Cambridge IGCSE Accounting · 0452
Chapter 5: Preparation of Financial Statements — Part 1
Section 5.1 · Sole Traders
A sole trader is a business owned and operated by one individual. Although they may employ others, the owner provides the capital and is personally liable for all business debts. At the year end, all ledger balances and adjustments are brought together in the Income Statement and Statement of Financial Position (SFP).
Advantages and Disadvantages of Sole Traders
- Advantages
-
- Quick decisions: The owner does not need to consult partners or shareholders.
- Keeps all profit: No profit-sharing with other owners.
- Simple records: Fewer legal formalities than a company or partnership.
- Privacy: Financial information does not have to be published publicly.
- Disadvantages
-
- Unlimited liability: The owner is personally responsible for all business debts.
- Limited capital: Finance is restricted to what the owner can invest or borrow.
- Lack of continuity: The business may close if the owner is ill or retires.
- Heavy workload: One person bears all management responsibility and risk.
Importance of Financial Statements
- Income Statement
- Its primary purpose is to calculate the Gross Profit (the result of trading activities) and the Profit for the Year (the final profit after all operating expenses).
- Statement of Financial Position (SFP)
- This statement records the assets and liabilities of a business on a specified date. It shows the “net worth” of the firm and its liquidity (the ability to pay debts).
Trading vs. Service Businesses
- Trading Business
- Involved in the purchase and sale of physical goods (inventory). It requires a Trading Account section within the Income Statement to calculate Gross Profit.
- Service Business
- Provides services (e.g., a school or a repair shop). It does not buy or sell inventory and therefore proceeds directly to calculating the Profit for the Year without a Gross Profit calculation.
The Vertical Income Statement Format (Trading Business)
The vertical format is the required examination layout as it is more user-friendly for stakeholders.
| Details | $ | $ |
|---|---|---|
| Revenue (Sales) | XXXX | |
| Less: Returns Inwards (Sales Returns) | (XXX) | |
| Net Revenue | XXXX | |
| Less: Cost of Sales | ||
| Opening Inventory | XXX | |
| Add: Purchases | XXX | |
| Add: Carriage Inwards | XXX | |
| Less: Returns Outwards (Purchases Returns) | (XXX) | |
| Less: Drawings of Inventory (at cost) | (XXX) | |
| XXX | ||
| Less: Closing Inventory | (XXX) | (XXX) |
| Gross Profit | XXXX | |
| Add: Other Income (e.g., Rent Received, Disc. Rec.) | XXX | |
| XXXX | ||
| Less: Operating Expenses | ||
| (Wages, Rent, Depreciation, Irrecoverable Debts, etc.) | XXX | (XXX) |
| Profit for the Year | XXXX |
The Statement of Financial Position (SFP)
The SFP is a formal list of balances and is not part of the double-entry system. It follows the equation: Non-current Assets + Working Capital − Non-current Liabilities = Capital.
- Non-Current Assets (Tangible): Land, buildings, machinery, and vehicles — shown at cost less accumulated depreciation.
- Non-Current Assets (Intangible): Assets without physical form but with long-term value, such as goodwill, patents, and trademarks. They are shown in the SFP at cost less any amortisation (the equivalent of depreciation for intangible assets).
- Current Assets: Short-term assets like Inventory (valued at the lower of cost and NRV), Trade Receivables, Prepayments, and Cash.
- Working Capital: Calculated as Current Assets − Current Liabilities. It represents the funds available for day-to-day operations.
Capital Section Calculation:
Opening Capital + Profit for the Year − Total Drawings (cash and goods) = Closing Capital
Essential Year-End Adjustments
| Adjustment | Income Statement | Statement of Financial Position |
|---|---|---|
| Depreciation | Operating expense | Reduces NBV of non-current asset |
| Accrued expense | Increase expense for the year | Current liability (other payables) |
| Prepaid expense | Reduce expense for the year | Current asset (other receivables) |
| Irrecoverable debt | Operating expense | Reduce trade receivables |
| Goods for own use | Deduct from purchases (reduces gross profit) | Add to drawings (reduces capital) |
All adjustments follow the Matching (Accruals) and Prudence concepts. Inventory is always valued at the lower of cost and NRV.
Worked Example 1: Integrated Year-End Adjustments
Mara is a sole trader. The following trial balance extract is available at 31 December 2025, together with year-end adjustments.
| Item | $ |
|---|---|
| Revenue | 48,000 |
| Purchases | 28,000 |
| Opening inventory | 4,000 |
| Closing inventory | 5,200 |
| Wages (paid) | 6,000 |
| Rent (paid) | 3,600 |
| Equipment at cost | 10,000 |
| Provision for depreciation | 2,000 |
| Drawings (cash) | 4,500 |
| Capital (opening) | 15,000 |
Adjustments: (1) Depreciation on equipment 20% straight line on cost; (2) Wages accrued $400; (3) Irrecoverable debt $250; (4) Goods taken for own use $600 at cost; (5) Rent prepaid $300.
Income Statement (extract):
| Details | $ | $ |
|---|---|---|
| Revenue | 48,000 | |
| Less: Cost of sales (4,000 + 27,400 − 5,200) | (26,200) | |
| Gross profit | 21,800 | |
| Wages (6,000 + 400) | 6,400 | |
| Rent (3,600 − 300) | 3,300 | |
| Depreciation (20% × 10,000) | 2,000 | |
| Irrecoverable debts | 250 | (11,950) |
| Profit for the year | 9,850 |
Purchases adjusted: 28,000 − 600 (goods for own use) = $27,400.
Closing capital: 15,000 + 9,850 − 4,500 (cash drawings) − 600 (goods drawings) = $19,750.
Worked Example 2: Effect of Balance Changes
Understanding how each adjustment changes the final accounts helps you check answers and explain examiner scenarios.
| If this balance increases… | Effect on Profit for the Year | Effect on Closing Capital |
|---|---|---|
| Closing inventory (with same opening inventory) | Increases (lower cost of sales) | Increases |
| Depreciation charge | Decreases | Decreases |
| Accrued wages at year end | Decreases | Decreases |
| Drawings (cash or goods) | No direct effect on profit | Decreases |
| Goods taken for own use (at cost) | Decreases gross profit | Decreases (via drawings) |
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