An organisation prepares several financial statements and documents which can be analysed to comprehend the financial status of a company. Profit and loss account and balance sheet are the same kinds of documents any organisation prepares to understand profit or loss earned by the company in a financial year.
Let us look at what these two terms mean and how these are different from one another.
What is a Balance Sheet?
A balance sheet can be alternatively known as a position statement. It can give the financial status of an organisation at any given point in time. It includes a list of all assets, liabilities, and equity so that one can quickly determine the amount of working capital available for use by the company.
Before delving further, it is essential to learn these terms, which are an integral part of a balance sheet.
Asset – These can be any resources owned by an organisation which can be liquefied for value in terms of money. Assets can be tangible or intangible and can be used in the production cycle or can be liquefied to accumulate funds for the organisation.
These are valuable items which a company possesses like cash equivalents, machinery, furniture, patents, property, plant, equipment, etc.
Liability – By liability, we mean a company has financial debts, loans or obligations to be paid to other entities. An organisation might have several liabilities during its operational period due to several unplanned circumstances or to overcome any financial requirement at that moment. Therefore, loans, mortgages, accounts payable, accrued expenses, etc. are all part of liability.
Equity – Equities can be defined as the difference between total assets to total liabilities. In case the liability is more than the value of the asset, then there is no equity.
Therefore, assets can be represented as the sum of liabilities and equity.
A balance sheet is broadly divided into two sections, assets and liabilities. Both the sections contain several sub-sections under them. For instance, assets are grouped as investments, current assets, fixed assets, etc. These two columns are assessed, and the value of contributor’s equity is calculated.
It helps determine the financial status of an organisation at any given point. If the value of assets is more than the cost of liabilities, then it has enough working capital to carry the day to day business operations else not.
What is Profit and Loss Account?
A profit and loss account prepared for a company includes all the expenses and revenue generated detailed in a sheet. All the costs a company bears in an accounting year are mentioned in the expenses section. Likewise, the sheet also includes another column which consists of the revenues generated from various business operations.
Finally, the amount of loss or gain is calculated by evaluating the expenses and revenues. If the value of revenue exceeds the total cost of expenses column, then the company is likely to earn profit, otherwise it is categorised as loss. It is to note that profit and loss accounts are created for an accounting year.
Further, students need to learn the difference between profit and loss account and balance sheet so that they can understand why and when they are used in a business.
Profit and Loss Account Vs Balance Sheet
A balance sheet determines if or not a company is financially stable or secure to carry various business operations. This is determined by listing the total value of assets, liquidity, and equity.
A profit and loss statement doesn’t depict the financial condition of an organisation but its economic production status. It is an estimation of a company’s total expenses and revenues to calculate the accrued profit or loss.
While the balance sheet is a sheet mentioning the assets and liabilities, profit and loss evaluation is concerned with an account.
Difference between balance sheet and profit and loss account is that a balance sheet can help determine financial status of the organisation on a particular date and the P&L account is to determine the profit or loss endured by them in a fiscal period.
A balance sheet is prepared on the last day of a financial year while the profit and loss account is maintained for the whole accounting period.
Value of assets, liabilities, and equity are mentioned in the balance sheet and profit and loss account of a company consisting of expenses and revenues to determine the financial standing.
Subsequently, students will be able to improve their understanding of the balance sheet and profit and loss account of any company by going through these notes and examples. In case they are seeking more comprehensive study notes, Vedantu can help them in this venture with quality study material.
FAQs on Profit & Loss Account vs. Balance Sheet Overview
1. How is a Profit and Loss Account prepared?
A Profit and Loss Account is prepared by summarising all revenues and expenses for a specific accounting period, usually a financial year. It follows the matching principle, recording all incomes earned and expenses incurred during that period, whether or not cash was received or paid. The primary goal is to determine the net profit or net loss of the business for that period.
2. What is the main purpose of a Balance Sheet?
The main purpose of a Balance Sheet is to present a snapshot of a company's financial position at a specific point in time, typically at the end of a financial year. It lists the company's assets (what it owns), liabilities (what it owes to others), and owner's equity (the owner's stake). It adheres to the accounting equation: Assets = Liabilities + Owner's Equity, ensuring that the financial position always balances.
3. What are the fundamental differences between a Profit and Loss Account and a Balance Sheet?
The fundamental differences lie in their purpose, time frame, and what they report:
- The Profit and Loss Account shows a company's financial performance (profit or loss) over a period (e.g., a year), focusing on revenues and expenses.
- The Balance Sheet shows a company's financial position (assets, liabilities, equity) at a specific point in time, like a single day, focusing on resources and obligations.
- The Profit and Loss Account is a flow statement, while the Balance Sheet is a stock statement.
4. Which financial statement should be prepared first, the Profit and Loss Account or the Balance Sheet, and why?
The Profit and Loss Account is typically prepared before the Balance Sheet. This is because the net profit or loss calculated in the Profit and Loss Account (also known as Statement of Profit or Loss) is a crucial figure that needs to be transferred to the Balance Sheet. Specifically, the net profit increases the owner's equity (capital), while a net loss decreases it. Without this figure, the Balance Sheet cannot be completed accurately.
5. How does the final outcome of the Profit and Loss Account impact the Balance Sheet?
The final outcome of the Profit and Loss Account, which is the net profit or net loss, directly impacts the owner's equity section of the Balance Sheet. If there's a net profit, it increases the owner's capital. Conversely, a net loss reduces the owner's capital. This connection highlights how the operational performance reflected in the Profit and Loss Account directly affects the financial position shown in the Balance Sheet.
6. Why is understanding both the Profit and Loss Account and the Balance Sheet crucial for assessing a business's health?
Understanding both financial statements is crucial because they offer complementary views of a business. The Profit and Loss Account reveals the company's profitability and operational efficiency over time, indicating if it's earning enough to cover costs. The Balance Sheet, on the other hand, shows its financial stability and structure at a given moment, detailing what assets it possesses and how they are financed. Together, they provide a holistic picture, allowing stakeholders to assess both current performance and long-term financial strength.
7. Can the terms 'Statement of Profit or Loss' and 'Statement of Financial Position' be used interchangeably with 'Profit and Loss Account' and 'Balance Sheet'?
Yes, for practical purposes in Commerce studies, the terms 'Statement of Profit or Loss' (SOPL) and 'Statement of Financial Position' (SOFP) are largely interchangeable with 'Profit and Loss Account' and 'Balance Sheet', respectively. The newer terms (SOPL and SOFP) are commonly used under international accounting standards (like IFRS) and reflect a more modern presentation of these financial statements. However, their core purpose and the information they convey remain the same, providing insights into a company's profitability and financial health.
