Preparation of financial statements (sole traders, partnerships, companies)
What the exam tests
This domain tests preparation of the statement of profit or loss (SPL) and statement of financial position (SFP) for sole traders, partnerships and companies, including capital and equity movements. You must distinguish expenses from drawings and dividends and apply the correct ownership structure.
Core rules
- Sole trader: profit increases capital; drawings reduce capital. The SFP shows capital as opening capital plus profit less drawings.
- Partnership: the appropriation account distributes profit. Partner salaries and interest on capital are appropriations, not expenses. Residual profit or loss is shared in the profit-sharing ratio. Each partner has a capital account and a current account.
- Company: share capital and share premium are contributed equity; retained earnings accumulate profits less dividends. Dividends are distributions, not expenses. Tax is an expense in the SPL. The statement of changes in equity reconciles opening and closing equity.
- Closing inventory reduces cost of sales; it is a current asset, not a purchase.
Worked example
A partnership earns profit of £60,000. A is entitled to a salary of £12,000 and interest on capital of £2,000; B receives interest on capital of £1,000. Residual profits are shared 2:1.
Appropriations total £15,000, leaving £45,000. A receives 2/3 × £45,000 = £30,000; B receives £15,000. A's total is £12,000 + £2,000 + £30,000 = £44,000; B's total is £1,000 + £15,000 = £16,000.
Reasoning: salary and interest are paid before the residual split, so they must be deducted first. The total appropriated equals £60,000.
Traps
Do not treat partner salaries as operating expenses. Do not deduct dividends in arriving at profit. Do not include tax in partnership appropriations. Watch for drawings wrongly posted as expenses. For companies, remember that share premium is not profit.
Key points
- Partnership salaries and interest on capital are appropriations, not expenses.
- Residual partnership profit is shared in the agreed ratio after appropriations.
- Dividends are distributions from retained earnings, not expenses.
- Closing inventory is a current asset and reduces cost of sales.
- The statement of changes in equity reconciles share capital, reserves and retained earnings.