Financial Statements: Sole Traders

What you'll learn

Financial statements for sole traders form the cornerstone of IGCSE Accounting assessments. You'll master the preparation of income statements and statements of financial position, apply year-end adjustments including accruals and prepayments, and understand how these statements present the financial performance and position of unincorporated businesses. This topic typically accounts for 20-30% of your examination marks.

Key terms and definitions

Sole trader — an unincorporated business owned and controlled by one individual who has unlimited liability for business debts

Income statement — a financial statement showing revenue, expenses, and profit or loss for a specific accounting period (formerly called trading and profit and loss account)

Statement of financial position — a financial statement showing assets, liabilities, and capital at a specific date (formerly called balance sheet)

Accruals — expenses incurred during an accounting period but not yet paid, recorded as current liabilities

Prepayments — expenses paid in advance for the next accounting period, recorded as current assets

Drawings — cash or goods taken from the business by the owner for personal use, reducing capital

Capital — the owner's investment in the business, calculated as assets minus liabilities

Carriage inwards — transport costs on purchases, treated as an expense in cost of sales

Core concepts

The structure of the income statement

The income statement for a sole trader follows a standardised format and calculates profit in two stages:

Trading section — calculates gross profit:

• Sales revenue (returns inwards deducted)
• Less: Cost of sales
• Equals: Gross profit

Cost of sales calculation:

• Opening inventory
• Add: Purchases (returns outwards deducted, carriage inwards added)
• Less: Closing inventory
• Equals: Cost of sales

Profit and loss section — calculates net profit:

• Gross profit
• Add: Other income (discount received, commission received, rent received)
• Less: Expenses (all operating expenses including depreciation, discount allowed, carriage outwards)
• Equals: Net profit

The net profit represents the profit available to the owner after all business expenses have been deducted. It transfers to the capital section of the statement of financial position.

The statement of financial position

The statement of financial position presents the financial position at a specific date using the accounting equation: Assets = Capital + Liabilities

Non-current assets:

• Premises, motor vehicles, fixtures and fittings, equipment
• Shown at carrying amount (cost less accumulated depreciation)
• Listed in order of permanence (premises first, equipment last)

Current assets:

• Inventory, trade receivables, prepayments, bank, cash
• Assets expected to be converted to cash within one year
• Listed in order of liquidity (inventory first, cash last)

Current liabilities:

• Trade payables, accruals, bank overdraft
• Debts payable within one year
• Deducted from current assets to give net current assets (working capital)

Capital section:

• Opening capital
• Add: Net profit, additional capital introduced
• Less: Drawings
• Equals: Closing capital

The closing capital must equal net assets (total assets minus total liabilities), proving the accuracy of the statement.

Year-end adjustments: accruals and prepayments

Adjustments ensure expenses match the accounting period (matching concept) and apply the accruals concept.

Accruals (expenses owing):

When expenses are incurred but unpaid at year-end:

• Increase the expense in the income statement
• Show as a current liability in the statement of financial position
• Example: Electricity expense £2,400 paid, £300 accrued = £2,700 charged to income statement

Prepayments (expenses paid in advance):

When expenses are paid but relate to the next period:

• Decrease the expense in the income statement
• Show as a current asset in the statement of financial position
• Example: Insurance £1,800 paid, £400 prepaid = £1,400 charged to income statement

Income accruals and prepayments:

The reverse logic applies to income:

• Income accrued (owed to the business) increases income and appears as a current asset
• Income prepaid (received in advance) decreases income and appears as a current liability

Depreciation adjustments

Depreciation is the allocation of the cost of a non-current asset over its useful life. Two methods appear in IGCSE examinations:

Straight-line method:

• Formula: (Cost - Residual value) ÷ Useful life
• Or: Cost × Depreciation percentage
• Charges the same amount each year
• Example: Asset cost £10,000, 20% per annum = £2,000 depreciation annually

Reducing balance method:

• Formula: Carrying amount × Depreciation percentage
• Charges higher depreciation in early years, declining over time
• Example: Asset cost £10,000, 25% reducing balance = Year 1: £2,500, Year 2: £1,875

Recording depreciation:

• Charge to expenses in the income statement
• Accumulate in provision for depreciation (or accumulated depreciation)
• Show assets at carrying amount (cost less accumulated depreciation) in statement of financial position

Bad debts and provision for doubtful debts

Bad debts are debts definitely irrecoverable, written off as an expense:

• Charge to expenses in the income statement
• Deduct from trade receivables in the statement of financial position

Provision for doubtful debts anticipates possible future bad debts:

• Create or adjust the provision based on a percentage of trade receivables
• Charge increases (or credit decreases) in provision to the income statement
• Deduct total provision from trade receivables in the statement of financial position

Example calculation:

• Trade receivables: £20,000
• Bad debt written off: £500
• Provision required: 5% of remaining receivables
• Receivables after bad debt: £19,500
• Provision: £19,500 × 5% = £975
• If opening provision was £800, increase provision by £175 (charge to income statement)
• Show trade receivables net: £19,500 - £975 = £18,525

Carriage costs

Different carriage costs receive different treatment:

Carriage inwards:

• Transport costs on purchases
• Add to purchases in cost of sales calculation
• Increases cost of sales, reduces gross profit

Carriage outwards:

• Delivery costs to customers
• Treat as an expense below gross profit
• Reduces net profit only

This distinction is crucial for correct gross profit calculation and frequently tested.

Worked examples

Example 1: Income statement preparation with adjustments (15 marks)

Question:

Ahmad runs a retail business. The following information is available for the year ended 31 December 2023:

• Sales revenue: £185,000
• Opening inventory: £18,500
• Purchases: £98,000
• Closing inventory: £22,300
• Rent: £12,000 (includes £1,000 prepayment)
• Wages: £28,400
• Insurance: £2,700 (£450 accrued)
• Depreciation on fixtures: £3,200
• Discount received: £1,850

Prepare Ahmad's income statement for the year ended 31 December 2023.

Solution:

Ahmad Income statement for the year ended 31 December 2023

		£	£
Sales revenue			185,000
Less: Cost of sales
Opening inventory		18,500
Add: Purchases		98,000
		116,500
Less: Closing inventory		(22,300)	(94,200)
Gross profit			90,800
Add: Other income
Discount received			1,850
			92,650
Less: Expenses
Rent (12,000 - 1,000)		11,000
Wages		28,400
Insurance (2,700 + 450)		3,150
Depreciation		3,200	(45,750)
Net profit			46,900

Mark scheme guidance:

• Correct format and headings (2 marks)
• Sales revenue (1 mark)
• Cost of sales calculation (3 marks)
• Gross profit (1 mark)
• Discount received correctly positioned (1 mark)
• Rent adjustment (2 marks)
• Insurance adjustment (2 marks)
• Other expenses correctly listed (2 marks)
• Net profit (1 mark)

Example 2: Statement of financial position with capital calculation (12 marks)

Question:

Using the net profit from Example 1 (£46,900) and the following additional information, prepare Ahmad's statement of financial position as at 31 December 2023:

• Premises at cost: £125,000
• Fixtures at cost: £18,000, accumulated depreciation: £8,500
• Closing inventory: £22,300
• Trade receivables: £14,800
• Bank: £6,750 (positive balance)
• Trade payables: £11,200
• Opening capital: £145,000
• Drawings: £32,000
• Rent prepayment: £1,000
• Insurance accrued: £450

Solution:

Ahmad Statement of financial position as at 31 December 2023

	Cost	Acc. Dep.	Carrying amount
	£	£	£
Non-current assets
Premises	125,000	-	125,000
Fixtures	18,000	8,500	9,500
			134,500
Current assets
Inventory			22,300
Trade receivables			14,800
Prepayment			1,000
Bank			6,750
			44,850
Current liabilities
Trade payables			11,200
Accrual			450
			(11,650)
Net current assets			33,200
Net assets			167,700
Capital
Opening capital			145,000
Add: Net profit			46,900
			191,900
Less: Drawings			(32,000)
Closing capital			167,700

Mark scheme guidance:

• Non-current assets correctly shown (3 marks)
• Current assets listed correctly (3 marks)
• Current liabilities and net current assets (2 marks)
• Net assets total (1 mark)
• Capital calculation with all components (3 marks)

Example 3: Provision for doubtful debts adjustment (6 marks)

Question:

On 31 December 2023, Sara's trade receivables totalled £28,000. She wrote off bad debts of £1,200 and maintains a provision for doubtful debts of 4% of trade receivables. The provision for doubtful debts at 1 January 2023 was £980.

Calculate: a) The charge to the income statement for bad debts (2 marks) b) The adjustment to provision for doubtful debts (2 marks) c) The trade receivables figure shown in the statement of financial position (2 marks)

Solution:

a) Bad debts written off: £1,200 (charged to income statement as an expense)

b) Trade receivables after bad debt: £28,000 - £1,200 = £26,800 Provision required: £26,800 × 4% = £1,072 Opening provision: £980 Increase in provision: £1,072 - £980 = £92 (charged to income statement)

c) Trade receivables shown in statement of financial position: £26,800 - £1,072 = £25,728

(Alternative presentation: Trade receivables £26,800, less provision for doubtful debts £1,072 = £25,728)

Common mistakes and how to avoid them

• Confusing carriage inwards and carriage outwards: Remember carriage inwards relates to getting purchases into the business (part of cost of sales), while carriage outwards is delivering goods to customers (an expense). Use the mnemonic: "Inwards = In cost of sales"

• Incorrect accruals and prepayments adjustments: Always add accruals to the expense paid and deduct prepayments. Draw a T-account if uncertain: expense account shows payments on one side, accruals and prepayments adjust to give the correct charge

• Forgetting to adjust opening capital: The capital section must start with opening capital (or prior year closing capital), not opening net assets. Opening capital is given information, not calculated from current year assets and liabilities

• Misplacing discount allowed and discount received: Discount allowed is given to customers (expense), discount received comes from suppliers (income). Discount allowed reduces net profit twice (reduces sales in principle, charged as expense), discount received is other income

• Showing bank overdrafts as current assets: A bank overdraft is always a current liability. A positive bank balance is a current asset. Check the question carefully for the nature of the bank balance

• Incorrect depreciation in year of purchase: Unless stated otherwise, charge a full year's depreciation in the year of purchase and no depreciation in the year of disposal. For reducing balance, always apply the percentage to the carrying amount at the start of the year

Exam technique for "Financial Statements: Sole Traders"

• Command word precision: "Prepare" requires formal financial statement layout with proper headings and columnar format. "Calculate" needs workings shown. "State" requires a brief answer without detailed explanation. Pearson mark schemes award presentation marks, so invest time in clear formatting

• Mark allocation guides time investment: Typically 1 mark = 1 minute. A 15-mark income statement deserves 15 minutes. If a figure awards 2 marks, show your working—one mark for method, one for accuracy. Don't spend 10 minutes on a 3-mark requirement

• Use the extended trial balance approach: When questions provide numerous adjustments, create columns for adjustments, income statement, and statement of financial position. This systematic approach reduces omissions and errors under exam pressure

• Check the balancing figures: Net profit must appear identically in both statements. Closing capital must equal net assets. These relationships provide built-in accuracy checks—use them before moving to the next question

Quick revision summary

Sole trader financial statements comprise the income statement (showing profit calculation through sales, cost of sales, and expenses) and statement of financial position (showing assets, liabilities, and capital at year-end). Master year-end adjustments: add accruals to expenses and show as current liabilities; deduct prepayments from expenses and show as current assets. Depreciation charges to the income statement and accumulates to reduce asset carrying amounts. Calculate closing capital as opening capital plus net profit less drawings. Ensure net assets equal closing capital to verify accuracy.