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In this chapter we look at preparing the year end financial statements of sole traders(that is, one person running their own business). We present the financial statements –statement of profit or loss and statement of financial position – using the conventionalformat. This chapter shows how the financial statements are adjusted ton present a more relevant and faithful representation of profit, and assets and

liabilitiesn enable comparisons to be made with financial statements from previous yearsn enable users of financial statements to understand and be assured of the

information given

The chapter continues with conventional format financial statements by bringingtogether into a trial balance the adjustments for:n closing inventoryn accruals and prepaymentsn depreciation of non-current assetsn irrecoverable debtsn allowance for doubtful debtsWe then see how these adjustments are incorporated into the conventional formatfinancial statements.

Sole trader financialstatements

3

this chapter covers...

s o l e t r a d e r f i n a n c i a l s t a t e m e n t s 5 3

s o l e t r a d e r s

Sole traders are people who run their own businesses: they run shops,factories, farms, garages, local franchises, etc. The businesses are generallysmall because the owner usually has a limited amount of capital. Profits areoften small and, after the owner has taken out drawings, are usually ploughedback into the business.

a d v a n t a g e s a n d d i s a d v a n t a g e sSole trader businesses are cheap and easy to set up; the advantages are:n the owner has independence and can run the business, often without the

need to consult othersn in a small business with few, if any, employees, personal service and

supervision by the owner are available at all timesn the business is easy to establish legally – either using the owner’s name,

or a trading name such as ‘The Fashion Shop’ or ‘Wyvern Plumbers’The disadvantages are:n the owner has unlimited liability for the debts of the business – this means

that if the sole trader should become insolvent, the owner’s personalassets may be used to pay business debts

n expansion is limited because it can only be achieved by the ownerploughing back profits, or by borrowing from a lender such as a bank

n the owner usually has to work long hours and it may be difficult to findtime to take holidays; if the owner should become ill the work of thebusiness will either slow down or stop altogether

F I N a N c I a l s tat e m e N t s o F a s o l e t r a d e r

The financial statements (final accounts) of a sole trader comprise:n statement of profit or loss n statement of financial position Such financial statements are produced annually at the end of the financialyear (which can end at any date – it doesn’t have to be the calendar year).The financial statements can be produced more often in order to giveinformation to the sole trader on how the business is progressing.

F I N a N c I a l s tat e m e N t s : t h e a d j u s t m e N t s

Many Activities and Assessments focus on aspects of the preparation offinancial statements in the conventional format used by accountants. Forexample, you may be asked to prepare some, or all, of a statement of profitor loss and statement of financial position. There may be a number ofadjustments incorporated into the year end financial statements. The diagramon the next page summarises the year end adjustments and their effect on thefinancial statements. The adjustments are made in order to: n present a more relevant and faithful representation of profit, and assets

and liabilitiesn enable comparisons to be made with financial statements from previous

yearsn enable users of financial statements to understand and be assured of the

information givenThe Case Study on page 56 brings together all of these adjustments.Although in total the Case Study is more complex than would be required inan Assessment, it does provide a useful reference point which shows theadjustments incorporated into the financial statements of a sole trader.The Activities at the end of this chapter are based on the preparation offinancial statements from a trial balance and provide practice to help withyour studies in preparing conventional format financial statements. Note that in AAT Assessments:n you will always be given a balancing trial balance which incorporates the

adjustmentsn you will be given an outline pro-forma of the financial statements

together with a list of pro-forma names to usen some adaptation of the pro-forma names may be needed – eg interest paid

may need to be shown as finance costs – and some accounts may need tobe combined – eg cash + bank = cash and cash equivalents

n some trial balance accounts may need translation to the pro-formanames – eg purchases ledger control accounts to be shown as tradepayables

n some account balances could appear on either side of the trial balance –eg VAT, loans, bank – and need to be treated correctly in the financialstatement pro-forma

5 4 f i n a l a c c o u n t s f o r s o l e t r a d e r s a n d p a r t n e r s h i p s t u t o r i a l

Note that, in AAT Assessments, you may be required to combine account balances beforetransferring the net amount or total amount to the statement of profit or loss or statement of financialposition. Examples include sales minus sales returns equals net sales, purchases minus purchasesreturns equals net purchases, trade receivables less allowance for doubtful debts equals net tradereceivables. An Assessment will always tell you when such combining is to be done – usually in theform of a statement of the business’ policy.


statemeNt oF ProFIt or loss

• deduct from purchases

• add to expense

• deduct from expense

• add to income

• deduct from income

• depreciation charge: expense

• expense

• debit balance: expense (loss ondisposal)

• credit balance: income (gain ondisposal)

• expense

• income

• add to sales revenue

summarY oF Year eNd adjustmeNts For FINaNcIal statemeNts

statemeNt oF FINaNcIalPosItIoN

• current asset

• current liability

• current asset

• current asset

• current liability

• non-current assets reducedby accumulated depreciationto give carrying amount

• deduct from trade receivables

• non-current assets reducedby disposal

• trade receivables figurereduced by total amount ofallowance

• trade receivables figurereduced by total amount ofallowance

• add to drawings

adjustmeNt

closing inventory

accrual of expenses

prepayment of expenses

accrual of income

prepayment of income

depreciation charge/accumulated depreciation ofnon-current assets

irrecoverable debts

disposal of non-current asset

creation of, or increase in,allowance for doubtful debts

decrease in allowance fordoubtful debts

goods taken by the owner forown use


S O L E T R A D E R F I N A N C I A L S TAT E M E N T Ss i t u a t i o nYou are the accountant to Olivia Boulton, a sole trader, who runs a kitchen andcookware shop. Her bookkeeper extracted the year end trial balance and you haveincorporated into it the adjustments advised to you by Olivia Boulton. The adjustedtrial balance is as follows:

trial balance of olivia Boulton as at 31 december 20-2Dr Cr£ £

Opening inventory 50,000Purchases 420,000Sales revenue 557,500Closing inventory 42,000 42,000Shop expenses 6,200Shop wages 33,300Prepayment of shop wages 200Telephone expenses 600Accrual of telephone expenses 100Interest paid 8,000Travel expenses 550Discounts allowed 450Discounts received 900Disposal of non-current asset 250Premises at cost 250,000Shop fittings at cost 40,000Premises: depreciation charge 5,000Shop fittings: depreciation charge 6,400Premises: accumulated depreciation 15,000Shop fittings: accumulated depreciation 14,400Sales ledger control 10,000Irrecoverable debts 500Allowance for doubtful debts 250Allowance for doubtful debts: adjustment 50Purchases ledger control 11,250Bank 2,650Capital 125,000Drawings 24,000Loan from bank (repayable in 20-9) 130,000Value Added Tax 3,250

899,900 899,900

You are to prepare the financial statements of Olivia Boulton for the year ended31 December 20-2, using the conventional format.

CaseStudy


s o l u t i o nThe financial statements incorporating these adjustments are shown on the next twopages. A summary of the effect of each adjustment is given below.

closing inventory– deduct £42,000 from purchases in the statement of profit or loss– show inventory at £42,000 as a current asset in the statement of financial position

prepayment of expenses– show £200 prepayment of shop wages as a current asset in the statement of

financial position

accrual of expenses– show £100 accrual of telephone expenses as a current liability in the statement of

financial position

depreciation of non-current assets– in the statement of profit or loss show as expenses the depreciation charges for

premises £5,000 and shop fittings £6,400– in the statement of financial position show accumulated depreciation amounts

deducted from non-current assets to give carrying amounts as follows:

cost accumulated carryingdepreciation amount

£ £ £Premises 250,000 15,000 235,000Shop fittings 40,000 14,400 25,600

290,000 29,400 260,600

disposal of non-current assetDuring the year a non-current asset has been sold. The bookkeeping entries fordisposals have been made and all that remains is a credit balance of £250 ondisposals account. This amount is shown as income, being a gain on disposal, in thestatement of profit or loss. (A debit balance on disposals account would mean a losson disposal – this would be shown as an expense in the statement of profit or loss.)

irrecoverable debts– record irrecoverable debts of £500 as an expense in the statement of profit or loss

allowance for doubtful debts: adjustment– in the statement of profit or loss record the £50 amount of the increase (debit side

of trial balance) in allowance for doubtful debts as an expense– in the statement of financial position deduct £250 from the trade receivables figure

of £10,000 to give net receivables of £9,750 – it is this amount that is listed incurrent assets

Note that, where there is a reduction in the allowance for doubtful debts, show theamount of the reduction as income in the statement of profit or loss.

financial statementsThe financial statements of Olivia Boulton that you prepare are shown below.

olIVIa BoultoNstatemeNt oF ProFIt or loss

for the year ended 31 december 20-2£ £

Sales revenue 557,500Opening inventory 50,000Purchases 420,000

470,000Less Closing inventory 42,000Cost of sales 428,000Gross profit 129,500Add other income:

Discounts received 900Gain on disposal of non-current asset 250

130,650Less expenses:

Shop expenses 6,200Shop wages 33,300Telephone 600Finance costs (interest paid) 8,000Travel expenses 550Discounts allowed 450Depreciation charges: premises 5,000

shop fittings 6,400Irrecoverable debts 500Allowance for doubtful debts: adjustment 50

61,050Profit for the year 69,600

Note that the balances of accounts such as discounts received, interest received,commission received, gain on disposal of non-current asset etc are always listed in thestatement of profit or loss under the heading of other income and are added to thegross profit.



statemeNt oF FINaNcIal PosItIoNas at 31 december 20-2

Non-current assets cost accumulated carryingdepreciation amount

£ £ £

Premises 250,000 15,000 235,000Shop fittings 40,000 14,400 25,600

290,000 29,400 260,600

current assetsInventory 42,000Trade receivables 10,000Less allowance for doubtful debts 250

9,750Prepayment of expenses 200Cash and cash equivalents (Bank) 2,650

54,600less current liabilitiesTrade payables 11,250Accrual of expenses 100Value Added Tax 3,250

14,600Net current assets 40,000

300,600less Non-current liabilitiesLoan from bank 130,000Net assets 170,600

FINaNced BYcapitalOpening capital 125,000Add Profit for the year 69,600

194,600Less Drawings 24,000Closing capital 170,600

t h e u s e o F c o s t o F s a l e s a c c o u N t

In some trial balances there is a debit column balance given for cost of sales(also referred to as cost of goods sold). This happens because the cost of salescalculation has been done already, and no amounts are shown in the trialbalance for:n in the debit column

– opening inventory– purchases

n in the credit column– purchases returns (if any)– closing inventory (but the debit column balance for closing inventoryis still shown, as this is the amount which is an asset for the statement offinancial position)

The calculation for cost of sales (cost of goods sold) is:Opening inventory

plus Purchasesless Purchases returns (if any)less Closing inventoryequals Cost of sales

It is the final figure for cost of sales that is shown in the debit column of thetrial balance – the other amounts are not shown – when the business is usinga cost of sales account.

c o s t o f s a l e s a c c o u n tThis account brings together the amounts that make up cost of sales, asfollows (using the figures from Olivia Boulton’s trial balance on page 56):

Dr cost of sales account Cr20-2 £ 20-2 £31 Dec Opening inventory 50,000 31 Dec Purchases returns* –31 Dec Purchases 420,000 31 Dec Closing inventory 42,000

31 Dec Balance c/d 428,000470,000 470,000

31 Dec Balance b/d 428,000 31 Dec Statement of 428,000profit or loss

* Note: there were no purchases returns in Olivia Boulton’s trial balance


The balance of the cost of sales account, £428,000, is transferred to thestatement of profit or loss where it is deducted from sales to give gross profit:

olIVIa BoultoNstatemeNt oF ProFIt or loss (extract)

for the year ended 31 december 20-2£ £

Sales revenue (less sales returns, if any) 557,500Less Cost of sales 428,000Gross profit 129,500

As you see, this is the same gross profit as we have seen already on page 58,but here gross profit has been calculated in just three lines (although theremay be sales returns to deduct from sales revenue). The rest of the statementof profit or loss continues as we have seen previously.

s u m m a r yIn Activities and Assessments you should be ready for a trial balance topresent you with two different circumstances:eithern full cost of sales amounts

– opening inventory, in debit column– purchases, in debit column– purchases returns (if any), in credit column– closing inventory, in both debit and credit columns (remember that the

debit amount is an asset on the statement of financial position, whilethe credit amount is used in cost of sales)

orn cost of sales account

– cost of sales, in debit column– closing inventory, in debit column (an asset on the statement of

financial position)In the first circumstance you will need to calculate the figure for cost of saleson the face of the statement of profit or loss. In the second circumstance it isonly necessary to deduct cost of sales from the figure for sales (allowing forsales returns, if any) in order to calculate the gross profit figure – after grossprofit, the statement of profit or loss continues as we have seen previously.



n Sole traders are people who run their own businesses; generally theirbusinesses are small because the owner usually has a limited amount ofcapital.

n The financial statements of a sole trader comprise

– statement of profit or loss– statement of financial position

n Adjustments are made to financial statements in order to improve theirrelevance and faithful representation.

n A fully adjusted trial balance incorporates the adjustments for– closing inventory– accruals and prepayments– depreciation of non-current assets– irrecoverable debts– allowance for doubtful debts

n A cost of sales account enables the statement of profit or loss to show grossprofit in three lines:

sales revenue, less sales returns (if any)– cost of sales= gross profit

sole trader one person running their own business

adjusted trial balance trial balance which incorporates the accountingadjustments and from which financial statementscan be prepared

cost of sales account account which brings together amounts that makeup cost of sales:

opening inventory+ purchases– purchases returns (if any)– closing inventory= cost of sales

ChapterSummary

KeyTerms


Blank photocopiable layouts of the statement of profit or loss and the statement of financial positionare included in the Appendix – it is advisable to enlarge them up to A4 size.

3.1 A statement of profit or loss shows a profit for the year of £10,500. It is discovered that no allowancehas been made for wages prepaid of £250 and administration expenses accrued of £100 at theyear end. What is the adjusted profit for the year?(a) £10,150(b) £10,350(c) £10,650(d) £10,850Answer (a) or (b) or (c) or (d)

3.2 A year end trial balance includes the following amounts:opening inventory £5,500closing inventory £6,500purchases £25,000sales revenue £48,000purchases returns £1,000sales returns £2,000

What is the cost of sales figure for the year?(a) £23,000(b) £25,000(c) £26,000(d) £47,000Answer (a) or (b) or (c) or (d)

3.3 A statement of profit or loss shows a profit for the year of £15,750. The owner of the businesswishes to reduce the allowance for doubtful debts by £500 and to write off irrecoverable debts of£300. What is the adjusted profit for the year?(a) £14,950(b) £15,550(c) £15,950(d) £16,550Answer (a) or (b) or (c) or (d)

Activities

3.4 You have the following trial balance for a sole trader known as Zelah Trading. All the necessary yearend adjustments have been made.

(a) Prepare a statement of profit or loss (on the next page) for the business for the year ended31 March 20-4.

Zelah tradingtrial balance as at 31 march 20-4

Dr Cr£ £

Accruals 950Bank 3,220Capital 22,000Closing inventory 6,500 6,500Depreciation charge 3,400Discounts allowed 750Drawings 6,500General expenses 21,240Machinery at cost 24,200Machinery: accumulated depreciation 8,400Opening inventory 4,850Prepayments 650Purchases 85,260Purchases ledger control 11,360Rent 8,900Sales revenue 155,210Sales ledger control 15,350Selling expenses 27,890Value Added Tax 4,290

208,710 208,710


Zelah tradingstatement of profit or loss for the year ended 31 march 20-4

£ £Sales revenue

Cost of salesGross profitLess expenses:

Total expensesProfit for the year

(b) Indicate where closing inventory should be shown in the statement of financial position. TickoNe from:

✓

As a non-current assetAs a current assetAs a current liabilityAs a deduction from capital

(c) State the meaning of a credit balance for Value Added Tax in a trial balance. Tick oNefrom:

✓

HM Revenue & Customs owes the businessHM Revenue & Customs is a receivable of the businessThere is an error – VAT is always a debit balanceThe business owes HM Revenue & Customs


3.5 The following adjusted trial balance has been taken from the books of Helena Ostrowska, who sellssoft furnishings, as at 31 March 20-5:

Dr Cr£ £

Sales ledger control 46,280Purchases ledger control 24,930Value Added Tax 3,860Bank 10,180Capital 62,000Sales revenue 243,820Purchases 140,950Opening inventory 30,030Shop wages 40,270Accrual of shop wages 940Heat and light 3,470Prepayment of heat and light 220Rent and rates 12,045Shop fittings at cost 30,000Shop fittings: depreciation charge 5,000Shop fittings: accumulated depreciation 15,000Disposal of non-current asset 850Irrecoverable debts 200Drawings 31,055Closing inventory 34,080 34,080

384,630 384,630

You are to prepare the financial statements of Helena Ostrowska for the year ended 31 March20-5, using the conventional format.


3.6 The following adjusted trial balance has been taken from the books of Mark Pelisi, a landscapegardener, as at 31 March 20-7:

Dr Cr£ £

Sales revenue 100,330Sales returns 120Cost of sales 35,710Discounts allowed and received 170 240Drawings 30,090Vehicles at cost 24,000Vehicles: depreciation charge 6,000Vehicles: accumulated depreciation 12,500Equipment at cost 18,500Equipment: depreciation charge 3,500Equipment: accumulated depreciation 8,000Disposal of non-current asset 160Wages 24,110Accrual of wages 400Advertising 770Administration expenses 14,830Bank 3,800Sales ledger control 3,480Irrecoverable debts 350Allowance for doubtful debts 620Allowance for doubtful debts: adjustment 180Purchases ledger control 2,760Value Added Tax 1,840Capital 35,040Bank loan (repayable in 20-9) 9,000Closing inventory 5,640

171,070 171,070

You are to prepare the financial statements of Mark Pelisi for the year ended 31 March 20-7, usingthe conventional format.


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