Cambridge O Level7707

Sole traders

Accounting 7707 Chapter Notes

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Sole tradersPartnershipsLimited companiesManufacturing accountsClubs and societiesIncomplete records
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In this chapter

  1. 1What is a Sole Trader?
  2. 2The Income Statement for a Trading Business
  3. 3The Statement of Financial Position
  4. 4Adjusting for Depreciation and Drawings
  5. 5Adjusting for Accruals and Prepayments
  6. 6Adjusting for Bad and Doubtful Debts
  7. 7Financial Statements for a Service Business

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, it's also a popular structure for service providers such as plumbers, graphic designers, and consultants.

Key term

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

Common pitfall

Students often forget that 'unlimited liability' is the key disadvantage and fail to explain that it puts the owner's personal assets at risk.

Fun fact

Despite the rise of large corporations, sole traders remain the most common type of business structure in many countries, including the UK and USA, making up the majority of all businesses.

Worked example 14 marks

Jamal is a skilled mechanic who wants to start his own garage. He is considering setting up as a sole trader. State two advantages and two disadvantages for Jamal if he chooses this business structure.

  1. 1

    Advantage 1: Full Control. Jamal would be his own boss and could make all business decisions quickly without needing to consult anyone.

  2. 2

    Advantage 2: Keeps all Profits. As the only owner, all profits the garage makes after tax belong entirely to him.

  3. 3

    Disadvantage 1: Unlimited Liability. If the garage fails and owes money, Jamal's personal possessions, such as his home, could be at risk to pay the debts.

  4. 4

    Disadvantage 2: Difficulty Raising Finance. Banks may be hesitant to lend large amounts of money to a new, small business, which could limit his ability to buy expensive equipment.

Recap

  • A sole trader is a business owned by one person.
  • The owner and the business are not separate legal entities.
  • Key advantages include total control and keeping all profits.
  • The main disadvantage is unlimited liability.
  • It is simple and inexpensive to set up.
  • The owner is personally responsible for all business debts.

Quick check

  1. What is the term for the owner being personally responsible for business debts?1 mark
  2. State one reason why a sole trader business is easy to set up.1 mark

2. The Income Statement for a Trading Business

The Income Statement, prepared for a specific period (e.g., a year), shows a business's financial performance. Its main purpose is to calculate whether the business has made a net profit or a net loss. For a trading business (one that buys and sells goods), it has two main sections. The first section calculates the 'Gross Profit' by subtracting the cost of the goods sold from the sales revenue. The second section then deducts all other running costs (expenses) to find the final 'Net Profit'.

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

Cost of Sales = Opening Inventory + Purchases (Net) - Closing Inventory

Net Purchases = Purchases - Purchase Returns + Carriage Inwards

Profit for the Year (Net Profit) = Gross Profit + Other Income - Total Expenses

Key term

Cost of Sales: The direct cost of acquiring the goods that were sold during a period.

Examiner insight

Examiners award specific marks for the correct calculation of Revenue, Cost of Sales, Gross Profit, and Profit for the Year. A clear layout using two columns for figures is expected.

Fun fact

The structure of the income statement is based on the 'matching principle' in accounting, which means you must 'match' the revenues you've earned with the expenses you incurred to earn them in the same period.

Worked example 18 marks

Using the following balances for Selma at 31 December 2018, prepare an Income Statement for the year. Opening inventory: $13,000; Purchases: $40,000; Sales: $100,000; Return inwards: $200; Return outwards: $2,000; Carriage inwards: $200; Carriage outwards: $500; Rent: $3,000; Internet charges: $1,500; Rent received: $3,700. Closing inventory was $6,000.

  1. 1

    Step 1: Start with the heading: Selma, Income Statement for the year ended 31 December 2018.

  2. 2

    Step 2: Calculate Revenue. Sales ($100,000) - Return inwards ($200) = $99,800.

  3. 3

    Step 3: Calculate Cost of Sales. Opening inventory ($13,000) + Purchases ($40,000) + Carriage inwards ($200) - Return outwards ($2,000) = $51,200 (Cost of goods available for sale). Then, $51,200 - Closing inventory ($6,000) = $45,200 (Cost of Sales).

  4. 4

    Step 4: Calculate Gross Profit. Revenue ($99,800) - Cost of Sales ($45,200) = $54,600.

  5. 5

    Step 5: Add other income. Gross Profit ($54,600) + Rent received ($3,700) = $58,300.

  6. 6

    Step 6: List and total expenses. Carriage outwards ($500) + Rent ($3,000) + Internet charges ($1,500) = $5,000.

  7. 7

    Step 7: Calculate Profit for the year (Net Profit). $58,300 - Total Expenses ($5,000) = $53,300.

Recap

  • The Income Statement calculates the profit or loss for a period.
  • Revenue minus Cost of Sales equals Gross Profit.
  • Carriage inwards is part of the Cost of Sales calculation.
  • Carriage outwards is an expense in the second part of the statement.
  • Net Profit is found by subtracting total expenses from Gross Profit plus other income.

Quick check

  1. Where in the Income Statement is 'Carriage Inwards' recorded?1 mark
  2. What is the formula for Gross Profit?1 mark

3. The Statement of Financial Position

The Statement of Financial Position (also known as the Balance Sheet) is a snapshot of what a business owns (Assets) and what it owes (Liabilities) on a specific date. It also shows the owner's investment in the business (Capital). It is based on the fundamental accounting equation. The statement is structured to show Non-Current Assets (long-term items, e.g., property, vehicles), Current Assets (short-term items, e.g., inventory, cash), Current Liabilities (debts due within a year, e.g., trade payables), and Non-Current Liabilities (long-term debts, e.g., bank loan).

Assets = Capital + Liabilities

Working Capital = Current Assets - Current Liabilities

Closing Capital = Opening Capital + Capital Introduced + Profit for the Year - Drawings

Key term

Accounting Equation: The formula Assets = Liabilities + Capital, which forms the foundation of the entire double-entry accounting system and the Statement of Financial Position.

Examiner insight

Examiners look for a correctly balanced statement. If your statement doesn't balance, check you have correctly calculated and transferred the profit for the year and deducted drawings from the capital section.

Fun fact

The world's first published 'balance sheet' is found in the book 'Summa de Arithmetica', written by Italian mathematician Luca Pacioli in 1494. He is often called the 'Father of Accounting'.

Worked example 17 marks

At the start of the year, Selma's capital was $497,800. During the year, she made a profit of $53,300 and took drawings of $300. Her business assets and liabilities at the year-end include: Property $500,000; Machinery $40,000; Trade receivables $20,000; Trade payables $30,000; Cash $800; Bank $14,000; Closing inventory $6,000. Prepare the Statement of Financial Position at 31 December 2018.

  1. 1

    Step 1: Start with the heading: Selma, Statement of Financial Position as at 31 December 2018.

  2. 2

    Step 2: List and total Non-Current Assets. Property $500,000 + Machinery $40,000 = $540,000.

  3. 3

    Step 3: List and total Current Assets. Closing inventory $6,000 + Trade receivables $20,000 + Bank $14,000 + Cash $800 = $40,800.

  4. 4

    Step 4: Calculate Total Assets. Non-Current Assets ($540,000) + Current Assets ($40,800) = $580,800.

  5. 5

    Step 5: Calculate Closing Capital. Opening Capital ($497,800) + Profit for the year ($53,300) - Drawings ($300) = $550,800. This section is called 'Financed by:'.

  6. 6

    Step 6: List Liabilities. There are no Non-Current Liabilities. Current Liabilities consist of Trade payables $30,000.

  7. 7

    Step 7: Calculate Total Capital and Liabilities. Closing Capital ($550,800) + Total Liabilities ($30,000) = $580,800. This figure must balance with Total Assets.

Recap

  • The Statement of Financial Position is a snapshot on a specific date.
  • It shows Assets, Liabilities, and Capital.
  • Assets are what the business owns; Liabilities are what it owes.
  • The statement must always balance: Assets = Capital + Liabilities.
  • Profit increases capital, while drawings decrease capital.

Quick check

  1. Is Inventory a Current Asset or a Non-Current Asset?1 mark
  2. State the full Accounting Equation.1 mark

4. Adjusting for Depreciation and Drawings

At the end of an accounting period, we must make adjustments to ensure the financial statements are accurate. Depreciation is an expense that represents the wearing out or loss of value of a non-current asset. We must account for it to show the asset's true value and match the cost of using the asset against the revenue it helped generate. Drawings are when the owner takes cash or goods from the business for personal use. This is not a business expense but a reduction of the owner's capital investment.

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

Reducing (Diminishing) Balance Depreciation = Net Book Value x % Rate

Net Book Value (NBV) = Cost - Accumulated Depreciation

Key term

Depreciation: The systematic allocation of the cost of a tangible non-current asset over its useful economic life.

Examiner insight

Always show your depreciation workings clearly. Marks are often available for the correct formula and substitution, even if the final calculation is wrong.

Common pitfall

When using the reducing balance method, students often mistakenly apply the percentage to the original cost of the asset instead of its Net Book Value (cost less accumulated depreciation).

Worked example 15 marks

A business owns machinery that cost $40,000. It is depreciated at 20% per year using the reducing balance method. At the start of the year, accumulated depreciation was $8,000. During the year, the owner also took goods costing $300 for her own use. Show the effect of these adjustments.

  1. 1

    Step 1 (Depreciation): Calculate the Net Book Value (NBV) at the start of the year. Cost ($40,000) - Accumulated Depreciation ($8,000) = $32,000.

  2. 2

    Step 2 (Depreciation): Calculate the depreciation charge for the year. NBV ($32,000) x 20% = $6,400.

  3. 3

    Step 3 (Depreciation): Show the dual effect. The Income Statement will show a depreciation expense of $6,400. The Statement of Financial Position will show the new NBV of the machinery as $32,000 - $6,400 = $25,600.

  4. 4

    Step 4 (Drawings): Identify the adjustment for goods taken. The owner took goods costing $300.

  5. 5

    Step 5 (Drawings): Show the dual effect. The 'Purchases' figure in the Cost of Sales calculation is reduced by $300 (as the goods were not sold). The 'Drawings' figure in the Capital section of the Statement of Financial Position is increased by $300.

Recap

  • Depreciation is an expense charged in the Income Statement.
  • Accumulated depreciation reduces the value of non-current assets in the Statement of Financial Position.
  • The straight-line method charges equal depreciation each year.
  • The reducing balance method charges more depreciation in the early years of an asset's life.
  • Drawings of goods reduce Purchases and increase total Drawings.

Quick check

  1. A machine costs $10,000 and is depreciated at 10% straight-line. What is the annual depreciation charge?1 mark
  2. How are drawings of cash by the owner recorded in the financial statements?2 marks

5. Adjusting for Accruals and Prepayments

To ensure expenses and revenues are recorded in the correct accounting period (the matching principle), we must adjust for accruals and prepayments. An accrued expense (or accrual) is an expense the business has used but not yet paid for at the year-end (e.g., an electricity bill for December that arrives in January). A prepaid expense (or prepayment) is an expense paid for in advance but not yet used up (e.g., paying a year's rent in advance). The same concepts apply to income.

Key term

Accruals Concept (Matching Principle): The accounting principle that states revenues and their related expenses should be recognised in the same accounting period, regardless of when the cash is actually received or paid.

Examiner insight

Examiners look for the dual effect of each adjustment. Ensure you show the impact on both the Income Statement (the expense/income for the year) and the Statement of Financial Position (the resulting asset/liability).

Common pitfall

Confusing the treatment of accruals and prepayments. Remember: Accruals are liabilities (you owe something), and Prepayments are assets (you are owed a service/good).

Worked example 14 marks

A sole trader's trial balance at year-end shows Insurance Paid $2,400 and Wages $50,000. Additional information reveals: (1) Insurance includes a prepayment of $400 for the next year. (2) Wages of $1,000 for the final week are due but will be paid next year. Calculate the correct figures for the financial statements.

  1. 1

    Step 1 (Insurance Adjustment): The amount paid was $2,400, but $400 of this relates to the next period. The expense for this year is $2,400 - $400 = $2,000.

  2. 2

    Step 2 (Insurance in Statements): The Income Statement will show an insurance expense of $2,000. The Statement of Financial Position will show a Current Asset called 'Prepayments' or 'Prepaid Insurance' of $400.

  3. 3

    Step 3 (Wages Adjustment): The amount paid was $50,000, but an extra $1,000 was incurred. The total expense for this year is $50,000 + $1,000 = $51,000.

  4. 4

    Step 4 (Wages in Statements): The Income Statement will show a wages expense of $51,000. The Statement of Financial Position will show a Current Liability called 'Accruals' or 'Accrued Wages' of $1,000.

Recap

  • Accrued expenses are added to the expense account and shown as a current liability.
  • Prepaid expenses are subtracted from the expense account and shown as a current asset.
  • Accrued income is added to the income account and shown as a current asset.
  • Prepaid (unearned) income is subtracted from the income account and shown as a current liability.
  • These adjustments ensure profit is calculated accurately based on the matching principle.

Quick check

  1. An unpaid electricity bill at year-end is an example of what?1 mark
  2. Where is a prepaid expense shown in the Statement of Financial Position?1 mark

6. Adjusting for Bad and Doubtful Debts

Businesses that sell on credit face the risk that some customers (trade receivables) will not pay. When a business is certain a specific debt will not be paid, it is written off as an irrecoverable debt (or bad debt). This is a business expense. Furthermore, to be prudent, a business may estimate that a certain percentage of its remaining receivables might not pay in the future. It creates a provision for doubtful debts for this. This provision is an estimate, and any increase in the provision during a year is treated as an expense.

Provision for Doubtful Debts = % x Trade Receivables (after deducting irrecoverable debts)

Key term

Irrecoverable Debt: A specific debt from a credit customer that is known to be uncollectable and must be written off as an expense.

Examiner insight

When dealing with an existing provision, remember that only the *increase* or *decrease* in the provision for the year goes to the Income Statement. An increase is an expense, while a decrease is treated as other income.

Common pitfall

Forgetting to deduct the irrecoverable debts *before* calculating the provision for doubtful debts, leading to an incorrect provision amount.

Worked example 15 marks

At 31 December, a sole trader's Trade Receivables are $10,500. It is decided to write off a debt of $500 from a bankrupt customer. The business also wants to create a provision for doubtful debts of 5% of the remaining receivables. Show the figures for the financial statements.

  1. 1

    Step 1 (Irrecoverable Debt): An expense of $500 for 'Irrecoverable Debts' is recorded in the Income Statement.

  2. 2

    Step 2 (Adjust Trade Receivables): The Trade Receivables figure is reduced by the written-off debt. New Trade Receivables = $10,500 - $500 = $10,000.

  3. 3

    Step 3 (Provision Calculation): Calculate the required provision. 5% of the new receivables balance: 5% x $10,000 = $500.

  4. 4

    Step 4 (Provision in Statements): As this is a new provision, the full amount is an expense. An expense of $500 for 'Provision for Doubtful Debts' is recorded in the Income Statement. The total expense related to debts is $500 + $500 = $1,000.

  5. 5

    Step 5 (SoFP Presentation): In the Statement of Financial Position, under Current Assets, Trade Receivables will be shown as: Trade Receivables $10,000 less Provision for Doubtful Debts ($500) = $9,500.

Recap

  • Irrecoverable debts written off are an expense in the Income Statement.
  • A provision for doubtful debts is an estimate of future irrecoverable debts.
  • The increase in the provision for doubtful debts for the year is an expense.
  • The total provision is deducted from Trade Receivables in the Statement of Financial Position.
  • Writing off a debt reduces the Trade Receivables figure before the provision is calculated.

Quick check

  1. A debt of $200 is declared irrecoverable. Which two accounts are affected?2 marks
  2. What is the purpose of a provision for doubtful debts?1 mark

7. Financial Statements for a Service Business

A service business, such as a hairdresser, accountant, or taxi service, earns its revenue by providing services rather than selling goods. This leads to a key difference in their financial statements. Since they do not have inventory, there is no 'Cost of Sales' to calculate. Their Income Statement is therefore simpler: it starts with the revenue earned (e.g., Fees, Commission) and then lists and deducts the operating expenses to arrive at the profit for the year. The Statement of Financial Position is largely the same, but it will not have 'Inventory' listed under Current Assets.

Profit for the Year = Total Service Revenue - Total Expenses

Key term

Service Revenue: The income earned by a business from providing services to customers, rather than from selling physical goods.

Worked example 14 marks

Anjali is a consultant. For the year ended 30 April, her records show: Fees Received $85,000; Rent Expense $12,000; Office Salaries $30,000; Office Equipment (Cost) $20,000. Prepare a simple Income Statement for her service business.

  1. 1

    Step 1: Start with the heading: Anjali, Income Statement for the year ended 30 April.

  2. 2

    Step 2: List the revenue. Fees Received: $85,000.

  3. 3

    Step 3: List and total the expenses. Rent Expense $12,000 + Office Salaries $30,000 = $42,000.

  4. 4

    Step 4: Calculate the Profit for the Year. Revenue ($85,000) - Total Expenses ($42,000) = $43,000.

  5. 5

    Note: The Office Equipment is a non-current asset and its cost does not appear directly in the Income Statement (though any depreciation on it would).

Recap

  • A service business provides services, it does not sell goods.
  • The Income Statement for a service business has no Cost of Sales section.
  • Profit is calculated simply as Revenue minus Expenses.
  • The Statement of Financial Position will not contain an entry for Inventory.
  • All other principles, like adjustments for accruals and prepayments, still apply.

Quick check

  1. What is the main section of a trading business's Income Statement that is missing from a service business's Income Statement?1 mark
  2. Give two examples of a service business.2 marks

End-of-chapter exercise

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

  1. State four advantages of operating as a sole trader.4 marks
  2. Explain the difference between a current asset and a non-current asset, giving one example of each.4 marks
  3. A business has the following figures: Opening inventory $5,000; Purchases $62,000; Carriage inwards $1,500; Purchase returns $2,000; Closing inventory $6,500. Calculate the Cost of Sales.3 marks
  4. A machine was bought for $50,000 on 1 January 2020. The business depreciates machinery at 20% per annum using the reducing balance method. Calculate the depreciation charge for the year ended 31 December 2021.4 marks
  5. Explain the accounting treatment for drawings of goods, valued at $150, taken by a sole trader for personal use.2 marks
  6. A business pays rent of $1,000 per month. During the year, it paid a total of $13,000 in rent. State the rent expense for the Income Statement and the relevant entry in the Statement of Financial Position at the year end.3 marks
  7. At the year end, a sole trader's trade receivables are $25,000. An irrecoverable debt of $1,000 is to be written off. The provision for doubtful debts is to be adjusted to 5% of receivables. The opening provision was $800. Calculate the total charge to the Income Statement for irrecoverable and doubtful debts.5 marks
  8. Ben, a sole trader, provides the following information: Opening Capital $40,000; Drawings during the year $8,000; Loss for the year $3,000; New capital introduced $5,000. Calculate Ben's closing capital.4 marks
  9. Distinguish between the purpose of an Income Statement and a Statement of Financial Position.4 marks
  10. From the following list of balances for a service business, prepare an Income Statement for the year ended 31 March: Fees Earned $120,000; Salaries $45,000; Rent $24,000; Advertising $5,000. At the year-end, rent of $2,000 was prepaid and salaries of $3,000 were accrued.6 marks

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