Revise Sole traders for Cambridge 9706 (1.5.2)

A sole trader is an individual who owns and runs their own business. For accounting purposes, the 'business entity concept' is applied, meaning the business's finances are recorded separately from the owner's personal finances. However, legally, the owner and the business are the same entity, which means the owner has unlimited liability for business debts. This distinction is crucial in preparing the two main financial statements: the Income Statement (also known as the Statement of Profit or Loss) and the Statement of Financial Position. The owner's investment is called 'capital', and any withdrawals of assets for personal use are termed 'drawings'. These two items are central to the unique structure of the sole trader's Statement of Financial Position.

The Income Statement for a sole trader follows a standard structure to determine the profit or loss for an accounting period. It begins with revenue (sales) and deducts the cost of sales to arrive at the gross profit. The cost of sales is calculated as: opening inventory + purchases – closing inventory. Note that any goods taken by the owner for personal use must be deducted from purchases. All other business-related expenses, such as rent, utilities, and staff wages, are then subtracted from the gross profit to calculate the profit for the year. Crucially, any 'salary' or regular sum taken by the owner is not an expense; it is treated as drawings and does not appear in the Income Statement.

A sole trader's Statement of Financial Position presents the business's assets, liabilities, and capital at a specific point in time. It is structured to show that Net Assets (Total Assets - Total Liabilities) are equal to the owner's Capital. The capital section is unique and requires a specific calculation. It starts with the opening capital balance, adds any new capital introduced by the owner during the period, adds the profit for the year (from the Income Statement), and finally subtracts the total drawings made during the period. The resulting figure is the closing capital, which must balance with the net assets figure, proving the accuracy of the accounting equation (Assets = Capital + Liabilities).

To ensure the financial statements present a true and fair view and adhere to the accruals concept, several adjustments are often needed at the end of the accounting period. These adjustments correct the initial trial balance figures for items like depreciation, accruals, and prepayments.

1. Depreciation

Depreciation is the systematic allocation of the cost of a non-current asset over its useful life. It is a non-cash expense that reflects the asset's wear and tear or obsolescence. The double entry is: Debit Depreciation Expense (in the Income Statement) and Credit Accumulated Depreciation (in the Statement of Financial Position, where it is deducted from the asset's cost). 2. Accruals (Accrued Expenses)

Accruals are expenses that have been incurred by the business during the accounting period but have not yet been paid for by the year-end. To match costs with revenues, these must be included. The double entry is: Debit the relevant Expense account (increasing the expense in the Income Statement) and Credit Accruals/Accrued Expenses (creating a current liability in the Statement of Financial Position). 3. Prepayments (Prepaid Expenses)

Prepayments are expenses that have been paid for in advance, where the benefit extends into the next accounting period. The portion of the payment that relates to the future period must be removed from the current year's expenses. The double entry is: Debit Prepayments (creating a current asset in the Statement of Financial Position) and Credit the relevant Expense account (reducing the expense in the Income Statement).

Drawings represent any assets withdrawn from the business by the owner for their personal use. This can be cash taken from the bank or till, or it can be inventory (goods) taken from the business's stock. Drawings are not a business expense and therefore do not reduce profit in the Income Statement. Instead, they represent a reduction in the owner's investment in the business. The double entry for cash drawings is a debit to the Drawings account and a credit to the Bank/Cash account. For drawings of goods, the entry is a debit to Drawings and a credit to the Purchases account. This removes the cost of the goods from the business's expenses. At the year-end, the total balance on the Drawings account is deducted from capital.