The profit and loss account shows, from the point of view of the shareholders, the performance of the year’s activities. Its key bottom line results are the operating profit for the year also called EBIT for Earnings Before Interest and Tax, and the Net Profit (after tax) attributable to shareholders, from which dividends can be distributed.
Profit is a flow, but unlike cashflows that deal with “real money”, profit is measured in “accounting money” as defined by the accruals principles. These state that revenues and costs are recognised as they are earned and incurred respectively (in practice when they are invoiced or recognised as such), and not as they are received from customers or paid to suppliers. So revenues (sales) in the P&L is not the same as cash received (“cash-in”), because most sales are credit sales: customers pay for services and goods sold a number of days after the invoicing date. This implies that customers are debtors to the business. Similarly on the cost side, companies pay their suppliers some time after the invoicing date, so suppliers are creditors to the company.
In addition, the accruals principles state that revenues and costs are matched as far as their relationship can be justified. One important implication is the concept of depreciation for fixed assets. These are assets that have a durable life longer than the reporting period, which is typically one year. As those assets will be participating in the generation of revenues over a period longer that the reporting period, their costs are not deducted from the P&L revenues in full, but pro-rata of their expected lifetime. Fixed assets are capitalised on the asset side of the balance sheet and written-off in the P&L statement over their depreciation lifetime.
Whereas cashflows can be quite volatile following the decision to buy new business assets, the P&L smoothes out the capital expenditure spikes and is a more appropriate instrument to measure the intrinsic profitability and viability of the business.
The P&L results are also used to calculate taxation in some countries, for instance Germany, but not in those where differing depreciation lifetimes are usually used for financial reporting and taxation purposes, in particular the USA and the UK. In some countries also, a dividend distribution when no profit has been generated during the year might not be allowed, so that being profitable is a prerequisite to paying dividends to shareholders. Profits which are not distributed as dividend are called retained profits and go into the balance sheet to increase the total shareholder equity on the liability side.