Cambridge IGCSE0452

Sole traders

Accounting 0452 Chapter Notes

What this chapter covers

Sole tradersPartnershipsLimited companiesManufacturing accountsClubs and societiesIncomplete records
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In this chapter

  1. 1What is a Sole Trader?
  2. 2The Purpose of Financial Statements
  3. 3Preparing the Income Statement
  4. 4The Statement of Financial Position
  5. 5Year-End Adjustment: Depreciation
  6. 6Year-End Adjustment: Accruals and Prepayments
  7. 7Year-End Adjustment: Irrecoverable and Doubtful Debts
  8. 8Year-End Adjustment: Drawings

1. What is a Sole Trader?

A sole trader is the simplest form of business structure, owned and run by one individual. There is no legal distinction between the owner and the business itself. This means the owner is personally responsible for all the business's debts. While common for small trading businesses (like a local shop) and service providers (like a plumber or graphic designer), some sole traders can be very successful. Key advantages include being easy to set up, having full control, and keeping all profits. However, the major drawback is unlimited liability.

Key term

Unlimited Liability: The owner of the business is personally responsible for all business debts, meaning their personal assets (like their house or car) can be used to pay off creditors if the business fails.

Examiner insight

Examiners look for clear application. When explaining an advantage or disadvantage, link it to a specific business context, like the example of Aisha the baker.

Common pitfall

Forgetting that unlimited liability means personal assets are at risk, not just the assets owned by the business.

Fun fact

Many global brands started as sole traders, including eBay, founded by Pierre Omidyar in his living room in 1995.

Worked example 14 marks

Aisha is a talented baker and is considering starting her own cake business from home. Advise her on two advantages and two disadvantages of setting up as a sole trader.

  1. 1

    Advantage 1: Full Control. Aisha would be her own boss and could make all business decisions quickly without needing to consult anyone, such as deciding on cake designs or pricing.

  2. 2

    Advantage 2: Keep All Profits. As the sole owner, any profit the business makes belongs entirely to her. This is a direct reward for her hard work and success.

  3. 3

    Disadvantage 1: Unlimited Liability. If the business were to incur debts it could not pay, Aisha's personal possessions, such as her car or savings, would be at risk to pay off the business creditors.

  4. 4

    Disadvantage 2: Difficulty Raising Finance. Banks may be reluctant to lend significant amounts of money to a new, small business, which could limit her ability to buy professional equipment or expand.

Recap

  • A sole trader is a business owned and operated by one person.
  • The owner and the business are not legally separate entities.
  • Key advantages include ease of setup, full control, and entitlement to all profits.
  • The main disadvantage is unlimited liability, where personal assets are at risk.
  • Sole traders often find it harder to raise capital compared to larger businesses.
  • Financial information can be kept private as there is no legal requirement to publish accounts.

Quick check

  1. State the major financial risk associated with being a sole trader.1 mark
  2. List two reasons why someone might choose to be a sole trader.2 marks

2. The Purpose of Financial Statements

Sole traders prepare two key financial statements at the end of an accounting period (usually a year). Their purpose is to measure performance and show financial position.

  1. The Income Statement: This statement calculates the profit or loss made by the business over a period of time (e.g., 'for the year ended 31 December 2024'). It shows if the business's revenues were greater than its expenses.
  2. The Statement of Financial Position: This statement is a snapshot of the business's assets, liabilities, and owner's capital on a specific date (e.g., 'as at 31 December 2024'). It shows what the business owns and what it owes.

A 'trading business' earns revenue by selling goods, so its income statement will calculate a 'gross profit' from buying and selling. A 'service business' earns revenue by providing a service (e.g., a hairdresser), so its income statement is simpler and does not have a trading account section to calculate gross profit.

Key term

Financial Statements: Formal reports that provide a summary of a business's financial performance (Income Statement) and financial position (Statement of Financial Position).

Examiner insight

Examiners reward precision. Clearly state that the Income Statement shows profit/loss 'over a period' and the Statement of Financial Position shows assets/liabilities 'at a specific date'.

Common pitfall

Confusing the timeframes. The Income Statement is for a period, while the Statement of Financial Position is for a single day.

Worked example 13 marks

James runs a car wash. Sarah runs a shop selling imported sweets.(a) Identify which person runs a trading business and which runs a service business.(b) State the main purpose of a Statement of Financial Position.

  1. 1

    (a) James runs a service business because he provides a service (washing cars). Sarah runs a trading business because she buys and sells goods (sweets).

  2. 2

    (b) The main purpose of a Statement of Financial Position is to show the assets, liabilities, and capital of a business at a single point in time, providing a snapshot of its financial health.

Recap

  • The Income Statement shows financial performance over a period.
  • The Statement of Financial Position shows financial position on a specific date.
  • A trading business buys and sells goods and calculates a gross profit.
  • A service business provides a service and does not calculate gross profit.
  • Financial statements help the owner make decisions and can be used to apply for loans.

Quick check

  1. Which financial statement is described as being 'for the year ended...'?1 mark
  2. Would a plumber prepare an income statement with a 'Cost of Sales' section? Explain why or why not.2 marks

3. Preparing the Income Statement

The Income Statement for a trading business is prepared in two parts. The first part is the Trading Account, which calculates the Gross Profit. This is the profit made purely from buying and selling goods. The second part is the Profit and Loss section, which deducts all other business expenses from the gross profit (and adds any other income) to find the final Profit for the Year. For a service business, there is no Trading Account; you start directly with the service revenue and deduct expenses.

Cost of Sales = Opening Inventory + Purchases + Carriage Inwards – Purchase Returns – Closing Inventory

Gross Profit = Revenue (Sales – Sales Returns) – Cost of Sales

Profit for the Year = Gross Profit + Other Income – Expenses

Key term

Cost of Sales: The direct cost of the goods that were sold during a period, including the purchase price and any costs to get them ready for sale (like delivery inwards).

Examiner insight

A clear, vertical format with correct headings for 'Revenue', 'Cost of Sales', and 'Expenses' is essential for full marks. Show all your workings for Cost of Sales.

Common pitfall

Placing 'Carriage Inwards' in the expenses section instead of adding it within the Cost of Sales calculation.

Worked example 16 marks

Using the following balances for a trader for the year ended 31 March 2025, prepare an Income Statement. Sales $85,000; Opening Inventory $7,000; Closing Inventory $9,000; Purchases $42,000; Sales Returns $1,000; Carriage Inwards $500; Rent Expense $12,000; Wages $18,000.

  1. 1

    Start with the heading: Income Statement for the year ended 31 March 2025.

  2. 2

    Calculate Revenue: Sales $85,000 - Sales Returns $1,000 = $84,000.

  3. 3

    Calculate Cost of Sales: Opening Inventory $7,000 + Purchases $42,000 + Carriage Inwards $500 - Closing Inventory $9,000 = $40,500.

  4. 4

    Calculate Gross Profit: Revenue $84,000 - Cost of Sales $40,500 = $43,500.

  5. 5

    List and total the expenses: Rent $12,000 + Wages $18,000 = $30,000.

  6. 6

    Calculate Profit for the Year: Gross Profit $43,500 - Expenses $30,000 = $13,500.

Recap

  • The Income Statement starts with Revenue (Sales less Sales Returns).
  • Cost of Sales is calculated to find the Gross Profit.
  • Carriage inwards is part of the Cost of Sales; carriage outwards is an expense.
  • Other incomes (e.g., rent received) are added to Gross Profit.
  • All other running costs (expenses) are deducted to find the Profit for the Year.

Quick check

  1. Where in the Income Statement would you record the cost of delivering goods to a customer?1 mark
  2. A business has sales of $20,000 and a gross profit of $8,000. What was its cost of sales?1 mark

4. The Statement of Financial Position

The Statement of Financial Position (SOFP) presents a snapshot of a business's financial health on a specific day. It is built around the accounting equation: Assets = Capital + Liabilities. It is always presented in a standard vertical format, listing Assets first, followed by Capital and Liabilities. The two sections must balance.

  • Assets are resources owned by the business. They are split into Non-Current Assets (long-term, e.g., Property, Machinery) and Current Assets (short-term, e.g., Inventory, Trade Receivables, Cash).
  • Liabilities are what the business owes to others. They are split into Non-Current Liabilities (due in more than one year, e.g., a long-term loan) and Current Liabilities (due within one year, e.g., Trade Payables, Bank Overdraft).
  • Capital (or Equity) is the owner's investment in the business. It's calculated by taking the opening capital, adding the profit for the year, and subtracting any drawings made by the owner.

Assets = Capital + Liabilities

Closing Capital = Opening Capital + Profit for the Year – Drawings

Key term

Accounting Equation: The fundamental principle that a business's total assets must equal the sum of its total liabilities and its owner's capital.

Examiner insight

Examiners award marks for correct classification. Ensure you know the difference between current/non-current assets and current/non-current liabilities.

Common pitfall

Incorrectly calculating the closing capital figure. Remember the formula: Opening Capital + Profit - Drawings. This is a crucial link between the two financial statements.

Worked example 17 marks

At 31 December 2025, a sole trader had the following balances: Non-current assets $50,000; Inventory $8,000; Trade receivables $6,000; Bank overdraft $2,000; Trade payables $7,000; Loan (repayable in 3 years) $10,000. The owner's capital at the start of the year was $35,000, profit for the year was $15,000 and drawings were $5,000. Prepare a Statement of Financial Position.

  1. 1

    Heading: Statement of Financial Position as at 31 December 2025.

  2. 2

    ASSETS section: List Non-Current Assets ($50,000).

  3. 3

    List Current Assets: Inventory ($8,000) + Trade Receivables ($6,000) = Total Current Assets $14,000.

  4. 4

    Calculate Total Assets: $50,000 + $14,000 = $64,000.

  5. 5

    CAPITAL AND LIABILITIES section: Calculate Closing Capital: Opening Capital $35,000 + Profit $15,000 - Drawings $5,000 = $45,000.

  6. 6

    List Non-Current Liabilities: Loan ($10,000).

  7. 7

    List Current Liabilities: Trade Payables ($7,000) + Bank Overdraft ($2,000) = Total Current Liabilities $9,000.

  8. 8

    Calculate Total Capital and Liabilities: $45,000 + $10,000 + $9,000 = $64,000. This balances with Total Assets.

Recap

  • The SOFP shows Assets, Liabilities, and Capital on a specific date.
  • Assets are split into Non-Current (long-term) and Current (short-term).
  • Liabilities are split into Non-Current (due > 1 year) and Current (due < 1 year).
  • Closing Capital is found by adjusting Opening Capital for profit and drawings.
  • The statement must balance: Total Assets = Total Capital and Liabilities.

Quick check

  1. Is inventory a current asset or a non-current asset? Why?2 marks
  2. A business has assets of $50,000 and liabilities of $20,000. What is its capital?1 mark

5. Year-End Adjustment: Depreciation

Depreciation is the process of spreading the cost of a non-current asset over its useful economic life. It is an application of the matching principle, matching the cost of the asset to the revenue it helps generate. It is an expense in the Income Statement and reduces the value of the asset in the Statement of Financial Position. There are three common methods:

  1. Straight-Line Method: Charges an equal amount of depreciation each year. Formula: (Cost - Residual Value) / Useful Life.
  2. Reducing (Diminishing) Balance Method: Charges a fixed percentage on the asset's Net Book Value (NBV). This results in higher depreciation in the early years and less in later years. NBV = Cost - Accumulated Depreciation.
  3. Revaluation Method: Used for assets like loose tools where individual tracking is impractical. The charge is the fall in value over the period. Formula: Opening Value + Purchases of new tools - Closing Value.

Straight-Line Depreciation = (Cost – Residual Value) / Useful Life

Reducing Balance Depreciation = Depreciation Rate % × Net Book Value

Net Book Value (NBV) = Cost – Accumulated Depreciation

Key term

Net Book Value (NBV): The value of a non-current asset on the Statement of Financial Position, calculated as its original cost minus all accumulated depreciation to date.

Examiner insight

Always state the method you are using and show your workings clearly. Separate marks are often available for the calculation and for placing the figures correctly in the financial statements.

Common pitfall

When using the reducing balance method, applying the percentage to the original cost of the asset instead of its Net Book Value (NBV).

Worked example 13 marks

A business buys a machine for $22,000 on 1 Jan 2024. It has an expected useful life of 5 years and a residual value of $2,000. Calculate the depreciation charge for the year ended 31 Dec 2024 using the straight-line method.

  1. 1

    Identify the formula: Straight-Line = (Cost – Residual Value) / Useful Life.

  2. 2

    Substitute the values: ($22,000 – $2,000) / 5 years.

  3. 3

    Calculate the result: $20,000 / 5 = $4,000 per year.

  4. 4

    The depreciation expense for the Income Statement is $4,000. The NBV on the SOFP at year-end would be $22,000 - $4,000 = $18,000.

Worked example 23 marks

A business owns a vehicle that cost $15,000. It is depreciated at 20% per annum using the reducing balance method. The accumulated depreciation at the start of the year was $3,000. Calculate the depreciation charge for the current year.

  1. 1

    First, calculate the Net Book Value (NBV) at the start of the year: Cost $15,000 - Accumulated Depreciation $3,000 = $12,000.

  2. 2

    Apply the depreciation rate to the NBV: 20% x $12,000.

  3. 3

    Calculate the result: $2,400.

  4. 4

    The depreciation expense for the Income Statement is $2,400.

Recap

  • Depreciation is an expense that spreads an asset's cost over its useful life.
  • The straight-line method gives a constant charge each year.
  • The reducing balance method gives a higher charge in the early years.
  • Depreciation is an expense in the Income Statement.
  • Accumulated depreciation reduces the asset's value in the Statement of Financial Position.

Quick check

  1. Why is depreciation not a cash expense?2 marks
  2. An asset cost $10,000. Depreciation is 10% straight-line. What is the NBV after 3 years?2 marks

6. Year-End Adjustment: Accruals and Prepayments

The matching (or accruals) principle states that income and expenses must be recorded in the financial period they relate to, regardless of when cash is paid or received. This requires year-end adjustments.

  • Accrued Expense (Expense Owing): An expense that has been used/incurred in the period but not yet paid for (e.g., electricity for December billed in January). You ADD this amount to the expense in the Income Statement and show it as a Current Liability on the SOFP.
  • Prepaid Expense (Prepayment): An expense paid in this period that relates to a future period (e.g., paying a full year's insurance in October). You SUBTRACT the future portion from the expense in the Income Statement and show it as a Current Asset on the SOFP.
  • Accrued Income (Income Owing): Revenue earned but not yet received. ADD to income in the IS, show as a Current Asset in SOFP.
  • Prepaid Income (Income in Advance): Cash received for revenue not yet earned. SUBTRACT from income in the IS, show as a Current Liability in SOFP.

Key term

Matching Principle: The accounting principle that requires expenses to be matched with the revenues they helped to generate in the same accounting period.

Examiner insight

Examiners frequently test this topic. Be clear on the dual effect: one adjustment impacts both the Income Statement and the Statement of Financial Position.

Common pitfall

Reversing the adjustments - for example, adding a prepayment instead of subtracting it. Remember: you are calculating the expense for *this year only*.

Worked example 13 marks

A sole trader's financial year ends on 31 December. During the year, they paid $6,000 for rent. This included a payment of $1,500 for the first quarter of the next year (Jan-Mar). Calculate the correct rent expense for the Income Statement and state the entry in the Statement of Financial Position.

  1. 1

    Identify the adjustment type: The $1,500 is for the next year, so it is a prepaid expense (prepayment).

  2. 2

    Calculate the Income Statement figure: Total paid $6,000 - Amount prepaid $1,500 = $4,500.

  3. 3

    The rent expense for the Income Statement is $4,500.

  4. 4

    State the SOFP entry: The prepaid rent of $1,500 is a Current Asset.

Worked example 23 marks

A business's telephone bills paid during the year amounted to $950. At the year-end, a bill for $120 for the final quarter was outstanding. Calculate the telephone expense for the year.

  1. 1

    Identify the adjustment type: The $120 is for the current year but is unpaid, so it is an accrued expense (accrual).

  2. 2

    Calculate the Income Statement figure: Total paid $950 + Amount accrued $120 = $1,070.

  3. 3

    The telephone expense for the Income Statement is $1,070.

  4. 4

    The accrued expense of $120 would be shown as a Current Liability on the SOFP.

Recap

  • Accruals and prepayments ensure expenses and revenues are matched to the correct period.
  • Accrued expenses are added to the expense account and are a current liability.
  • Prepaid expenses are subtracted from the expense account and are a current asset.
  • Accrued income is added to the income account and is a current asset.
  • Prepaid income is subtracted from the income account and is a current liability.

Quick check

  1. If a business has an accrued electricity expense of $200, is this an asset or a liability?1 mark
  2. Wages paid during the year were $50,000. At the year end, $2,000 was owing to employees. What is the wages expense for the year?1 mark

7. Year-End Adjustment: Irrecoverable and Doubtful Debts

Businesses that sell on credit face the risk that some customers (trade receivables) will not pay. This must be reflected in the accounts.

  • Irrecoverable Debt (or Bad Debt): This is a specific debt from a customer that is confirmed to be uncollectible. It is written off by debiting an 'Irrecoverable Debts Expense' account (an expense in the IS) and crediting the Trade Receivables account (reducing the asset in the SOFP).
  • Provision for Doubtful Debts: This is an estimate of potential future bad debts from the remaining receivables. It is an application of prudence. The provision is created or adjusted at year-end. The 'increase' in the provision is an expense in the IS. A 'decrease' is treated as other income. The total provision is then deducted from trade receivables in the SOFP to show a more realistic value of what is likely to be collected.

Provision for Doubtful Debts = % rate × (Trade Receivables – specific irrecoverable debts)

Key term

Prudence Concept: An accounting principle that ensures assets and income are not overstated, and liabilities and expenses are not understated.

Examiner insight

This is a multi-step process. Show each step clearly: (1) Adjust receivables for new write-offs, (2) Calculate the new required provision, (3) Calculate the increase/decrease for the IS, (4) Show the final figures in the SOFP.

Common pitfall

Placing the full provision for doubtful debts in the Income Statement. Only the movement (increase or decrease) for the year goes to the IS.

Worked example 15 marks

At 31 May 2025, a trader's receivables were $10,500. They decided to write off a debt of $500 from a bankrupt customer. They also wish to create a provision for doubtful debts of 5% of the remaining receivables. Calculate the figures for the financial statements.

  1. 1
    1. Irrecoverable Debt Expense: An expense of $500 will be shown in the Income Statement.
  2. 2
    1. Adjust Trade Receivables: The receivables balance is reduced by the written-off debt: $10,500 - $500 = $10,000.
  3. 3
    1. Calculate the Provision: The new provision is 5% of the remaining receivables: 5% x $10,000 = $500.
  4. 4
    1. Provision Expense: As this is a new provision, the full amount of $500 is an expense in the Income Statement.
  5. 5
    1. SOFP Presentation: In the Statement of Financial Position, under Current Assets: Trade Receivables $10,000 less Provision for Doubtful Debts ($500) = $9,500.

Recap

  • An irrecoverable debt is a confirmed bad debt and is written off as an expense.
  • A provision for doubtful debts is an estimate of potential future bad debts.
  • Always write off any new irrecoverable debts before calculating the provision for doubtful debts.
  • The increase in the provision is an expense; a decrease is other income.
  • The total provision is deducted from trade receivables in the Statement of Financial Position.

Quick check

  1. A business has a provision for doubtful debts of $200 at the start of the year. The closing provision needs to be $250. What is the entry in the Income Statement?1 mark
  2. Where is an irrecoverable debt expense recorded?1 mark

8. Year-End Adjustment: Drawings

Drawings occur when the sole trader takes assets out of the business for their own personal, non-business use. This is not a business expense, but a reduction of the owner's investment (capital). There are two types:

  1. Cash Drawings: The owner takes cash from the business bank account or till. The double entry is Dr Drawings, Cr Bank/Cash. In the financial statements, this reduces the cash/bank balance and is deducted in the capital section of the SOFP.
  2. Goods Drawings: The owner takes inventory for personal use. These must be valued at their cost price, not their selling price, because no sale has occurred. The double entry is Dr Drawings, Cr Purchases. The effect is that it reduces the 'Purchases' figure in the Cost of Sales calculation (increasing gross profit) and is also deducted in the capital section of the SOFP.

Key term

Drawings: The withdrawal of assets, such as cash or goods, from a business by its owner for their personal use.

Examiner insight

Examiners often include drawings of goods as an adjustment. Remember the double effect: it reduces Purchases in the IS and is deducted from Capital in the SOFP.

Common pitfall

Valuing drawings of goods at their selling price. They must always be recorded at cost, as the business has not earned any profit on them.

Worked example 14 marks

Selma, a sole trader, has a Purchases balance of $40,000. During the year, she took goods that cost the business $300 for her own use. Her opening capital was $497,800, profit for the year was $60,000 and she took no cash drawings. Show the effect of the drawings of goods on the Cost of Sales and the Capital account.

  1. 1
    1. Adjust Purchases: The Purchases figure used in the Cost of Sales calculation will be reduced. Adjusted Purchases = $40,000 - $300 = $39,700.
  2. 2
    1. Impact on Cost of Sales: This adjustment reduces the Cost of Sales and therefore increases the Gross Profit by $300.
  3. 3
    1. Calculate Closing Capital: The drawings of $300 must be deducted from capital.
  4. 4
    1. Capital Section of SOFP: Opening Capital $497,800 + Profit for the Year $60,000 - Drawings $300 = Closing Capital $557,500.

Recap

  • Drawings are not a business expense.
  • Drawings reduce the owner's capital in the Statement of Financial Position.
  • Cash drawings reduce the cash or bank balance.
  • Drawings of goods must be valued at cost price.
  • Drawings of goods are credited to the Purchases account, reducing the Cost of Sales.

Quick check

  1. A trader takes goods costing $50 (selling price $80) for personal use. By what amount should the Purchases account be adjusted?1 mark
  2. Where are drawings shown in the final accounts?1 mark

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Define the term 'sole trader' and state two disadvantages of this business structure.3 marks
  2. Differentiate between a current asset and a non-current liability, providing a clear example of each.4 marks
  3. A business provides the following figures for the year: Revenue $150,000, Opening Inventory $12,000, Purchases $80,000, Closing Inventory $10,000, Rent expense $18,000, Discount Received $2,000. Calculate the Gross Profit and the Profit for the Year.6 marks
  4. An owner's capital on 1 January was $40,000. During the year, the business made a profit of $22,000. The owner took cash drawings of $1,000 per month. Prepare the capital section of the Statement of Financial Position as at 31 December.4 marks
  5. A business buys a delivery van for $30,000 with a useful life of 4 years and an estimated residual value of $6,000. Calculate the annual depreciation charge using the straight-line method and state the double entry to record this.4 marks
  6. A business pays insurance of $4,800 on 1 July for 12 months. Its financial year ends on 31 December. Calculate the insurance expense for the Income Statement for the year ended 31 December and the value of the prepayment to be shown on the Statement of Financial Position.5 marks
  7. Explain the difference in the structure of an Income Statement for a trading business compared to a service business.4 marks
  8. At the year end, a business has trade receivables of $25,000. A specific debt of $1,000 is to be written off as irrecoverable. The provision for doubtful debts is to be set at 2% of remaining receivables. The opening provision was $300. Calculate the total charge to the Income Statement for irrecoverable and doubtful debts.6 marks
  9. Explain the accounting treatment for goods, costing $200, taken from inventory by a sole trader for their own personal use. State the effect on Gross Profit and Profit for the Year.4 marks
  10. From the following balances, prepare a Statement of Financial Position as at 31 December 2025: Machinery at cost $80,000; Accumulated depreciation $20,000; Inventory $15,000; Trade receivables $12,000; Cash at bank $5,000; Trade payables $9,000; Bank loan (repayable 2028) $25,000; Closing Capital $58,000.8 marks

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