Statement of affairs versus the capital account: finding the profit
Marlow Antiques is a sole trader who keeps only a cash book and lists of debtors and creditors, with no double-entry records. At 31 December 20X5 the following were verified: shop premises £150,000, fixtures £24,000, inventory £18,600, trade receivables £31,400, prepaid expenses £1,250 and a bank balance of £6,850. Liabilities were trade payables £22,900, a bank loan £30,000 and accrued expenses £1,400. Capital at 1 January 20X5 was agreed at £160,000 and cash drawings during the year were £21,300. The owner mentions, almost in passing, that he took goods costing £1,900 home during the year and paid £2,600 of business cash sales into his own personal bank account. Neither of these has been recorded anywhere.
1. Calculate Marlow Antiques' capital at 31 December 20X5 using the accounting equation.
Read the worked answer
Total assets = 150,000 + 24,000 + 18,600 + 31,400 + 1,250 + 6,850 = £232,100
Total liabilities = 22,900 + 30,000 + 1,400 = £54,300
Capital = assets − liabilities = 232,100 − 54,300 = £177,800
Reasoning points:
- The prepaid expenses of £1,250 are an asset (a benefit paid for but not yet consumed); the accrued expenses of £1,400 are a liability. Putting either on the wrong side changes closing capital.
- Inventory is the year-end count, so any goods that left the business during the year are already excluded from it.
- Capital here is derived from the net assets, not from the capital account, which is exactly why it can be trusted as the starting point for a profit calculation.
2. Calculate the profit for the year, explaining the treatment of the goods taken by the owner and the cash sales paid into his personal account.
Read the worked answer
Rearrange the capital equation: capital c/f = capital b/f + profit − drawings, therefore:
Profit = capital c/f − capital b/f + drawings
Drawings to include:
| Item | £ |
|---|---|
| Cash drawings recorded | 21,300 |
| Goods taken for own use | 1,900 |
| Cash sales retained by the owner | 2,600 |
| Total drawings | 25,800 |
Profit = 177,800 − 160,000 + 25,800 = £43,600
Why the £2,600 is drawings and not a reduction in profit: the business made the sale and earned the margin, and the owner then took the proceeds. Because neither the sale nor the receipt appears in the business records, the net assets at the year end are £2,600 lower than they should be, so the profit derived from those net assets is £2,600 too low. Adding it back as drawings restores both figures. The £1,900 of goods works in exactly the same way.
3. Explain why closing capital is unaffected by the two unrecorded items, but profit is. Name the concept involved and state the consequence of ignoring them.
Read the worked answer
Closing capital of £177,800 is calculated from the assets and liabilities themselves, which are physical or externally confirmed facts. Those items do not change because the bookkeeping is incomplete - the goods have gone and the cash never arrived either way. What the omissions distort is the split between profit and drawings.
If the two items are ignored: profit = 177,800 − 160,000 + 21,300 = £39,100. So profit is understated by £4,500 and drawings are understated by the same £4,500. The statement of financial position total is right; the income statement and the drawings figure are both wrong, and the owner would believe he had taken far less out of the business than he actually has.
Concepts involved:
- Business entity - the owner and the business are separate. Goods taken for private use and cash retained privately are drawings, not business expenses and not sales.
- Accruals - prepayments and accruals must be recognised so that the net assets (and therefore capital) reflect the period correctly.