To prepare a profit and loss account, choose a reporting period and accounting method, collect your revenue and expense records, and then work from the top of the statement down: revenue, minus cost of goods sold, minus operating expenses, minus non-operating items and taxes, to arrive at net income. Everything else is detail hanging off that sequence.
Set the Reporting Period and Accounting Method
Most businesses close their books on December 31, but you can pick a fiscal year that matches your operating cycle. Retailers with heavy holiday sales often end on January 31 so the season’s revenue and returns land in the same period. A 52-53 week fiscal year, which always ends on the same weekday, keeps each period the same length; that election requires a statement filed with your first return identifying the ending day and reference month.1eCFR. 26 CFR 1.441-2 – Election of Taxable Year Consisting of 52-53 Weeks Whatever you pick, stay with it so year-over-year comparisons hold up.
Your accounting method controls timing. Cash accounting records income when payment arrives and expenses when they are paid. Accrual accounting records revenue when it is earned and expenses when they are incurred, whether or not money has moved. Accrual lines up with Generally Accepted Accounting Principles and gives a truer view of profitability, at the cost of more bookkeeping.
You can use the cash method if your average annual gross receipts over the prior three tax years stay at or below the inflation-adjusted threshold, which is $32 million for 2026.2Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting Carrying inventory no longer forces accrual: since the Tax Cuts and Jobs Act, businesses under the gross receipts test can use cash accounting even with inventory, treating it as non-incidental materials and supplies or following their financial statement method.3Internal Revenue Service. IRS Issues Proposed Regulations for TCJAs Simplified Tax Accounting Rules for Small Businesses Once average receipts pass $32 million, accrual is mandatory.
Gather the Source Documents
Revenue
Sales receipts, invoices, and payment processor reports are the base. Independent contractors should also receive a 1099-NEC from any client that paid them $2,000 or more during 2026, which serves as a check against your own numbers.4Internal Revenue Service. Form 1099-NEC and Independent Contractors Revenue on the P&L is the gross amount earned, before any deductions. Every calculation below depends on this figure, so it has to be right.
Cost of Goods Sold
COGS is the direct cost of what you sell: raw materials and production wages for a manufacturer, wholesale purchases and inbound freight for a retailer. Pull supplier invoices, production payroll, and inventory counts at the start and end of the period. The formula: beginning inventory plus purchases minus ending inventory equals COGS. Inventory counting errors flow straight into your gross profit, so keep the log detailed.
Operating Expenses
Operating expenses cover the cost of running the business outside direct production: rent, utilities, insurance, office supplies, marketing, administrative payroll. Source them from lease agreements, utility bills, bank statements, and payroll reports. Include the employer share of FICA, 7.65 percent on top of every employee’s wages (6.2 percent Social Security and 1.45 percent Medicare).5Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates
If you work from home, the simplified home office deduction is $5 per square foot of dedicated workspace, capped at 300 square feet, so $1,500 maximum.6Internal Revenue Service. Simplified Option for Home Office Deduction The regular method prorates your actual housing expenses by the business-use percentage and often produces a bigger deduction, with more paperwork.
Digital Records
Paper originals are not required. The IRS accepts scanned receipts and digital invoices if your system accurately transfers the original, prevents unauthorized changes, indexes records to your general ledger, and can produce legible hard copies in an audit.7IRS. Rev. Proc. 97-22 Most accounting software and cloud storage meet these standards, but confirm your setup creates an audit trail linking each transaction back to its source document.
Calculate Gross Profit and Operating Income
Subtract COGS from revenue to get gross profit. On $600,000 of sales with $250,000 in direct production costs, gross profit is $350,000. This shows the margin you have before overhead. A gross profit that keeps shrinking usually points to rising supplier costs, prices that haven’t kept up, or inventory shrinkage.
Subtract total operating expenses from gross profit to reach operating income. If overhead runs $150,000, operating income is $200,000. This line isolates the profitability of the core business, before financing and one-off items. Lenders and investors look here because it reflects whether the operation itself makes money.
Depreciation and amortization are operating expenses that owners often miss. Physical assets lose value over time, and the IRS requires the cost to be spread across the asset’s useful life instead of deducted all at once. Under MACRS, computers depreciate over 5 years, office furniture over 7 years, and commercial buildings over 39 years.8IRS. Publication 946 – How to Depreciate Property Goodwill, patents, and trademarks acquired in a business purchase amortize over 15 years.9Office of the Law Revision Counsel. 26 USC 197 – Amortization of Goodwill and Certain Other Intangibles
Section 179 offers a shortcut: you can deduct the full cost of qualifying equipment and software in the year it is placed in service, up to $2,500,000 for tax year 2025 (adjusted yearly for inflation), with a phase-out starting when qualifying purchases exceed $4,000,000.10IRS. Publication 463 – Travel, Gift, and Car Expenses Whether you take Section 179 or spread depreciation over multiple years, the annual figure sits on the P&L as an operating expense.
Add Non-Operating Items
Below operating income, list what falls outside daily operations. Interest paid on business loans goes here; $10,000 in interest gets subtracted from operating income. Gains or losses from selling business assets belong in this section as well. Sell equipment above its depreciated book value and the difference is a gain that gets added; sell it for less and the loss gets subtracted.
Bad debt expense can sit here or in operating expenses, depending on how central credit sales are to the business. If a customer owes you money, you’ve taken reasonable collection steps, and the debt is clearly uncollectible, you can write it off in the year it becomes worthless. The controlling requirement is that you previously included the amount in your income.11Internal Revenue Service. Topic No. 453, Bad Debt Deduction Court action is not required, but documented collection efforts are.
Keep Owner Draws Off the Statement
Money you take out as an owner’s draw is not an expense. It reduces equity and belongs on the balance sheet, not the income statement. Sole proprietors and single-member LLCs generally pay themselves through draws, with no tax withheld at the moment of withdrawal; the owner settles self-employment and income tax through a personal return.
S corporation owners follow a different rule. You must pay yourself a reasonable W-2 salary before taking any distributions. That salary is an operating expense on the P&L. Distributions beyond it are not.12IRS. Wage Compensation for S Corporation Officers The IRS weighs your training, responsibilities, hours, and comparable pay to judge reasonableness. Setting salary artificially low to dodge payroll taxes is a fast way to draw an audit. C corporation shareholders cannot take draws at all; they receive dividends, declared by the board and never deducted on the P&L.
Apply Taxes and Reach Net Income
How taxes hit the statement depends on structure. C corporations pay federal income tax at the entity level at a flat 21 percent rate.13Office of the Law Revision Counsel. 26 USC 11 – Tax Imposed A C corporation with $190,000 in taxable income after interest and other deductions owes $39,900 in federal tax, leaving net income of $150,100. State corporate taxes, where they apply, add to that.
Sole proprietorships, partnerships, and S corporations are pass-through entities. The business does not pay federal income tax; profits move to the owners’ personal returns and are taxed at individual rates. Pass-through P&Ls typically show net income before income taxes, because that liability belongs to the owners. The statement still needs to reflect self-employment tax on a sole proprietor’s or partner’s share: 15.3 percent on the first $176,100 of net earnings for 2025, then 2.9 percent above that.
One recent shift matters for 2026 planning. The Section 199A qualified business income deduction, which let eligible pass-through owners deduct up to 20 percent of qualified business income, expired at the end of 2025.14Internal Revenue Service. Qualified Business Income Deduction Unless Congress reinstates it, 2026 pass-through income no longer gets that benefit, which can noticeably raise the effective tax rate on your P&L profits compared to recent years.
Reconcile the Statement
Before treating the statement as final, reconcile every line against bank and credit card statements. Discrepancies almost always come from the same few places: unrecorded bank fees, outstanding checks, automatic subscription charges, and transactions sitting on the period boundary. Move through each account in order rather than spot-checking. On accrual, verify that receivables and payables tied to the period are recorded even if cash has not moved.
Not every small mismatch needs an adjustment. The SEC has noted that a 5 percent of net income threshold is a common rule of thumb for materiality, while stressing that no single percentage is automatically immaterial.15SEC.gov. SEC Staff Accounting Bulletin No. 99 – Materiality A workable approach for a small business is to investigate anything that would move your bottom line by more than a few percentage points, and to document your reasoning when you decide an item is immaterial. Compare against the prior period to catch odd swings. If marketing doubled or COGS dropped sharply, be ready to explain why before the statement goes out.
File the Right Return and Keep the Records
The P&L feeds directly into your tax return. The form depends on structure:
- Sole proprietors report income and expenses on Schedule C, attached to the personal Form 1040.16Internal Revenue Service. About Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship)
- Partnerships file Form 1065 as an information return; each partner receives a Schedule K-1 with their share of income.17Internal Revenue Service. About Form 1065, U.S. Return of Partnership Income
- S corporations file Form 1120-S, with income passing through to shareholders on Schedule K-1.18Internal Revenue Service. Instructions for Form 1120-S (2025)
- C corporations file Form 1120 and pay tax at the entity level on the return itself.19Internal Revenue Service. About Form 1120, U.S. Corporation Income Tax Return
Keep the P&L and its supporting documents for at least three years from the date you filed, which covers the standard audit window. Extend that to seven years if you claim a bad debt deduction or a loss from worthless securities. If gross income is underreported by more than 25 percent, the IRS has six years to assess more tax. If a return is never filed or is fraudulent, there is no statute of limitations at all.20Internal Revenue Service. How Long Should I Keep Records?
Errors on the P&L that lead to underpaid tax carry real cost. For careless mistakes or positions without a reasonable basis, the IRS imposes a 20 percent accuracy-related penalty on the underpayment.21Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments Willful tax evasion is a separate category: a felony with fines up to $100,000 for individuals ($500,000 for corporations) and up to five years in prison.22Office of the Law Revision Counsel. 26 USC 7201 – Attempt to Evade or Defeat Tax A miscategorized expense is a penalty situation. Deliberately hiding revenue is a criminal one.
Pull a Few Ratios from the Finished P&L
A finished P&L gets more useful once you translate its numbers into ratios that compare across periods and against industry benchmarks.
- Gross profit margin is gross profit divided by revenue. On $350,000 of gross profit and $600,000 in sales, that is about 58 percent. Track it quarterly; a declining margin signals production costs are outpacing prices.
- Operating profit margin is operating income divided by revenue. It captures how much of each sales dollar survives after all operating costs, depreciation included. A healthy gross margin paired with a thin operating margin points to overhead running too high.
- Interest coverage is operating income divided by interest expense. Under 1 means earnings will not cover interest payments, which is a serious warning for lenders and owners alike.23Board of Governors of the Federal Reserve System. Interest Coverage Ratios: Assessing Vulnerabilities in Nonfinancial Corporate Credit
Run these each period. Individual numbers matter less than the trend. A gross margin steady at 40 percent tells a different story from one that slid from 50 percent to 40 percent in two quarters.