Welcome to Financial Statements: The Sole Trader Edition! (9706 AS Level)

Hello future accountants! This chapter is incredibly important because it brings together almost everything you have learned so far about recording transactions. Think of preparing financial statements as the grand finale of the accounting cycle.

You are learning how to create the two main reports that tell the owner (the sole trader) exactly how well the business has performed and what it owns and owes.

Don't worry if this seems like a lot of steps. We will break down the process for preparing statements for the simplest type of business entity: the sole trader.

Key Learning Objectives (Syllabus 1.5.2):

  • Prepare a Statement of Profit or Loss (SPL) (often called an Income Statement).
  • Prepare a Statement of Financial Position (SFP) (often called a Balance Sheet).
  • Perform these tasks using figures from both full (a trial balance) and incomplete accounting records.

Section 1: The Core Process – Preparation from Full Records (Trial Balance)

If a sole trader keeps full double-entry records, we start with a Trial Balance. However, the trial balance figures are 'raw' and need final adjustments before the statements can be drawn up accurately.

1.1 Crucial Adjustments Before Drafting (Syllabus 1.5.1)

These adjustments are essential applications of accounting concepts like the matching concept (or accruals concept) and the prudence concept.

1. Inventory Valuation (Closing Inventory)

  • Inventory (stock) remaining unsold at the end of the period is a current asset and must be valued at the lower of cost and net realisable value (NRV) (Prudence Concept).
  • Impact: Increases profit (it is deducted in the Cost of Sales section of the SPL) and appears as a Current Asset in the SFP.

2. Depreciation

  • This is the expense of using up non-current assets (like machinery or vehicles).
  • The charge for the year is calculated (using Straight Line or Reducing Balance methods).
  • Impact: Expense in the SPL; Accumulated Depreciation reduces the Non-current Assets value in the SFP.

3. Accruals and Prepayments (Matching Concept)

  • Accruals: Expenses incurred but not yet paid (e.g., electricity bill for December received in January). They are Current Liabilities.
    • Impact: Increase the expense in the SPL.
  • Prepayments: Expenses paid in advance for the next period (e.g., insurance paid for 12 months in November). They are Current Assets.
    • Impact: Decrease the expense in the SPL.

4. Irrecoverable Debts and Allowances

  • Irrecoverable Debts (Bad Debts): Customers who definitely won't pay. This amount is written off as an expense.
    • Impact: Expense in the SPL; reduces Trade Receivables in the SFP.
  • Allowance for Irrecoverable Debts: An estimate of future bad debts (Prudence Concept). We adjust the existing allowance.
    • If Allowance Increases: Expense in SPL.
    • If Allowance Decreases: Income in SPL.
    • Impact on SFP: The new, adjusted allowance is deducted from Trade Receivables.

Quick Review: The Double Impact Rule

Every adjustment has a double-entry. If you adjust an expense/income figure in the SPL, the balancing entry goes into the SFP (usually as a Current Asset or Current Liability).

Section 2: The Statement of Profit or Loss (SPL)

The SPL shows the business's performance over a period of time (e.g., "for the year ended 31 December 20X4"). Its main purpose is to calculate the Profit for the Year.

2.1 Format: Trading Account Section

This section calculates the Gross Profit, which is the profit made purely from buying and selling goods.

Calculation Steps:

  1. Start with Revenue (Sales) and deduct Sales Returns. This gives Net Revenue.
  2. Calculate Cost of Sales (CoS):
    \( \text{CoS} = \text{Opening Inventory} + \text{Net Purchases} - \text{Closing Inventory} \)
    • Net Purchases = Purchases + Carriage Inwards - Purchases Returns
  3. Deduct the Cost of Sales from Net Revenue to get the Gross Profit.

Analogy: Gross Profit is like the money you made selling lemonade, before paying for your stall rent or advertising signs.

2.2 Format: Operating Profit Section

This section takes the Gross Profit and adjusts it for all other day-to-day running costs (Expenses) and other forms of Income.

Calculation Steps:

  1. Add all Other Income (e.g., rent received, irrecoverable debts recovered).
  2. Deduct all Operating Expenses (e.g., wages, rent, electricity, depreciation, change in allowance for irrecoverable debts).
  3. The result is the Profit from Operations (or Operating Profit).

2.3 Final Calculation: Profit for the Year

For a sole trader, the Profit from Operations is often the final profit figure unless there are specific finance costs or income.

  • If the result is positive, it is a Profit for the Year.
  • If the result is negative, it is a Loss for the Year.

This final profit figure is the single most important number, as it is transferred to the Statement of Financial Position to increase the owner's capital.

Common Mistake to Avoid:
Do not include Drawings (money the owner took out) in the SPL. Drawings are treated later in the SFP, as they are not an expense of the business, but a distribution of profit.

Section 3: The Statement of Financial Position (SFP)

The SFP (Balance Sheet) shows the financial health of the business at a specific date (e.g., "as at 31 December 20X4"). It is built around the fundamental accounting equation:

\( \mathbf{\text{Assets}} = \mathbf{\text{Capital}} + \mathbf{\text{Liabilities}} \)

3.1 Assets Section

Assets are resources owned by the business that have future economic value.

  • Non-current Assets: Held for long-term use (more than 1 year). Show these at Net Book Value (NBV) (Cost minus Accumulated Depreciation).
    • Example: Buildings, machinery, fixtures.
  • Current Assets: Held for short-term use (converted to cash within 1 year).
    • Example: Inventory, Trade Receivables (minus allowance), Bank, Cash, Prepayments.

3.2 Capital and Liabilities Section

This section shows where the money came from to acquire the assets (owner's equity and external borrowings).

1. Capital: The owner's investment in the business.

This calculation is crucial for the sole trader format:

Opening Capital
+ Profit for the Year (or - Loss for the Year)
+ Additional Capital Introduced
- Drawings (Money or goods taken by the owner)
= Closing Capital (or Capital at end of year)

2. Non-current Liabilities: Long-term debts (due after 1 year).

  • Example: Long-term bank loan, mortgage.

3. Current Liabilities: Short-term debts (due within 1 year).

  • Example: Trade Payables, Accruals, Bank Overdraft (if any), Current portion of a long-term loan.

Key Takeaway: The total of Non-current Assets + Current Assets MUST equal the total of Capital + Non-current Liabilities + Current Liabilities.

Section 4: Preparation from Incomplete Records (The Conversion Method)

Sometimes, sole traders do not keep full double-entry bookkeeping (they may just track cash). This results in incomplete accounting records. The task here is to use the limited information available to construct the full financial statements.

4.1 Why Incomplete Records Exist

Usually, it's due to poor bookkeeping, loss of records, or the owner keeping track primarily through a basic cash book (single entry).

4.2 Step 1: Finding Missing Capital (The Statement of Affairs)

We cannot find the profit for the year directly using the SPL method if we don't know all the income and expenses. Instead, we use the change in capital.

To find the capital at the start and end of the year, we use a Statement of Affairs. This is simply the accounting equation rearranged, prepared at two different dates (start and end).

\( \mathbf{\text{Opening Assets}} - \mathbf{\text{Opening Liabilities}} = \mathbf{\text{Opening Capital}} \)

\( \mathbf{\text{Closing Assets}} - \mathbf{\text{Closing Liabilities}} = \mathbf{\text{Closing Capital}} \)

Did you know? The Statement of Affairs is exactly like a Statement of Financial Position, but it's used when we are unsure about the reliability of the underlying records.

4.3 Step 2: Calculating Profit using Change in Capital

Once you have the Opening and Closing Capital, you can calculate the profit for the year.

Encouraging Trick: Remember the flow of the owner's capital account.

\( \mathbf{\text{Profit}} = \mathbf{\text{Closing Capital}} - \mathbf{\text{Opening Capital}} + \mathbf{\text{Drawings}} - \mathbf{\text{Additional Capital Introduced}} \)

(A loss will result in a negative profit figure.)

4.4 Step 3: Finding Missing Revenue or Expenses (T-Accounts)

To prepare a detailed SPL (which examiners often require), you must find the missing figures that were not recorded properly, usually sales, purchases, or specific expenses.

We create Total Accounts or Control Accounts in reverse:

  • Total Trade Receivables Account: Use this to find missing Credit Sales. You start with the opening balance, add cash received from debtors, add irrecoverable debts, and balance with the closing figure. The balancing figure is usually the credit sales figure.
  • Total Trade Payables Account: Use this to find missing Credit Purchases.
  • Analysis of the Cash Book: This is used to find cash sales, cash purchases, and specific cash expenses (like rent paid) which are then adjusted for accruals/prepayments.

Key Takeaway for Incomplete Records: When records are incomplete, you must first calculate the missing capital figures using Statements of Affairs. Then, use T-accounts to find the missing revenue/expense figures necessary for the full Statement of Profit or Loss.


Chapter Summary Checklist

When preparing sole trader accounts (from any source data), always ensure you have accurately accounted for:

  1. Inventory: Use the closing figure (CoS in SPL, Current Asset in SFP).
  2. Non-current assets: Calculate and include depreciation (Expense in SPL, Reduction in NBV in SFP).
  3. Accruals/Prepayments: Adjust expenses to reflect the current period only.
  4. Irrecoverable Debts/Allowance: Ensure receivables are shown at their estimated recoverable value.
  5. Drawings: Only appear in the Capital calculation in the SFP, never in the SPL.