👋 Welcome to Sole Traders: Preparing the Financial Statements!

Hello future accountants! This chapter is the core of IGCSE Accounting. We are moving from recording transactions (book-keeping) to showing the full picture of the business's performance and position (accounting).

We start with the simplest type of business: the Sole Trader. Don't worry if the statements look long; we will break down exactly how they are put together, step-by-step!

🎯 What You Will Learn in This Chapter

  • The basics of sole trader businesses (pros and cons).
  • How to prepare the Income Statement (to find the profit).
  • How to prepare the Statement of Financial Position (to show what the business owns and owes).
  • How to handle crucial year-end adjustments.

SECTION 1: Understanding the Sole Trader

1.1 What is a Sole Trader?

A Sole Trader is a business owned and controlled by one person. Think of your local baker, a freelance graphic designer, or a small market stall owner.

Key Features:
  • The owner provides the capital.
  • The owner receives all the profit.
  • The owner is responsible for all the losses (this links to unlimited liability).

1.2 Advantages and Disadvantages of a Sole Trader

It's important to understand why someone chooses this structure.

👍 Advantages
  • Easy to set up: There are fewer legal formalities compared to larger companies.
  • Owner keeps all the profits: The profit is the owner's reward.
  • Quick decision-making: The owner makes all decisions without needing to consult partners or shareholders.
  • Personal connection: Often offers a personal service to customers.
👎 Disadvantages
  • Unlimited Liability: This is the biggest risk! If the business goes bankrupt, the owner’s personal assets (like their house or car) can be sold to pay off business debts.
  • Difficulty raising capital: Relying only on personal savings or small bank loans.
  • Heavy workload: The owner has to manage everything (accounting, marketing, sales, etc.).
  • Lack of continuity: If the owner dies or becomes ill, the business may cease to exist.
💡 Quick Review: Unlimited liability means unlimited debt risk. Always remember this key disadvantage!

SECTION 2: The Financial Statements

2.1 Importance of Financial Statements

Financial statements (or 'final accounts') are prepared at the end of an accounting period (usually one year). They summarise all the business activity and provide crucial information to the owner and other interested parties.

2.2 The Two Main Statements (Purpose and Timing)

1. The Income Statement (IS)

The Income Statement is prepared to measure the financial performance of the business over a period of time (e.g., for the year ended 31 December 2024).

Its main purpose is to calculate the business’s Profit for the year (or loss).

2. The Statement of Financial Position (SFP)

The Statement of Financial Position (sometimes called the Balance Sheet) is prepared to show the financial position of the business at a specific date (e.g., as at 31 December 2024).

It is a snapshot of everything the business owns (Assets) and everything it owes (Liabilities), and how much the owner has invested (Owner's Equity).

SECTION 3: The Income Statement (IS)

3.1 Trading Business vs. Service Business

The structure of the Income Statement depends on the type of business:

  • Trading Business: Buys goods and sells them at a profit (e.g., shops, retailers). These businesses calculate Gross Profit.
  • Service Business: Provides a service (e.g., accountant, plumber, tutor). They do not buy and sell goods, so they skip the Gross Profit calculation step.

3.2 Preparing the Income Statement for a Trading Business

The Trading Section finds the Gross Profit. The Profit and Loss Section finds the Profit for the year.

Step 1: Calculate Gross Profit (The Trading Account Section)

The formula for Gross Profit is simple, but calculating the Cost of Goods Sold (CoGS) requires several steps.

Formula:

\(Gross \ Profit = Revenue - Cost \ of \ Goods \ Sold\)


We need to calculate CoGS first:

Calculation of Cost of Goods Sold (CoGS)

  • Opening Inventory: Inventory at the start of the year.
  • Add: Purchases: Cost of goods bought during the year.
  • Less: Returns Outwards (Purchases Returns): Goods returned to suppliers.
  • Equals: Cost of Goods Available for Sale.
  • Less: Closing Inventory: Inventory unsold at the end of the year.
  • Equals: Cost of Goods Sold.

Did you know? The CoGS calculation is a real-world application of the Matching Principle. We are matching the cost of the goods sold with the revenue earned from those same goods.

Step 2: Calculate Profit for the Year (The Profit and Loss Section)

We start with the Gross Profit and then account for all other income and expenses.

  • Gross Profit (from Step 1)
  • Add: Other Income (e.g., rent received, discount received).
  • Less: Expenses (e.g., rent paid, wages, electricity, depreciation, discount allowed).
  • Equals: Profit for the year.
🛑 Common Mistake Alert!
Do NOT mix up Returns Outwards (reducing purchases) and Returns Inwards (reducing revenue).

3.3 Preparing the Income Statement for a Service Business

Since a service business does not buy and sell physical goods, the trading section is skipped.

  • Revenue: Fees earned for services provided.
  • Less: Expenses: All operational costs (wages, rent, utilities, depreciation, etc.).
  • Equals: Profit for the year.

SECTION 4: The Statement of Financial Position (SFP)

The SFP is where the Accounting Equation comes to life. Remember:

\[Assets = Owner's \ Equity + Liabilities\]

4.1 Structure and Definitions of Key Elements

The SFP is structured to classify all items owned or owed by the business.

1. Non-Current Assets (NCA)

Definition: Assets that are bought for use in the business over a long period (more than 12 months) and are not intended for resale.
Examples: Premises, machinery, motor vehicles.

In the SFP, these are shown at their Net Book Value (NBV), which is:

\(NBV = Cost - Accumulated \ Depreciation\)


2. Current Assets (CA)

Definition: Assets that are expected to be converted into cash within 12 months.
Examples: Inventory, Trade Receivables (debtors), Bank balance, Cash balance.

3. Owner's Equity (Capital)

Definition: The financial interest of the owner in the business. It shows how much the owner has invested and what the business owes back to the owner.

Formula for Closing Capital:

\[Opening \ Capital + Profit \ for \ the \ year - Drawings = Closing \ Capital\]

4. Non-Current Liabilities (NCL)

Definition: Debts or amounts owed by the business that are payable after more than 12 months.
Examples: Long-term bank loans, mortgage.

5. Current Liabilities (CL)

Definition: Debts or amounts owed by the business that are payable within 12 months.
Examples: Trade Payables (creditors), Bank Overdraft, Accrued Expenses.

4.2 Inter-relationship in the SFP

The statement must always balance because of the Duality Concept (every debit has a corresponding credit).

The total of all Assets must equal the total of Owner's Equity plus Liabilities. This proves the accuracy of the accounting records.

🧠 Memory Trick: The SFP Order
Start with the longest-term items first: NCA -> CA (Assets), then Owner's Equity -> NCL -> CL (Financing). Think of it as classifying items by how quickly they turn into cash or need to be paid off.

SECTION 5: Year-End Adjustments (Crucial Step 5.1)

Before finalising the financial statements, we must ensure all figures are accurate and reflect the economic reality of the period. This means making adjustments.

5.1 Depreciation of Non-Current Assets

Depreciation is the process of allocating the cost of a Non-Current Asset over its useful life. It is an expense, but it is not a cash payment.

Analogy: Imagine buying a brand-new phone. It loses value the moment you start using it. Depreciation reflects this usage and loss of value in the accounts.

Methods Required by Syllabus 0452:
  1. Straight-Line Method: Depreciates the asset evenly over its life.
    \[Annual \ Depreciation = \frac{Cost - Residual \ Value}{Estimated \ Useful \ Life}\]
  2. Reducing Balance Method: Charges a fixed percentage on the Net Book Value (NBV) each year. This means the depreciation charge is higher in the early years and lower later on.
  3. Revaluation Method: Primarily used for small assets (like loose tools).
    \[Depreciation \ Charge = Opening \ Value + Additions - Disposals - Closing \ Value\]

Impact on Financial Statements:

  • Income Statement: The depreciation charge for the year is added to expenses.
  • SFP: The Non-Current Asset cost remains the same, but the Accumulated Depreciation increases, thereby reducing the Net Book Value (NBV).

5.2 Accrued and Prepaid Expenses and Income

These adjustments adhere to the Matching Principle—expenses and income must be recorded in the period they relate to, regardless of when cash is paid or received.

Don't worry if this seems tricky at first; practice makes perfect here!

Expenses:

  • Accrued Expenses (Accruals): Expenses incurred (used) but not yet paid by the year-end. (e.g., unpaid electricity bill).
    Treatment: Added to the expense in the IS. Shown as a Current Liability in the SFP.
  • Prepaid Expenses (Prepayments): Expenses paid in advance for the next period. (e.g., paid 14 months of rent).
    Treatment: Deducted from the expense in the IS. Shown as a Current Asset in the SFP.

Income:

  • Accrued Income (Other Receivables): Income earned but not yet received. (e.g., commission owed to us).
    Treatment: Added to income in the IS. Shown as a Current Asset in the SFP.
  • Prepaid Income (Other Payables): Income received in advance for the next period. (e.g., rent received for the next 3 months).
    Treatment: Deducted from the income in the IS. Shown as a Current Liability in the SFP.

5.3 Irrecoverable Debts and Provision for Doubtful Debts

1. Irrecoverable Debts (Bad Debts)

These are amounts owed by customers (Trade Receivables) that are definitely never going to be paid.

Treatment: Written off as an expense (Irrecoverable Debt Expense) in the Income Statement. The Trade Receivables balance in the SFP is reduced.

2. Provision for Doubtful Debts (PPDD)

This is an estimated amount set aside for debts that might become irrecoverable in the future. It reflects the Prudence Principle—we anticipate losses but not profits.

Treatment:

  • Creation/Increase: Treated as an expense in the Income Statement.
  • Decrease: Treated as income in the Income Statement (as less expense is needed this year).
  • SFP: The Provision is deducted from the Trade Receivables total to show the expected recoverable amount.

5.4 Goods Taken by Owner for Own Use (Drawings)

If the owner takes goods (inventory) from the business for personal use, this transaction must be recorded.

Treatment:

  1. Income Statement: The cost of the goods taken is deducted from Purchases (to reduce the Cost of Goods Sold).
  2. SFP: The amount is treated as Drawings, reducing the Owner's Equity (Capital).

✅ KEY TAKEAWAY SUMMARY

Preparing Sole Trader financial statements involves two major steps:

  1. Adjusting the figures from the Trial Balance using the year-end information (Depreciation, Accruals, Debts).
  2. Presenting the results: Using the adjusted figures to prepare the Income Statement (to find Profit) and the Statement of Financial Position (to prove the Accounting Equation holds true).