Financial Statements of Sole Proprietors and Partnership Firms
What the domain tests
This domain tests preparation and interpretation of trading account, profit and loss account and balance sheet, including adjustments, and partnership profit appropriation. Expect computation of gross profit, net profit and partners' capital balances.
Core rules
- Trading account gives gross profit = sales - cost of goods sold. Cost of goods sold = opening stock + purchases + direct expenses - closing stock.
- Profit and loss account gives net profit after indirect expenses and incomes.
- Balance sheet shows assets, liabilities and capital on a date and must balance.
- Adjustments include closing stock, outstanding and prepaid expenses, accrued and unearned income, depreciation, bad debts, provision for doubtful debts and drawings.
- Partnership profit and loss appropriation account charges interest on capital and partner's salary, credits interest on drawings, then divides residual profit in the profit-sharing ratio.
- Drawings reduce capital; they are not an expense.
Worked example
Sales are Rs. 5,00,000; opening stock Rs. 40,000; purchases Rs. 3,00,000; closing stock Rs. 50,000; direct expenses Rs. 10,000. Cost of goods sold = 40,000 + 3,00,000 + 10,000 - 50,000 = Rs. 3,00,000. Gross profit = 5,00,000 - 3,00,000 = Rs. 2,00,000. If indirect expenses are Rs. 80,000, net profit is Rs. 1,20,000. Closing stock is a current asset in the balance sheet and is deducted in arriving at cost of goods sold.
Traps
Do not treat closing stock as a purchase; do not add drawings to expenses; do not ignore outstanding expenses; do not compute interest on capital on closing rather than opening capital; and do not divide profit before charging partner's salary.