Reconstructing profit after a flood at Rita's Boutique
Rita's Boutique is a sole trader. A burst pipe destroyed most of the accounting records for the year ended 31 December 2024. The accountant has established the following. Capital at 1 January 2024, per the previous year's statement of financial position, was €48,000. A statement of affairs at 31 December 2024 shows net assets of €72,500; this figure includes a delivery van at €9,000, which Rita introduced into the business in March when she transferred it from private use. During the year Rita withdrew €750 in cash each month for personal living costs and took goods costing €3,200 for her own use. She also paid a personal insurance premium of €1,400 from the business bank account; the bookkeeper treated it as business insurance. Rita received a €5,000 inheritance in June and paid it into the business bank account to support cash flow. No other capital movements are known. The business bank balance fell by €11,000 during the year and Rita cannot understand how the business can be profitable.
1. Calculate the profit for the year using the capital comparison method, showing all adjustments.
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Profit for the year - capital comparison
| € | |
|---|---|
| Capital at 31 December 2024 (net assets) | 72,500 |
| Less capital at 1 January 2024 | (48,000) |
| Increase in capital | 24,500 |
| Add drawings: cash (12 × €750) | 9,000 |
| Add drawings: goods taken | 3,200 |
| Add drawings: personal insurance paid by the business | 1,400 |
| Less capital introduced: van | (9,000) |
| Less capital introduced: inheritance | (5,000) |
| Profit for the year | 24,100 |
The logic is that closing capital is increased by profit and by capital introduced, and reduced by drawings. Rearranging: profit = closing capital − opening capital + drawings − capital introduced. The personal insurance must be treated as drawings because it is not a business expense; if it were left in expenses, profit would be understated by €1,400. The goods taken are drawings at cost; if they were left in purchases, profit would be understated by €3,200. The van and the inheritance are capital introduced, not income.
2. Explain how the treatment of the goods taken and the personal insurance affects the profit figure, and state what evidence the accountant should seek.
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The goods taken are a distribution to the owner, not a sale. They must be removed from purchases at cost (€3,200) and charged to drawings. If the accountant used selling price instead of cost, both profit and drawings would be overstated by the mark-up.
The personal insurance premium is a private expense. The bookkeeper treated it as business insurance, which understates profit by €1,400 and understates drawings. The correction is Dr Drawings €1,400, Cr Insurance expense €1,400, or a journal reclassifying the item.
Evidence to seek includes: the insurance policy schedule showing the life assured and beneficiary; the bank statement and standing order; the van registration document and a valuation at the date it was introduced; the solicitor's letter confirming the inheritance; stock sheets and any record of goods taken; and the statement of affairs working papers. The accountant should also check that the van is depreciated and that no other personal expenses are hidden in business expense accounts.
3. Rita believes a profit must mean more cash in the bank. Using the figures in the case, explain why this is not so, and state what further work is needed to reconcile profit with the fall in the bank balance.
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Starting from profit, the cash and non-cash items given produce:
| € | |
|---|---|
| Profit | 24,100 |
| Less cash drawings | (9,000) |
| Less personal insurance paid from the bank | (1,400) |
| Add inheritance paid into the bank | 5,000 |
| Expected increase in bank | 18,700 |
But the bank balance actually fell by €11,000, so there is an unexplained outflow of about €29,700. That is not necessarily an error: the business may have bought fixtures, repaid a loan, increased inventory or receivables, or reduced payables, none of which is given. The van (€9,000) and the goods taken (€3,200) are non-cash items and do not affect the bank at all.
The accountant should prepare a statement of cash flows or a reconciliation of profit to the bank movement and investigate the unexplained difference. Rita's confusion is common: profit is measured on an accruals basis, while the bank balance reflects the timing of cash receipts and payments, drawings, capital injections and asset purchases. Because the records were destroyed, some cash outflows may be missing altogether.