Welcome to Financial Statements: The Grand Finale!

Hi everyone! This chapter is where everything you’ve learned about debits, credits, and ledger accounts finally comes together. We are going to transform those long lists of balances (the Trial Balance) into the official report card for a sole trader’s business: the Financial Statements.

Don't worry if this seems like a big step! We will break it down using simple steps and focus heavily on the adjustments required by those important rules we call Accounting Concepts.

What We Will Achieve in This Chapter:

  • Understand why adjustments are necessary.
  • Apply core accounting concepts (like Prudence and Matching).
  • Prepare the Statement of Comprehensive Income (to find profit).
  • Prepare the Statement of Financial Position (to show the business's worth).

Section 1: The Need for Adjustments

When we first take figures from the ledger and create a Trial Balance, those figures often don't represent the *true* situation of the business for the specific year we are reporting on. This is because some expenses or revenues might relate to the next year, or some assets might have lost value.

We must apply adjustments to ensure our financial statements are accurate and reliable.

1.1 The Crucial Role of Accounting Concepts

These concepts are the rules of the game. They dictate how and when we record items. The following three are the most important for adjustments:

A. The Matching/Accruals Concept

The Rule: Expenses must be matched against the revenue they helped generate in the same accounting period, regardless of when the cash was paid or received.

Analogy: Imagine paying your rent. If you pay for January 2024 and February 2024 in December 2023, only the January rent should be charged against the January revenue.

This leads to two types of adjustments:
1. Accruals (Expenses Due):
These are expenses that relate to the current period but have not yet been paid (we owe them).
Example: Electricity used in December 2023, but the bill arrives and is paid in January 2024.
Impact: Increase the expense in the Statement of Comprehensive Income (SCI) and create a Current Liability in the Statement of Financial Position (SFP).

2. Prepayments (Expenses Paid in Advance):
These are expenses that were paid during the current period but relate to the next period.
Example: Paying 12 months of insurance on July 1st. Six months of that payment relate to the following year.
Impact: Decrease the expense in the SCI and create a Current Asset in the SFP.

B. The Prudence Concept

The Rule: We should be cautious when recording profit. We must anticipate all losses but only recognise profits when they are certain. "Better safe than sorry."

This affects three major areas:
1. Closing Inventory Valuation:
We must value closing inventory at the lower of cost or net realisable value (NRV). If the market value (NRV) of the goods has fallen below what we paid for them (cost), we must record the loss now.
2. Irrecoverable Debts (Bad Debts):
If a debtor (customer) is confirmed bankrupt and will definitely not pay, we write off the amount as an expense.
Impact: Expense in SCI, decreases Trade Receivables (Debtors) in SFP.
3. Provision for Doubtful Debts (PPDD):
If we *think* some debtors might not pay (even if it's not confirmed yet), Prudence requires us to estimate this potential loss and record it as a Provision.
Impact: Expense in SCI (the increase/decrease in the provision) and shown as a deduction from Trade Receivables in the SFP.

C. The Historical Cost Concept and Depreciation

The Rule: Assets are initially recorded at their original purchase price (cost).

Depreciation: Although assets are recorded at cost, most non-current (fixed) assets like vehicles and machinery lose value over time. Depreciation is the estimated expense of using up that asset during the year.
Analogy: A brand new car starts losing value (depreciating) the moment you drive it off the lot.
Impact: Expense in SCI (reducing profit) and accumulated depreciation is deducted from the asset's cost in the SFP.

Section 2: Preparing the Statement of Comprehensive Income (SCI)

The SCI (sometimes called the Income Statement or Trading and Profit and Loss Account) shows whether the sole trader made a profit or a loss over a specific period (usually 12 months).

2.1 Step 1: The Trading Section (Calculating Gross Profit)

The trading section deals only with the buying and selling of goods.

Formula Tip: The goal is to calculate Cost of Goods Sold (COGS) and subtract it from Sales Revenue.

Element Source/Calculation
Revenue (Sales) From Trial Balance, adjusted for returns inwards.
Less: Cost of Goods Sold (COGS) Calculated below.
Opening Inventory Inventory figure from the start of the year (Trial Balance).
Add: Purchases From Trial Balance, adjusted for returns outwards.
Add: Carriage Inwards Cost of bringing inventory to the premises (part of COGS).
Total Goods Available for Sale (Opening Inv. + Net Purchases + Carriage Inwards)
Less: Closing Inventory Figure determined by stocktake (adjustment).
COGS The final result of the calculation above.
GROSS PROFIT Revenue – COGS

2.2 Step 2: The Profit and Loss Section (Calculating Net Profit)

This section takes the Gross Profit and adjusts it for all other running expenses and incomes (like rent, salaries, interest, depreciation, etc.). These are often called Operating Expenses.

Start with Gross Profit
Add: Other Incomes (e.g., Rent Received, Commission Received).
Less: Expenses (Administrative, Selling, Financial).

Remember to include adjustments here!

  • If salaries in the Trial Balance are $10,000, but $500 is accrued (unpaid), you must charge $10,500 in the SCI.
  • If the rent expense includes $800 prepaid (paid in advance for next year), you only charge $(X - 800)$ this year.
  • Depreciation expense is added here.
  • Irrecoverable debts written off and the change in the Provision for Doubtful Debts are also expenses here.


\( \text{Gross Profit} \pm \text{Other Incomes} - \text{Total Expenses} = \text{Net Profit (or Loss)} \)

Quick Review: The Profit Journey

The Net Profit is the most important number because it shows the overall success of the business. This figure is not kept separate; it belongs to the owner. It will be transferred to the Statement of Financial Position to increase the owner’s Capital.

Section 3: Preparing the Statement of Financial Position (SFP)

The SFP (sometimes called the Balance Sheet) is a snapshot of the business’s assets, liabilities, and owner’s capital at a specific moment in time (e.g., 31 December 2024).

3.1 The Fundamental Accounting Equation

All financial statements revolve around this concept. The SFP must always balance!

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

3.2 The Structure of the SFP

A. Assets (What the business owns)

1. Non-Current Assets (Fixed Assets): Items held for more than 12 months, used to help the business generate income (e.g., land, equipment, motor vehicles).
Crucial Calculation:

\( \text{Cost} - \text{Accumulated Depreciation} = \text{Net Book Value (NBV)} \)

Note: The accumulated depreciation figure is the sum of depreciation charged since the asset was purchased.

2. Current Assets: Items expected to be converted into cash within 12 months.
  • Closing Inventory: (The adjustment from the end of the SCI).
  • Trade Receivables (Debtors): (Adjusted for irrecoverable debts and provision for doubtful debts).
  • Bank/Cash Balance: (From Trial Balance).
  • Prepayments: (The expense paid in advance—an asset because the business has paid for future services).

B. Capital and Liabilities (Where the money came from)

1. Capital (Owner's Equity): The amount invested by the owner, adjusted for performance and drawings.
Remember the Separate Entity Concept: The owner's capital is a liability to the business itself.

The Capital Account Reconciliation:

Opening Capital (from Trial Balance)
Add: Net Profit (from SCI) OR Less: Net Loss
Add: Additional Capital introduced during the year
Less: Drawings (Money or goods taken out by the owner)
CLOSING CAPITAL (The figure used in the SFP)

2. Non-Current Liabilities: Debts repayable after more than 12 months (e.g., long-term bank loan).

3. Current Liabilities: Debts repayable within 12 months.

  • Trade Payables (Creditors): (Money owed to suppliers).
  • Bank Overdraft: (If applicable).
  • Accruals: (Expenses owed but not yet paid—a liability because we must pay them).

3.3 Common Mistakes to Avoid

  • Mixing up inventory figures: Opening Inventory goes into the SCI, Closing Inventory goes into both the SCI (as a deduction from COGS) and the SFP (as a Current Asset).
  • Forgetting the "Double Impact": Every adjustment affects two places (e.g., Accrued Rent is an increase to Rent Expense in SCI AND a Current Liability in SFP).
  • Ignoring Drawings: Drawings are NOT an expense in the SCI; they only reduce Capital in the SFP.
Did You Know?

For sole traders, the financial statements are often confidential. Unlike large public companies, sole traders do not usually have to share their SCI and SFP with the general public—only with tax authorities and potentially their bank.

By the end of this process, the total calculated value of Assets should exactly match the total of Capital plus Liabilities. If they don't, it means you missed an adjustment or made an error in transferring the ledger balances!

Key Takeaway

The preparation of financial statements is the final check and presentation stage. It requires taking raw ledger data and refining it using accounting concepts to show the true performance (SCI) and true position (SFP) of the business.