Financial Statements of Sole Proprietorship

The One Thing

Financial statements of a sole proprietorship determine both the business’s profitability and its financial position. This requires the systematic preparation of the Trading Account, Profit and Loss Account, and Balance Sheet, with correct classification of items, application of adjustments, and reconstruction of missing information where records are incomplete.

Definitions and Results

• Financial Statements: Statements prepared at the end of an accounting period to find profit or loss and show the financial position of the business.
• Trading Account: An account prepared to determine gross profit or gross loss from trading activities.
• Gross Profit: The excess of net sales over the cost of goods sold.
• Gross Loss: The excess of the cost of goods sold over net sales.
• Profit and Loss Account: An account prepared to determine net profit or net loss after recording indirect expenses and indirect incomes.
• Net Profit: The excess of total operating incomes and gross profit over indirect expenses.
• Net Loss: The excess of indirect expenses over gross profit and indirect incomes.
• Balance Sheet: A statement showing the assets, liabilities, and capital of the business on a specific date.
• Opening Stock: The value of goods available for sale at the beginning of the accounting period.
• Closing Stock: The value of unsold goods remaining at the end of the accounting period.
• Purchases: Goods bought for resale in the ordinary course of business.
• Net Purchases: Purchases after deducting purchase returns and adding direct expenses related to bringing goods to the business.
• Net Sales: Sales after deducting sales returns.
• Cost of Goods Sold: The cost of goods actually sold during the accounting period.
• Direct Expenses: Expenses directly connected with purchasing, manufacturing, or bringing goods to a saleable condition, such as wages, carriage inward, and power used in production.
• Indirect Expenses: Expenses related to administration, selling, distribution, or finance, such as rent, salaries, advertising, insurance, and interest.
• Capital: The owner’s investment in the business, adjusted for additional capital, drawings, and profit or loss.
• Drawings: Cash or goods withdrawn by the proprietor for personal use.
• Adjustment: An accounting item given outside the trial balance that must be recorded in the appropriate accounts and Balance Sheet.
• Outstanding Expense: An expense incurred but not yet paid; it is added to the related expense and shown as a current liability.
• Prepaid Expense: An expense paid in advance; it is deducted from the related expense and shown as a current asset.
• Accrued Income: Income earned but not yet received; it is added to the related income and shown as a current asset.
• Income Received in Advance: Income received before it is earned; it is deducted from the related income and shown as a current liability.
• Depreciation: The decrease in the value of a fixed asset due to use, passage of time, or obsolescence.
• Bad Debts: Amounts due from customers that are no longer expected to be recovered.
• Provision for Doubtful Debts: An estimated amount set aside for possible future losses from debtors.
• Incomplete Records: A system in which all accounting records are not maintained according to the double-entry system.
• Statement of Affairs: A statement prepared under incomplete records to estimate capital by comparing assets and liabilities.
• Single Entry System: An incomplete method of recording transactions in which some accounts, especially personal and cash accounts, may be maintained while other records are missing.
• Conversion Method: A method of preparing final accounts from incomplete records by reconstructing missing accounts such as total debtors, total creditors, and cash.

The principal equations are:

• Gross Profit or Gross Loss = Net Sales − Cost of Goods Sold
• Net Sales = Sales − Sales Returns
• Net Purchases = Purchases − Purchase Returns
• Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses − Closing Stock
• Gross Profit = Net Sales − Opening Stock − Net Purchases − Direct Expenses + Closing Stock
• Net Profit = Gross Profit + Indirect Incomes − Indirect Expenses
• Assets = Capital + Liabilities
• Closing Capital = Opening Capital + Additional Capital + Net Profit − Drawings

Net loss is subtracted instead of net profit in the closing-capital equation. Under the Statement of Affairs method:

• Opening Capital = Opening Assets − Opening Liabilities
• Closing Capital = Closing Assets − Closing Liabilities
• Profit = Closing Capital + Drawings − Additional Capital − Opening Capital

A negative result indicates a loss.

The Trading Account and Profit and Loss Account cover an accounting period, commonly one year. The Balance Sheet is prepared on the last date of that period and shows the position on that specific date.

Worked Methods

1. Preparing the Trading Account

• Record opening stock.
• Calculate net purchases by deducting purchase returns from purchases.
• Add direct expenses.
• Deduct closing stock to determine the cost of goods sold.
• Calculate net sales by deducting sales returns from sales.
• Compare net sales with the cost of goods sold:

- If net sales exceed the cost of goods sold, the result is gross profit. - If the cost of goods sold exceeds net sales, the result is gross loss.

The main formula is:

Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses − Closing Stock

Direct expenses include carriage inward, wages, factory power, import duty, and clearing charges.

Closing stock is generally shown on the credit side of the Trading Account and as a current asset in the Balance Sheet when it is given as an adjustment outside the trial balance. If closing stock appears inside the trial balance, it is normally shown only in the Balance Sheet because it has already been adjusted in the accounts. Closing stock should generally be valued at cost or net realisable value, whichever is lower, unless applicable accounting rules specify otherwise.

Goods withdrawn by the proprietor for personal use are deducted from purchases, and drawings are increased by the same value. Goods distributed as free samples are treated as an indirect expense, such as advertising, and deducted from purchases. Goods destroyed by fire or other abnormal events are removed from purchases; any insurance claim or loss is recorded separately.

2. Preparing the Profit and Loss Account

• Begin with the gross profit or gross loss transferred from the Trading Account.
• Add indirect incomes.
• Deduct indirect expenses.
• Determine net profit or net loss.

Indirect expenses include office salaries, rent, insurance, advertising, carriage outward, depreciation, repairs, and interest paid. Indirect incomes include commission received, discount received, rent received, and interest received.

The formula is:

Net Profit = Gross Profit + Indirect Incomes − Indirect Expenses

If indirect expenses exceed gross profit and indirect incomes:

Net Loss = Indirect Expenses − Gross Profit − Indirect Incomes

The matching principle requires expenses related to the revenue of an accounting period to be charged in the same period, whether or not they have been paid. The accrual principle requires incomes and expenses to be recorded when they are earned or incurred, rather than merely when cash is received or paid.

3. Recording Common Adjustments

Adjustments normally have a dual effect: one effect is recorded in the relevant account and the other is shown in the Balance Sheet.

• Outstanding expenses: Add the amount to the related expense in the Profit and Loss Account and show it as a current liability.
• Prepaid expenses: Deduct the amount from the related expense and show it as a current asset.
• Accrued incomes: Add the amount to the related income and show it as a current asset.
• Incomes received in advance: Deduct the amount from the related income and show it as a current liability.
• Depreciation: Debit it to the Profit and Loss Account and deduct it from the related asset in the Balance Sheet.
• Bad debts: Debit them to the Profit and Loss Account and deduct them from debtors in the Balance Sheet.
• Provision for doubtful debts: Calculate it on adjusted debtors after deducting further bad debts and other required adjustments.
• Interest on capital: Treat it as an expense for the business, debit it to the Profit and Loss Account, and credit it to the proprietor’s capital account.
• Interest on drawings: Treat it as income for the business and add it to the Profit and Loss Account; it reduces the proprietor’s capital.

Capital and revenue items must be distinguished. Capital items affect assets or capital, whereas revenue items affect profit or loss. Personal expenses and drawings must be separated from business expenses so that business profit is measured accurately.

4. Preparing the Balance Sheet

• Determine closing capital using opening capital, additional capital, profit or loss, and drawings.
• List the business’s assets.
• List the liabilities.
• Confirm that the equation balances:

Assets = Capital + Liabilities

The Balance Sheet shows the financial position on a particular date. It includes current assets such as closing stock, prepaid expenses, and accrued income, and current liabilities such as outstanding expenses and income received in advance.

5. Statement of Affairs Method under Incomplete Records

• Calculate opening capital:

Opening Capital = Opening Assets − Opening Liabilities

• Calculate closing capital:

Closing Capital = Closing Assets − Closing Liabilities

• Apply:

Profit = Closing Capital + Drawings − Additional Capital − Opening Capital

• If the result is negative, report a loss.

Incomplete records do not provide complete reliability by themselves. Missing figures must therefore be reconstructed using available evidence and accounting relationships.

6. Conversion Method under Incomplete Records

The Conversion Method prepares final accounts by reconstructing missing accounts, including total debtors, total creditors, and cash.

To reconstruct credit sales, prepare a Total Debtors Account and use:

Credit Sales = Closing Debtors + Cash Received from Debtors + Sales Returns + Bad Debts − Opening Debtors − Bills Receivable Received

This formula is applied subject to the information provided.

To reconstruct credit purchases, prepare a Total Creditors Account and use:

Credit Purchases = Closing Creditors + Cash Paid to Creditors + Purchase Returns + Bills Payable Accepted − Opening Creditors − Other Relevant Credits

The exact items included depend on the information available.

Where It Goes Wrong

• Treating all expenses as direct expenses: carriage inward, wages, factory power, import duty, and clearing charges are direct, whereas office salaries, rent, insurance, advertising, carriage outward, depreciation, repairs, and interest paid are indirect.
• Forgetting the distinction between the accounting period and the Balance Sheet date: Trading and Profit and Loss Accounts cover a period, while the Balance Sheet reports the position on a particular date.
• Recording adjustments only once: outstanding expenses, prepaid expenses, accrued incomes, incomes received in advance, depreciation, bad debts, and closing stock generally have both an account effect and a Balance Sheet effect.
• Misclassifying personal transactions: goods withdrawn by the proprietor are deducted from purchases and added to drawings; personal expenses must not be treated as business expenses.
• Applying the provision for doubtful debts to unadjusted debtors: further bad debts and other required adjustments must first be deducted.
• Using incomplete-records formulas without checking the available evidence: Total Debtors and Total Creditors Accounts require the relevant cash, returns, bills, opening balances, closing balances, and other credits or debits.

What Gets Asked

This material supports questions requiring students to:

• Define Financial Statements, Trading Account, Gross Profit, Gross Loss, Profit and Loss Account, Net Profit, Net Loss, Balance Sheet, capital, drawings, adjustments, incomplete records, Statement of Affairs, Single Entry System, and Conversion Method.
• Calculate net sales, net purchases, cost of goods sold, gross profit, gross loss, net profit, and net loss.
• Prepare a Trading Account from opening stock, purchases, purchase returns, direct expenses, sales, sales returns, and closing stock.
• Prepare a Profit and Loss Account using gross profit or gross loss, indirect expenses, and indirect incomes.
• Prepare a Balance Sheet using assets, liabilities, capital, additional capital, drawings, and profit or loss.
• Apply adjustments for outstanding expenses, prepaid expenses, accrued incomes, incomes received in advance, depreciation, bad debts, provision for doubtful debts, interest on capital, and interest on drawings.
• Explain the matching principle, accrual principle, distinction between capital and revenue items, and the dual effect of adjustments.
• Calculate opening and closing capital under the Statement of Affairs method and determine profit or loss.
• Reconstruct credit sales through a Total Debtors Account and credit purchases through a Total Creditors Account under the Conversion Method.
• Explain the treatment of goods withdrawn for personal use, goods distributed as free samples, and goods destroyed by fire or other abnormal events.
• State why the Balance Sheet balances and explain that every business resource is financed by the owner’s capital or by liabilities.