Notes · AccountingUK · A-Levels

Financial statements of sole traders (with adjustments)

This chapter brings the double-entry records together into the two financial statements - the income statement, which measures profit, and the statement of financial position, which shows what the business owns and owes. It then works through the year-end adjustments (accruals and prepayments, depreciation and disposals, irrecoverable debts and the allowance for doubtful debts, and inventory valuation) that must be made before the statements give a true and fair view.

5 sections~22 min reading time3 competenciesLevel Standard 3 · Advanced 2

T·0666 / 18

Exam profile

AO1 · Understand the structure of the income statement and the statement of financial position and the year-end adjustmentsAO2 · Prepare the financial statements of a sole trader from a trial balance, incorporating all adjustmentsAO3 · Analyse how each adjustment affects profit and the statement of financial position and evaluate the reliability of the figures

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basic level

AS-Level expects the income statement and statement of financial position with the main adjustments (accruals, prepayments, depreciation, closing inventory).

higher level

The full A-Level expects confident handling of every adjustment together, including disposals and the allowance for doubtful debts, and analysis of their effect on the reported figures.

Depth

Text

Contents · 5 sections

Financial statements of sole traders (with adjustments)

The income statement#

StandardAQA 7127 3.6

Income statement of a sole trader

Fig. 1The income statement in two stages: revenue less cost of sales gives gross profit £83,000; less other expenses of £48,000 gives a profit for the year of £35,000.

The income statement measures the profit or loss a business made over a period, and it is built in two stages. The first stage - historically the 'trading account' - calculates gross profit, the profit from buying and selling before other expenses: revenue less the cost of sales. The cost of sales is not simply purchases; it is the cost of the goods actually sold, calculated as opening inventory plus purchases (adjusted for carriage inwards and purchases returns) minus closing inventory. Subtracting cost of sales from revenue gives gross profit, the fundamental measure of trading success and the basis of the gross profit margin.

The second stage deducts all the other expenses of running the business - the overheads such as rent, wages, insurance, depreciation, irrecoverable debts and administrative costs - and adds any other income (such as rent received or discounts received) to arrive at the profit for the year (the net profit). This is the bottom line: the amount by which the owner's capital has increased through trading, before any drawings. The profit for the year is the figure that flows into the capital section of the statement of financial position and the figure on which the net profit margin and, ultimately, judgements about performance are based.

Preparing an income statement from a trial balance means picking out the revenue and expense balances and, crucially, adjusting them. The trial balance figures are the amounts recorded during the year, which are not yet on the correct accruals basis: an expense may have been prepaid or accrued, depreciation for the year must be charged, closing inventory must be brought in, and irrecoverable debts and allowances dealt with. Only after these adjustments do the figures represent the income earned and the costs incurred in the period, so the discipline is always: take the trial balance figure, apply the adjustment, then enter the adjusted figure in the statement.

A worked income statement shows the structure. Suppose a sole trader has revenue of £200,000, opening inventory £15,000, purchases £120,000, closing inventory £18,000, rent £10,000 (after a prepayment adjustment), wages £33,000 (after an accrual), depreciation £4,000 and irrecoverable debts £1,000. Cost of sales is £15,000 + £120,000 - £18,000 = £117,000, so gross profit is £200,000 - £117,000 = £83,000. Expenses total £10,000 + £33,000 + £4,000 + £1,000 = £48,000, leaving a profit for the year of £83,000 - £48,000 = £35,000. Every figure traces back to a trial-balance amount adjusted to the accruals basis.

\text{Cost of sales} = \text{Opening inventory} + \text{Purchases} - \text{Closing inventory}

Cost of sales

The cost of the goods actually sold, not the goods bought. Add carriage inwards and deduct purchases returns where present.

\text{Gross profit} = \text{Revenue} - \text{Cost of sales}

Gross profit

Trading profit before overheads - the basis of the gross profit margin.

\text{Profit for the year} = \text{Gross profit} + \text{Other income} - \text{Expenses}

Profit for the year

The net profit that increases the owner's capital, before drawings.

Worked example

Preparing an income statement

A sole trader has revenue £200,000, opening inventory £15,000, purchases £120,000, closing inventory £18,000, rent £10,000, wages £33,000, depreciation £4,000 and irrecoverable debts £1,000. Prepare the income statement.

Cost of sales
Opening inventory £15,000 + purchases £120,000 - closing inventory £18,000 = £117,000.
Gross profit
Revenue £200,000 - cost of sales £117,000 = £83,000.
Profit for the year
Expenses = £10,000 + £33,000 + £4,000 + £1,000 = £48,000. Profit for the year = £83,000 - £48,000 = £35,000.

Result: Gross profit is £83,000 and the profit for the year is £35,000, after cost of sales of £117,000 and expenses of £48,000.

Typical mistakes

Using purchases instead of cost of sales - forgetting to add opening and deduct closing inventory.
Entering unadjusted trial-balance figures without applying accruals, prepayments and depreciation.

Active revision

From: revenue £180,000, opening inventory £12,000, purchases £100,000, closing inventory £14,000, expenses (after adjustments) £40,000. Prepare the income statement and calculate gross profit and profit for the year.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA)

The statement of financial position#

StandardAQA 7127 3.6

Statement of financial position of a sole trader

Fig. 2Net assets of £65,000 (non-current £28,000 plus net current £37,000) equal closing capital of £65,000 (opening £40,000 plus profit £35,000 less drawings £10,000) - the statement balances.

The statement of financial position (formerly the balance sheet) is a snapshot at a point in time of what the business owns and owes, and it is simply the accounting equation set out in full: assets equal capital plus liabilities. It is arranged to show, on one side, the assets classified into non-current assets (held for long-term use - property, equipment, vehicles, shown at cost less accumulated depreciation) and current assets (held short-term and expected to be turned into cash within a year - inventory, trade receivables, prepayments, bank and cash), and on the other side the claims against them: the liabilities (current and non-current) and the owner's capital. Because it is the accounting equation, it must balance.

The modern vertical format arranges these to highlight two useful sub-totals. Current assets less current liabilities gives net current assets (working capital) - the liquid buffer available to meet short-term obligations, and a key measure of liquidity. Non-current assets plus net current assets, less any non-current liabilities, gives net assets - the value of the business to its owner. The bottom half of the statement then shows how those net assets are financed: the capital section, which for a sole trader is the opening capital plus profit for the year less drawings, giving the closing capital. Net assets must equal closing capital - that equality is the statement balancing, and it is the check that the whole set of accounts is internally consistent.

The capital section deserves particular attention because it links the two statements. The profit for the year, calculated in the income statement, is added to the owner's capital (profit belongs to the owner and increases their stake), and the drawings the owner has taken during the year are deducted (they reduce the stake). So closing capital = opening capital + profit - drawings. This is the expanded accounting equation from the double-entry chapter, made visible: the income statement feeds the capital section, and the capital section balances against the net assets. If the statement does not balance, an adjustment has been made inconsistently between the two statements.

Continuing the worked example makes the structure concrete. The same sole trader has equipment costing £40,000 with accumulated depreciation of £12,000 (carrying amount £28,000); current assets of inventory £18,000, trade receivables £24,000, a prepayment £2,000 and bank £6,000 (total £50,000); and current liabilities of trade payables £10,000 and an accrual £3,000 (total £13,000). Net current assets are £50,000 - £13,000 = £37,000, so net assets are £28,000 + £37,000 = £65,000. The capital section is opening capital £40,000 + profit £35,000 - drawings £10,000 = £65,000. Net assets (£65,000) equal closing capital (£65,000): the statement balances, confirming the accounts are consistent.

\text{Net current assets} = \text{Current assets} - \text{Current liabilities}

Working capital

The short-term liquid buffer. Also the numerator idea behind the current ratio.

\text{Closing capital} = \text{Opening capital} + \text{Profit} - \text{Drawings}

The capital section

Links the income statement to the statement of financial position; closing capital must equal net assets.

Worked example

Preparing a statement of financial position

A sole trader has equipment (carrying amount) £28,000; inventory £18,000, receivables £24,000, a prepayment £2,000 and bank £6,000; trade payables £10,000 and an accrual £3,000; opening capital £40,000, profit £35,000 and drawings £10,000. Prepare the statement of financial position.

Net current assets
Current assets = £18,000 + £24,000 + £2,000 + £6,000 = £50,000; current liabilities = £10,000 + £3,000 = £13,000; net current assets = £50,000 - £13,000 = £37,000.
Net assets
Non-current assets £28,000 + net current assets £37,000 = £65,000.
Capital section and check
Opening capital £40,000 + profit £35,000 - drawings £10,000 = £65,000. Net assets (£65,000) equal closing capital (£65,000), so the statement balances.

Result: Net assets of £65,000 equal closing capital of £65,000 - the statement balances, confirming the income statement and the statement of financial position are consistent.

Typical mistakes

Failing to make the statement balance because an adjustment was applied to one statement but not consistently to the other.
Adding drawings to capital instead of deducting them, or omitting depreciation from the asset's carrying amount.

Active revision

A trader has non-current assets (carrying amount) £30,000, current assets £22,000, current liabilities £9,000, opening capital £35,000, profit £15,000 and drawings £7,000. Prepare the statement of financial position and confirm it balances.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA)

Accruals and prepayments in the ledger#

StandardAQA 7127 3.6

The rent account with a prepayment

Fig. 3The rent account: opening prepayment £1,000 plus £11,000 paid, less the £2,000 closing prepayment carried down, gives a £10,000 charge to the income statement.

The accruals concept met earlier is applied at the year end through the expense accounts. Each expense account is adjusted so that the amount charged to the income statement is the cost incurred in the year, not the cash paid, and the difference is carried forward as an accrual or a prepayment. Working through the expense account itself - rather than just the arithmetic - makes the double entry clear and is the safest method when a question gives both opening and closing adjustments, which is common at A-Level.

Take the rent account as an example. Suppose the year began with £1,000 of rent prepaid (an asset brought down on the debit side), £11,000 of rent was paid during the year (debited from the bank), and £2,000 is prepaid at the year end (to be carried down). The account's debit side totals £1,000 + £11,000 = £12,000. The closing prepayment of £2,000 is carried down on the credit side, and the balancing figure - the amount transferred to the income statement - is £12,000 - £2,000 = £10,000. So the rent expense for the year is £10,000, and the £2,000 closing prepayment reappears as a debit balance brought down (a current asset) in the new year.

An accrued expense works the mirror image. If an expense account has amounts paid on the debit side and an amount still owing at the year end, the closing accrual is carried down on the debit side (below the total) and brought down as a credit balance - a current liability. The amount transferred to the income statement is the total charge including the accrual. The key discipline is to remember which balance is which: a prepayment leaves a debit balance brought down (an asset), an accrual leaves a credit balance brought down (a liability). Getting the brought-down balance on the correct side is what makes the statement of financial position balance.

The same technique handles accrued and prepaid income. Income received in advance is a credit-natured account with a liability brought down; income earned but not yet received leaves an asset brought down. Whether the item is an expense or income, the principle is identical - charge or credit the income statement with the amount relating to the period, and carry the timing difference to the statement of financial position as the appropriate asset or liability. Mastery of this small ledger routine underlies almost every financial-statements question, because most trial balances come with two or three such adjustments.

\text{Expense to I/S} = \text{Opening prepaid} + \text{Paid} - \text{Closing prepaid} + \text{Closing accrual} - \text{Opening accrual}

The adjusted expense

Charge the income statement with the cost that relates to the period; carry the difference to the statement of financial position as a prepayment (asset) or accrual (liability).

Worked example

Adjusting an expense account

The rent account began the year with a £1,000 prepayment. £11,000 was paid during the year, and £2,000 is prepaid at the year end. Prepare the rent account and state the charge to the income statement.

Enter the opening balance and payments
Debit side: opening prepayment brought down £1,000 (an asset) and bank payments £11,000, total £12,000.
Carry down the closing prepayment
The £2,000 still prepaid at the year end is carried down on the credit side; it will be brought down as a £2,000 debit balance (a current asset) next year.
Find the income statement charge
The balancing figure transferred to the income statement is £12,000 - £2,000 = £10,000 - the rent that relates to this year.

Result: The rent charged to the income statement is £10,000, and a £2,000 prepayment is carried to the statement of financial position as a current asset.

Typical mistakes

Carrying the closing balance down on the wrong side, turning a prepayment into a liability or an accrual into an asset.
Ignoring the opening accrual or prepayment when calculating the charge for the year.

Active revision

The insurance account opens with a £300 accrual, £3,600 is paid in the year, and £500 is prepaid at the year end. Prepare the insurance account and state the charge to the income statement and the SOFP items.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA)

Depreciation of non-current assets#

AdvancedAQA 7127 3.6

Carrying amount under two depreciation methods

Fig. 4Carrying amount over an asset's life: the straight-line method falls evenly, the reducing-balance method falls steeply early - the choice changes the pattern of expense each year.

Depreciation is the systematic allocation of the cost of a non-current asset over its useful life, spreading that cost across the periods that benefit from the asset. It is an application of the accruals concept: because an asset such as a machine helps to earn revenue over several years, its cost should be matched against the revenue of each of those years rather than charged in full when it is bought. It is important to be clear about what depreciation is not - it is not an attempt to show the asset at its market value, and it is not a fund of cash set aside for replacement. It is purely the matching of cost to periods, a non-cash expense that reduces profit and reduces the asset's carrying amount.

The straight-line method charges an equal amount each year, calculated as the cost less any residual (scrap) value, divided by the useful life in years. It suits assets that give even service over their life - fixtures, buildings - and it is simple and produces a steady charge. The reducing-balance method instead charges a fixed percentage of the carrying amount (cost less accumulated depreciation) each year, so the charge is high at first and falls over time. It suits assets that lose most of their value early and that may incur rising repair costs later (such as vehicles and machinery), because the falling depreciation charge offsets the rising repair charge to give a more even total cost. The consistency concept requires that whichever method is chosen is then applied consistently.

A schedule makes the contrast vivid. A machine costing £50,000 with a residual value of £5,000 and a five-year life is depreciated by (£50,000 - £5,000) / 5 = £9,000 a year under the straight-line method, so its carrying amount falls evenly to £5,000 after five years. Under a 40% reducing-balance method, the first year's charge is £20,000 (leaving £30,000), the second £12,000 (leaving £18,000), the third £7,200, and so on - far heavier early depreciation. The choice of method therefore affects the pattern of expense and the carrying amount reported each year, even though the total depreciated over the asset's life is broadly similar.

In the ledger, depreciation is recorded by debiting a depreciation expense (which goes to the income statement) and crediting an accumulated-depreciation account (a running total that is deducted from the asset's cost in the statement of financial position to give its carrying amount). The asset itself stays at cost; the accumulated-depreciation account grows each year. When the asset is eventually sold or scrapped, both the cost and its accumulated depreciation are removed and a profit or loss on disposal recognised, exactly as in the double-entry chapter. Because depreciation rests on estimates of useful life and residual value, it involves judgement - and a business must review those estimates and apply the method consistently, or the comparability of its profits is lost.

\text{Straight-line depreciation} = \frac{\text{Cost} - \text{Residual value}}{\text{Useful life (years)}}

Straight-line method

An equal charge each year. Suits assets that give even service over their life.

\text{Reducing-balance depreciation} = \text{Rate} \times \text{Carrying amount at start of year}

Reducing-balance method

A fixed percentage of the falling carrying amount, so the charge is high early and falls over time.

\text{Carrying amount} = \text{Cost} - \text{Accumulated depreciation}

Carrying amount (net book value)

The figure shown in the statement of financial position; the asset stays at cost, with accumulated depreciation deducted.

Worked example

Depreciation under two methods

A machine costing £50,000 has an estimated residual value of £5,000 and a useful life of five years. (a) Calculate the annual straight-line depreciation and the carrying amount after two years. (b) Calculate the first two years' depreciation under the reducing-balance method at 40%.

Straight-line annual charge
(Cost - residual) / life = (£50,000 - £5,000) / 5 = £45,000 / 5 = £9,000 per year.
Straight-line carrying amount after two years
Accumulated depreciation = 2 x £9,000 = £18,000; carrying amount = £50,000 - £18,000 = £32,000.
Reducing balance at 40%
Year 1: 40% x £50,000 = £20,000 (carrying amount £30,000). Year 2: 40% x £30,000 = £12,000 (carrying amount £18,000). The charge falls each year.

Result: Straight-line depreciation is £9,000 a year (carrying amount £32,000 after two years); reducing balance charges £20,000 then £12,000 in the first two years, depreciating far more heavily early in the asset's life.

Typical mistakes

Forgetting to deduct residual value before dividing by the life in the straight-line method.
Applying the reducing-balance rate to the original cost every year instead of to the falling carrying amount.

Active revision

A machine costs £50,000, has a residual value of £5,000 and a five-year life. Calculate the annual straight-line depreciation and the carrying amount after two years, and the first two years' reducing-balance depreciation at 40%.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA)

Irrecoverable debts, allowances and inventory#

AdvancedAQA 7127 3.6

Irrecoverable debts and the allowance for doubtful debts

Fig. 5The write-off (£1,000) plus the increase in the allowance (£500) give a £1,500 charge; receivables are shown net at £48,000 (£50,000 less the £2,000 allowance).

Two further adjustments protect the value at which receivables and inventory are shown, and both are applications of prudence. Irrecoverable debts (bad debts) are amounts owed by customers who will definitely not pay; they are written off by debiting an irrecoverable-debts expense and crediting the receivable, removing the worthless asset and recognising the cost. This is a certainty - the specific debt is known to be uncollectable. It is distinct from the allowance for doubtful debts, which deals with the estimated risk that some of the remaining receivables may not pay, even though no specific debt has yet failed.

The allowance for doubtful debts is a prudent estimate, usually a percentage of the receivables remaining after irrecoverable debts have been written off, set aside against the possibility of non-payment. Creating or increasing the allowance is an expense (debit the income statement, credit the allowance account); reducing the allowance is income (debit the allowance, credit the income statement). Crucially, only the change in the allowance from one year to the next affects profit - not the whole allowance each year, because the allowance is a running balance. In the statement of financial position, trade receivables are shown net: gross receivables (after write-offs) less the allowance for doubtful debts, giving the amount realistically expected to be collected.

A worked adjustment ties the two together. Suppose year-end receivables are £51,000, but a £1,000 debt is to be written off as irrecoverable, and the business maintains an allowance of 4% of the remaining receivables, having brought forward an allowance of £1,500. Writing off the £1,000 leaves receivables of £50,000. The required allowance is 4% x £50,000 = £2,000, and since the opening allowance was £1,500, the allowance must be increased by £500 (an expense). The total charge to the income statement is the £1,000 write-off plus the £500 increase in the allowance = £1,500. Net trade receivables in the statement of financial position are £50,000 - £2,000 = £48,000.

Inventory is the last major adjustment and, as seen under prudence, is valued at the lower of cost and net realisable value (the expected selling price less any costs to complete and sell). Cost may be measured on a first-in-first-out (FIFO) or weighted-average basis, applied consistently, but never on a last-in-first-out (LIFO) basis, which is not permitted under IAS 2. Valuing inventory too high overstates both closing inventory (raising this year's profit) and the following year's opening inventory (lowering next year's profit), so an error in inventory valuation distorts two years' profits - which is why the prudent lower-of-cost-and-NRV rule matters. Together, these receivables and inventory adjustments ensure the current assets are stated at amounts the business can realistically expect to realise, completing the true and fair view.

\text{Allowance for doubtful debts} = \text{Rate} \times \text{Receivables after write-offs}

The allowance

A prudent estimate against the risk of non-payment. Only the CHANGE in the allowance affects profit.

\text{Charge to I/S} = \text{Debts written off} + \text{Increase in allowance}

Total receivables charge

A decrease in the allowance is income, not an expense. Net receivables = gross (after write-offs) - allowance.

Worked example

Irrecoverable debts and the allowance

A business has receivables of £51,000 at the year end. It writes off £1,000 as irrecoverable and maintains an allowance for doubtful debts of 4% of the remaining receivables. The allowance brought forward was £1,500. Calculate the total charge to the income statement and the net receivables in the statement of financial position.

Write off the irrecoverable debt
Debit irrecoverable debts £1,000, credit receivables £1,000. Receivables fall to £51,000 - £1,000 = £50,000.
Adjust the allowance
Required allowance = 4% x £50,000 = £2,000. Opening allowance £1,500, so it must rise by £500 - an expense (Dr income statement, Cr allowance).
Total charge and net receivables
Charge to the income statement = write-off £1,000 + increase in allowance £500 = £1,500. Net receivables = £50,000 - allowance £2,000 = £48,000.

Result: The income statement is charged £1,500 (write-off £1,000 plus the £500 increase in the allowance), and trade receivables appear net at £48,000.

Typical mistakes

Charging the whole allowance to the income statement each year instead of only the increase (or crediting the decrease).
Valuing inventory at selling price or at cost when net realisable value is lower.

Active revision

Receivables are £51,000. Write off £1,000 as irrecoverable and set the allowance at 4% of the remainder; the opening allowance was £1,500. Calculate the charge to the income statement and the net receivables figure.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA) · Ofqual - GCE AS and A level qualifications (Ofqual)

References & sources

Sources

AQA

AQA A-level Accounting 7127 specification

Ofqual

Ofqual - GCE AS and A level qualifications

Financial statements of sole traders (with adjustments)

5 sections~22 min reading time3 competenciesLevel Standard 3 · Advanced 2

Financial statements of sole traders (with adjustments)

Key points

Preparing an income statement

Key points

Preparing a statement of financial position

Key points

Adjusting an expense account

Key points

Depreciation under two methods

Key points

Irrecoverable debts and the allowance

Sources

Financial statements of sole traders (with adjustments)

Key points

Preparing an income statement

Key points

Preparing a statement of financial position

Key points

Adjusting an expense account

Key points

Depreciation under two methods

Key points

Irrecoverable debts and the allowance

Sources