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Understanding Financial Reports - Part Three

Man reading the financial report

So far in our Understanding Financial Reports series we have looked at the context of financial governance and a brief Accounting 101 on the chart of accounts, cost centres and cash vs accrual accounting. This time around we will examine the Profit & Loss report.

The Profit & Loss report is also known as Income & Expenditure statement, and in your annual financial statements it is (currently) called the Statement of Profit or Loss and Other Comprehensive Income. For convenience, we’ll use P&L in this article.

The P&L is about performance during a period—typically for a financial year.

It presents income (also known as revenue) and expenses, with the difference between the two being your profit or loss for the period in question. When income is higher than expenditure you have a profit or surplus, and when expenses are greater than income for the period you will have a loss or deficit.

Female financial advisor preparing statistic report

The P&L report

Elements of the report are fairly straightforward.

Income accounts are always displayed at the top of the report (the ‘top line’), followed by the expense accounts. The ‘bottom line’ is the Profit/(Loss) or Surplus/(Deficit) calculation which is the difference between income and expenses.

Many NFPs prefer to use Surplus/(Deficit) to reflect their not-for-profit focus. Either term is correct, and many accounting software programs will let you customise the reports to use the terminology you prefer.

Organisations that sell goods or services might use a ‘Cost of Sales’ category, which is an expense category that sits between the income and expense sections in a P&L report. It generates a Gross Profit Figure, which shows your income less the direct cost of producing that income.

Some organisations make a distinction between operating and non-operating income and expenses. Non-operating often includes extraordinary items or things that are outside of the organisation’s control—the COVID economic stimulus measures are a recent example, as is investment income or profit/loss on disposal of an asset. If these categories are used for reporting purposes, they appear ‘below the line’, that is, the operating profit/loss is calculated as described above (operating income less operating expenses) and these non-operating income and expense categories are then shown below that operating result with a final net profit/loss calculation.

For simple or early-stage organisations, a profit and loss report straight out of your accounting software can be all that you need. It provides a view of the income and expenses for the period and calculates whether you have made a surplus or a deficit. But it can be helpful to have some context – a simple guideline is to compare against a previous period, eg. this quarter vs last quarter, or this year-to-date vs same period last year. Measuring against a prior period can help you understand whether your income and expenditure are okay – did you raise more revenue last year? And if so, what was different? Can you make changes to get it back to that level again? Have your costs increased by a reasonable amount, or has something blown out? And if so, can you correct it?

Businessman accountant analyst holding documents

The best view, in our opinion, is a profit and loss report against budget – this is perfect for providing context as it measures your actual income and expenses against what you expected them to be.

It is also an important governance control – the Committee or Board should approve the annual budget, providing a way of delegating authority to spend for planned activities through the financial year, and setting a target for income generation.

The Board or Committee should then see the P&L vs Budget as part of routine reporting to them, so that they can understand whether things (financially speaking) are in line with the approved plans for the year.

So far we’ve talked about what are essentially the ‘rows’ in the report – let’s now look at the ‘columns’. The first column at the left of the report page is your chart of accounts, categorised as described above. In the most basic layout, the next column you see would be your actuals for the period. If you are using a comparative – budget or prior period – then those figures would appear in the next column.

A further ‘upgrade’ you can make to your profit and loss reporting is to add variance analysis and commentary. You can show a variance analysis column alongside your actuals and budget or prior period data, calculating the variance between the two. You can show this as a $ figure or a % – sometimes one makes more sense than the other, depending on the scale of your organisation. We’ve found that the $ can really help put big numbers into perspective while a % can help the reader make a quick judgement about whether variance is within tolerance.

When an organisation has multiple sources of revenue and is capturing financial data across a number of cost centres, some written analysis can really help the report’s audience to gain a greater understanding of the information. A written commentary is helpful to add nuance or detail that the raw numbers can’t provide – the why behind variances, for example – and also gives you an opportunity to look forward and discuss financial projections.

Two serious business partners discussing financial report

How to analyse a profit & loss

Now that we’ve laid out the map of the report, let’s look at how to analyse it.

Take a look at the bottom line – do you have a profit or a loss? Whichever it is, is that good or bad news? If you are comparing to budget, is the variance positive or negative?

Where are the variances? Looking at the Variance $ column, cast your eye back up that column to identify where the big variances are – are they in income or on the expense side?

Why? Next step is to understand why there are variances – what could have changed from your original budget expectations? Perhaps it is just a timing issue, eg. the income will arrive next month. If it is a real variance, are there actions the organisation can take to rectify it – eg. raise revenue from elsewhere, or reduce costs to compensate?

These few questions are where you should start with understanding your Profit & Loss – you may not be able to answer all those questions, which is the point at which you need to be able to ask them of someone else who has access to more detail.

Next in our series...

Tune in again next month when we’ll explore the Balance Sheet and help you to get familiar with what is often viewed as quite a mysterious report.

Accounting For Good offers our Understanding Financial Reports training as custom training, delivered in the comfort of your boardroom or ours. Contact our team of dedicated professionals to find out how we can help you.

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