Easy steps to close a P&L account

The Financial Accounting Standards Board (FASB) establishes the US-GAAP (Generally Accepted Accounting Principles adopted in the United States) and regulates commercial accounting for any commercial activities, or in other words, all enterprise forms pursuing commercial operations. Merchants systematically record their transactions in accordance with the requirements of the accounting principles on a double-entry basis. This entails creating an annual financial statement for each fiscal year, which includes a balance sheet as well as a profit and loss account.

The profit and loss account (P&L account) is central to this accounting concept, as it splits expenses from income (nominal accounts) with the aid of two columns, namely the debit and credit sides. It is a sub-account of a company’s equity account, which has the power to validate the success of a company. It forms an informative basis not only for external parties such as investors or suppliers, but also notifies the company itself about its current economic position. For example, limited liability companies are obliged to inform their supervisory boards about respective profits and losses. Tax authorities value clear and, above all, correct information. The successful completion of your profit and loss account brings you one step closer to a correctly executed annual financial statement. Here, with the aid of some examples, we present the manner in which you should close your profit and loss account.

Over the course of a company’s financial year, at least one expense and one income account is created. Account balances of both the former and the latter form the basis for profit and loss accounts. These so called T-accounts are made up of two opposing sides, namely the "debit" and "credit" sides. Both are nominal accounts, which can be closed by means of a P&L account.

Expense accounts reduce the value of equity capital. Since expenses are otherwise known as payments for temporary assets and services, they do not enable the acquisition of assets. They include:

• Shortterm acquisitions (raw materials, commodities)
• Consumption costs (water, sewage, energy)
• External services (advertising, maintenance)
• Personnel costs (wages and salaries, social benefits)
• Fees and charges

Expense account are treated as asset accounts with no opening balance and are mainly used for payments to third parties. You should therefore record earnings on the debit side, and losses on the credit side. If the total of the former is greater than that of the latter, insert the account’s balance on the credit side, as shown below. What is visible in the following example are various monthly expenses, the figures of which are intended as an example. The list of expenses has been shortened for reasons of clarity.

Expense account

Payments from third parties are recorded in income accounts. Their totals rise when you sell your own products or services, which subsequently adds to equity capital. Examples of incomes include:

• Sale of goods or services (product sale, rental income)
• Interest on financial investments
• Legal claims (compensation, overdue fees)
• Sale of fixed assets

Just like with expense accounts, income accounts are also created without any opening balance. Any increase in income is noted on the credit side, while returns and other reductions to income are not settled immediately, but rather noted on the debit side. Balance visible on the debit side represents profit. The following figures also serve as an example and the list of possible incomes is also shortened.

Income account

Closing P&L accounts is a mandatory when creating annual financial reports. Profit and loss accounts can also be presented by means of T-accounts. The Generally Accepted Accounting Principles indicate the preferable structure and order of every P&L account. Since both the nature of the expense and the cost of sales methods achieve the same end result, it is up to you to decide which one to assess your account with.

The following example shows a P&L account for the purpose of completing an annual financial statement, which is used to close nominal accounts. The debit column includes balances of expense accounts for a given financial year, whereas the credit column lists the balances of income accounts.

Profit and loss account | Table 1a

In this example, the total value of the debit side amounts to $1,985,000. Since it is the highest of the two values, it is also considered the sum of the overall account. However, the calculation does not end here. Firstly, the difference between the two sides must be determined in the following manner:

       $1,985,000 (total of the credit side)

-      $1,374,000 (rental costs, wages and salaries, operating costs)

           $611,000 (account balance, i.e. the difference)

The difference is therefore recorded under “account balance” on the debit side. This, on the other hand, signifies that the credit side is greater, which creates a credit balance. The annual net profit therefore amounts to $611,000.

Profit and loss account | Table 2a

         $1,763,000

        - $1,698,000

                $65,000

In this example however, a total of $1,763,000 appears on the debit side, which exceeds the sum of $1,698,000 on the credit side. What results from this is a debit balance of $65,000. This is a so-called net loss.

P&L accounts are sub-accounts of equity accounts. Tables 1a and 2a show not only their structure but also the manner in which they are used to determine the annual balance. The corresponding expense and income accounts have therefore been closed. However, in order to close the P&L account in full, all that remains is to complete an equity account. Since this is a liability account, losses from P&L accounts must be recorded under “outflows” on the debit side, and profits under “inflows” on the credit side.

Equity account | Table 1b

In order to close the P&L account, the last step involves entering corresponding balances into an equity account. Table 1b includes the balance from table 1a under "P&L account balance." This closing entry of the profit and loss account increases the value of credit side’s equity capital. Together with other deposits and withdrawals, which had no influence on the success of the company, what results is the final equity capital value of $2,093,000. In other words, a profit has been made.

Annual closing entry: The P&L account balance of $611,000 is entered directly into the equity account (previously, income account balances were recorded in P&L accounts).

Equity account | Table 2b

In this example, the P&L account has recorded a loss. Equity in Table 2b is greater than the debit balance of $65,000. Together with the remaining inflows and outflows, what results is a final equity capital value of $1,417,000.

Annual closing entry: $65,000 are contributed from the company’s equity capital toward the P&L account (in other words, the sum of $65,000 is then recorded in the expense accounts).

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