learning unit 4

Financial Statements of a Sole Trader

Learning Objectives

• Complete year-end adjustments (including depreciation) for accruals.

• Prepare the post-adjustment trial balance.

• Complete year-end adjustments (including depreciation) for allowances of credit losses.

• Prepare a statement of financial position.

• Prepare a statement of profit or loss and other comprehensive income according to both inventory methods.

• Prepare a statement of changes in equity.

• Prepare all relevant notes to the financial statements.

Overview

• Definition: A sole trader (or sole proprietorship) is the oldest form of ownership.

• Characteristics:

  • No legal personality; assets belong to the owner.

  • Owner personally liable for liabilities.

  • All profits generated belong to the owner.

Year-End Adjustments

• Importance: Ensures that the trial balance reflects the correct financial performance and position at year-end.

• Purpose: Year-end adjustments help make financial results more realistic.

Types of Year-End Adjustments

• Depreciation (from Learning Unit 3)

• Accrual Concept

• Creating an Allowance for Credit Losses

• Adjusting Existing Allowance for Credit Losses

The Accrual Concept

• Basis of Preparation: Financial statements follow the accrual basis of accounting.

• Key Principles:

  • Match all revenue and expenses to the period incurred or earned, regardless of actual cash flow.

  • Immediate recognition of income and expenses in relation to the service rendered and cost incurred, respectively.

Applying the Accrual Concept

1. Accrued Expenses: Costs incurred but not paid; recorded as liabilities.

2. Prepaid Expenses: Payments made for services in future periods; treated as assets.

3. Accrued Income: Earnings owed for services rendered; treated as assets.

4. Income Received in Advance: Payments received for future services; treated as liabilities.

Adjusting for Stock Count at Year-End

1. Trading Inventory on Hand:

   • Conduct a stock count to evaluate physical stock.

   • Adjustment for stock losses:

     • Debit: Cost of Sales

     • Credit: Trading Inventory

2. Consumable Stores on Hand:

   • Items purchased but not yet used during the financial year; classified as assets.

   • Typical journal entry will involve a debit.

Creating an Allowance for Credit Losses

• Rationale: Not all amounts owed by debtors are recoverable (e.g. insolvency).

• Writing off bad debts is essential for accurate financial reporting.

• Timing of adjustments:

  • Income: When current allowance < previous allowance.

  • Expense: When current allowance > previous allowance.

Financial Statement Structure

• Statement of Profit/Loss and Other Comprehensive Income:

  • Revenue, cost of sales, gross profit,

  • Operating expenses, profitability calculations.

• Statement of Changes in Equity:

  • Starting capital, additional contributions, profit/loss,

  • Drawings, final equity balance.

• Statement of Financial Position:

  • Non-current and current assets, total assets,

  • Owner's equity, liabilities, ensuring assets = equity + liabilities.

Notes to Financial Statements

1. Interest Income:

   • Reported from fixed deposits and other credit accounts.

2. Interest Expense:

   • Documented from loans, overdrafts, and other debts.

3. PPE/Fixed Assets:

   • Values are sourced from detailed notes.

4. Inventories and Receivables:

   • Must reflect year-end stock counts and allowance adjustments.

5. Cash and Cash Equivalents:

   • Overview of bank balances and petty cash.

6. Trade and Other Payables:

   • Listing of creditors and accrued expenses.