it as a 'capital item'.
Depreciation and allowances
The cost of capital items is not deducted from your profits in the same way that ordinary business expenses are. Instead, you make a charge for depreciation each year, reflecting the fall in the value of the asset over time. This spreads the cost of the asset over several years.
For your own profit and loss, you typically choose a depreciation charge that provides a realistic reflection of how long the asset will be useful. For example, you might expect a computer to be obsolete after three years, so charge a third of its cost against profit each year.
Read about depreciation in decide whether to lease or buy assets.
For tax purposes, depreciation is not an allowable expense. Instead, there are set allowances that you can claim. For small businesses, the costs of most asset purchases can be fully claimed against tax using the annual investment allowance.
For further information, see capital allowances.
Profit and loss accounting periods and tax
Accounting periods to use for the self-employed, partnerships and limited companies
Businesses normally work out their profit and loss for a twelve month period. This makes it easy to see how well your business is doing each year, and to compare one year with the next.
The way your accounts are taxed depends on what type of business you have.
Accounts for self-employed and partnerships
Self-employed sole traders and business partnerships are normally taxed on the profits for the 12 month accounting period ending during the tax year. The tax year runs from 6 April to 5 April the following year.
For example, if you make your annual accounts up to 31 December each year, your profits to 31 December 2020 are used in your 2020-21 tax return (for the year to 5 April 2021).
The simplest approach can be to make your annual accounts up to 31 March or 5 April, so that they match the tax year.
Special rules apply when you start or close a business, or if you decide to change your accounting period, to ensure that all your profits are fairly taxed.
To find out more about accounting periods for the self-employed and partnerships, see how to calculate your taxable profits: HS222 Self Assessment helpsheet.
Accounting periods for limited companies
Limited companies are required to submit annual accounts to Companies House, including a profit and loss account.
When you start a new company, the financial year automatically runs to the end of the month a year after the company is incorporated.
Your profit subject to Corporation Tax is normally based on an accounting period that matches this financial year. There are special rules if your accounting period is longer than twelve months (for example, if your new company makes up its accounts to a date more than a year away).
For more information, see Corporation Tax.