Financial Statements of Sole Traders and Adjustments
What this domain tests
The exam expects you to prepare an income statement and a statement of financial position for a sole trader from a trial balance, applying year-end adjustments for inventory, accruals, prepayments, depreciation, bad debts and drawings, and to reconcile the closing capital figure.
Core rules
- Net sales = sales − returns inwards. Cost of sales = opening inventory + purchases + carriage inwards − returns outwards − closing inventory.
- Gross profit = net sales − cost of sales. Net profit = gross profit + other income − all expenses.
- Accrued expense: add to the expense in the income statement and show as a current liability. Prepaid expense: deduct from the expense and show as a current asset.
- Depreciation is an expense in the income statement and is added to accumulated depreciation, which is deducted from cost in the statement of financial position.
- Bad debts are written off as an expense. The provision for doubtful debts is calculated on receivables remaining after bad debts; only the movement in the provision goes to the income statement.
- Goods taken by the owner: debit drawings, credit purchases.
- Capital section: opening capital + net profit − drawings = closing capital, which must equal net assets.
Worked example
Net sales $80,000; opening inventory $10,000; purchases $50,000; carriage inwards $2,000; closing inventory $12,000. Expenses paid were $9,000, with $1,000 accrued at year end; depreciation is $2,000. Cost of sales = 10,000 + 50,000 + 2,000 − 12,000 = $50,000. Gross profit = 80,000 − 50,000 = $30,000. Expenses charged = 9,000 + 1,000 accrued + 2,000 depreciation = $12,000. Net profit = $18,000. Reasoning: the accrual belongs to this period even though it is unpaid, and the closing inventory is deducted in cost of sales because it was not sold.
Traps that cost marks
- Deducting drawings as an expense instead of from capital.
- Omitting closing inventory from the cost of sales calculation.
- Calculating the provision on receivables before writing off bad debts.
- Treating carriage outwards as part of cost of sales; it is a selling expense.
- Recording a prepayment as an expense and an accrual as an asset.
- Forgetting that accumulated depreciation, not the year's charge, is deducted from asset cost.