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Sole Proprietorship’s Financial Statements

Lecture Notes 9

Sole Proprietorship’s Financial Statement

IntroductionThere are basically three (3) forms of business organizations:

1. Sole Proprietorship2. Partnerships3. Limited Liability Companies or Corporations

• Sole proprietorship however is by far the most common form of business organization in our society.

Sole Proprietorship’s Financial Statement

Definition• A sole proprietorship or simply a proprietorship is a

business owned by one person.

• A proprietorship is no more than a collection of business activities carried on by an individual person

• For example – Small retail stores and service businesses often are organized as proprietorships.

Sole Proprietorship’s

Characteristics

Lecture Notes 9

Sole Proprietorship’s Financial Statement

Characteristics • No Legal Requirements - There is no special legal

requirements to start a sole proprietorship.

• Legal Status - While it is a separate entity for accounting purposes, it is not a separate legal entity from its owner.

• It does not exist apart from the owner.

Sole Proprietorship’s Financial Statement

Characteristics (cont.)• Unlimited Liability – Because a proprietorship is not

legally separate from its owner, the owner is personally liable and responsible for its liabilities.– A court can order an owner to sell his personal assets or

belongings to pay the debts of the business.

• Personal Income Tax – Tax authorities do not separate a proprietorship from its owner.

This means that the profits are not subject to a business income tax, but are reported and taxed on the owner’s personal income tax return.

Sole Proprietorship’s Financial Statement

Characteristics (cont.)• Similarity of Financial Statements – While there maybe

many differences in the legal status, structure and organization of the different forms of business, their financial statements are very similar except for the distribution of profit, and capital or equity.

• Business Entity Concept – The accounting records and financial statements for a proprietorship are based on the assumption of the business entity concept, that is the business is a separate entity (Not a Legal Entity).

Sole Proprietorship’s Financial Statement

Characteristics (cont.)• Drawings – When an owner of a proprietorship takes

cash or other assets from the company, the distribution is called withdrawals and reduces their capital.

• Salary – Salaries paid to the owner of the business is recorded as withdrawals of profits and not expenses, even if he is the owner.

However salaries paid to managers or employees besides the owner should be reported as expenses.

Sole Proprietorship’s

Financial Statements

Lecture Notes 9

Sole Proprietorship’s Financial Statement

Financial StatementsThere is basically two (2) sets of financial statements prepared for a Sole Proprietor:

1. Trading and Profit & Loss Account2. Balance Sheet

• These financial statements helps the owner to asses:– The profit made for a particular period – The change in his assets, liabilities and capital as at a

particular date.

Sole Proprietorship’s Financial Statement

Trading and Profit and Loss AccountIt is possible to have two (2) separate accounts:

1. Trading Account2. Profit & Loss Account

However there are combined for convenience .

• The combined account measures the Financial Performance of the proprietorship for a given period

• In other words, it calculate how much profit is made over a particular period.

Sole Proprietorship’s Financial Statement

Trading and Profit and Loss Account• Trading Account – An account in which the gross profit

earned from the proprietorships is calculated.– Gross Profit:– This is the excess of sales over the cost of

goods sold in the period.

• Profit and Loss Account – An account in which net profit is calculated from the proprietorships non trading activities.– Net Profit – This is what is left of gross profit after all

other expenses have been deducted.

Sole Proprietorship’s Financial Statement

Trading and Profit and Loss Account• It is usually prepared for a one (1) period even though it

can be prepared for a lesser period.

• Its main purpose is for the owners to be able to see how profitably the business is being run.

• It can also be used for other purposes such as:– Income Taxes Calculation.– Comparing results obtained with the results expected.

Sole Proprietorship’s Financial Statement

Information Source for T&P&L• The Trial Balance contains all the information needed

for preparing the Trading and Profit & Loss Account.

• Trial Balance – is a list of account titles and their balances in the ledgers or books on a specific date shown in debit and credit columns.

• The Trial balance however does not contain adjustments made subsequent to extraction of the list of balances from the ledgers.

Sole Proprietorship’s Financial Statement

Information Source for T&P&L• Thus there is usually notes beneath the trial balance

outlining adjustments to be accounted for at the close of the financial period. For Example:

• Accruals and Prepayments• Depreciation of Fixed Assets• Provision for bad debts• Closing Stock• Unrecorded withdrawals or further investments• And others.

• Each item in the notes should be recorded at least two (2) time in the financial statements.

Sole Proprietorship’s Financial StatementTrial Balance Format

K WilliamsTrial Balance as on December 31, 2003

Details Debit Credit

SalesPurchasesGeneral ExpensesFixtures and FittingsDebtorsCreditorsCapitalDrawingsBankCash

7,150550

1,8401,460

1,750820

60

13,630

9,650

1,1802,800

_

13,630

Sole Proprietorship’s Financial Statement

Trading and Profit & Loss Presentation Format• There are two (2) presentation formats either of which

can be used to report items of the Trading and Profit and Loss:1. Horizontal Style – Where the Double entry system

accounting is used for presentation, that is, the left-hand side is the debit side and the right-hand side is credit side.

2. Vertical Style – Where profit is vertically calculated beginning with Sales and ending with Net Profit, that is, Sales less Cost Goods Sold, less expenses

Sole Proprietorship’s Financial Statement

T&P&L Horizontal Presentation FormatK Williams

Trading and Profit and Loss AccountFor the period ended December 31, 2003

$ $

Purchases 7,150 Sales 9,650Gross Profit c/d

2,500

9,6509,650

Gross Profit b/dGeneral Expenses 550Net Profit c/d 1,950

2,5002,500

2,500

Trading

P & L

Sole Proprietorship’s Financial Statement

T&P&L Vertical Presentation FormatK Williams

Trading and Profit and Loss AccountFor the period ended December 31, 2003

$

Purchases (7,150)

Sales 9,650

Gross Profit 2,500

General Expenses (550)

Net Profit c/d 1,950

Less Cost of Goods Sold

Less Expenses

Trading

P & L

Sole Proprietorship’s Financial Statement

Trading Account – Unsold Stock• This represents goods that were bought (Purchases) and

remained unsold at the end of the accounting period.• It will be classified as:

– Closing Stock – at the end of the accounting period. Usually found in Notes beneath the Trial Balance– Opening Stock – at the beginning of the new accounting

period• This will therefore change how the Cost of Goods Sold

is calculated in order to arrive at Gross Profit.

Sole Proprietorship’s Financial Statement

Trading Account – Cost of Goods SoldLess Cost of Goods SoldOpening Stock xxxxAdd Purchases xxxxTotal Stock Available for Sale xxxxLess Closing Stock xxxxCost of Goods Sold xxxx

• This calculation used regardless of whether the format of the T&P&L is Horizontal or Vertical

Sole Proprietorship’s Financial Statement

Trading Account – Other Adjustments• Purchases – There are some adjustments that maybe

needed in order to derive Total Purchases and before Cost of Goods Sold is Calculated.

Opening Stock xxxxAdd PurchasesPurchases xxxxLess Purchases Returns/Stock adjustments (xxxx)Net Purchases xxxxAdd Carriage Inwards xxxxTotal Purchases xxxxLess Closing Stock (xxxx)

Sole Proprietorship’s Financial Statement

Trading Account – Other Adjustments• Purchases Returns/Return Inwards – Goods that were

faulty or unsuitable and returned to the supplier.• In order to derive the Net Purchase of Goods, Purchase

Returns is deducted from Purchases.• Carriage Inwards – Carriage or cost of transportation of

goods into a firm.• This cost is viewed as part of the cost of purchases since

unless the cost is incurred the goods will not be brought into the business and made available for sale.

Sole Proprietorship’s Financial Statement

Trading Account – Other Adjustments• Sales – Some of the goods sold to customers may be

returned because of it being faulty or unsuitable. • This return of goods is called Sales Returns or Return

Inwards and is treated as such:

Sales xxxxLess Sales Returns/Return Inwards (xxxx)Net Sales xxxx

Sole Proprietorship’s Financial Statement

Profit and Loss Account – Adjustments – (Notes to TB)• Before expenses are deducted from Gross Profit to

derive Net Profit there may be need for some:– Adjustments to Expenses:-

• Prepayments – Deducted from expenses• Accruals – Added to Expenses • Improvements to Buildings – Added to “Repairs to

Building” Expense– Additional Expenses:-

• Depreciation of Fixed Assets – New and Continuing Provisions.

Sole Proprietorship’s Financial Statement

Profit and Loss Account – Adjustments (Notes to TB)– Additional Expenses:-

• Provision for Bad Debts – Initial Provision and Increased amount of Provisions.

• Other unrecorded expenses or payments– Adjustments to Income

• Prepayments – Deducted from Income• Accruals – Added to Income

– Additional Income:-• Provision for Bad Debts – Decreased amount of

Provisions.

Sole Proprietorship’s Financial Statement

Balance Sheet• A statement showing present position of the assets,

capital and liabilities of a firm.• The accounting equation is shown in this statement.• It consist of all balances remaining in our records once

the trading and profit and loss account for the period is completed

• It measures the financial position or status of the company at the end of the accounting period and is reported as at that date.

Sole Proprietorship’s Financial Statement

Balance Sheet• The balance sheet is also described as a list of balances

arranged according to whether they are:– Assets:- Resources owned by the business– Capital:- Total resources supplied by the owner– Liabilities:- Total money owed for assets supplied to the

business.• The balance sheet is not an account and as such is not

part of the double entry system of accounting like the Trading and Profit and Loss Account.

Sole Proprietorship’s Financial Statement

Balance Sheet Layout• This is the way in which the assets, liabilities and capital

is laid out in the balance sheet.

• It allows for easy reading, analysis and comparison of balance sheets between firms and prior financial years,

• Thus the information found in the balance sheet becomes more useful to its users.

Sole Proprietorship’s Financial Statement

Balance Sheet Layout• There are two (2) types of layout:

– Order of Permanence:- Items in the balance sheet is arranged according to the length of time held or outstanding

– Order of Liquidity:- Items arranged according to how easily and quickly it can be converted to cash.

Sole Proprietorship’s Financial Statement

Balance Sheet Layout• Assets - are presented under two headings:

1. Fixed Assets 2. Current Assets

• Fixed Assets – are classified as such when they:– are of long life– are to be in the business– were not bought for the purpose of resale

• Examples: Buildings, machinery, motor vehicles, fixtures and fittings

Sole Proprietorship’s Financial Statement

Balance Sheet Layout• Fixed Assets – are listed in ‘order of permanency’,

starting with the most permanent and finishing with the least permanent.

• For instance;– Land and Buildings– Fixtures and Fittings– Machinery– Motor Vehicles

Sole Proprietorship’s Financial Statement

Balance Sheet Layout• Currents Assets – are items owned by the business

which have a short life.• They are listed in ‘Order of Liquidity’, that is, from the

least liquid (furthest away from being turned into cash) to cash itself,

• For instance;– Stock– Debtors– Cash at Bank– Cash in Hand

Sole Proprietorship’s Financial Statement

Balance Sheet Layout• Capital and Liabilities

The other side of the balance sheet (or accounting equation) is as follows:

– Capital– Long-term Liabilities:– for instance , loans that do not

have to be repaid in the near future.– Current Liabilities:- items to be paid in the near future.

Sole Proprietorship’s Financial Statement

Balance Sheet Presentation Format• There are two (2) presentation formats either of which

can be used to report items of the Balance Sheet1. Horizontal Style – Where the assets are presented

along side the capital and liabilities in a ‘T’ account format, that is side by side.

2. Vertical Style – Where assets are vertically compared to capital and liabilities.

• Both styles are presented according to the accounting equation: Assets = Capital + Liabilities.

Sole Proprietorship’s Financial Statement

Balance Sheet Horizontal Presentation FormatK Williams

Balance SheetAs at December 31, 2003

Fixed Assets

Current Assets

$ Capital

Current Liab.

$

Furniture & Fittings 1,840 Cash Intro. 2,800

Stock1,750

820

2,340

3,000

4,180

000Debtors 1,460BankCash 60

Add Net Profit 1,950

Less Drawings4,750

Creditors 1,180

4,180

Sole Proprietorship’s Financial Statement

Balance Sheet Vertical Presentation Format

K WilliamsBalance Sheet

As at December 31, 2003 Fixed Assets

Current Assets

Financed By

Current Liabilities

$

Furniture & Fittings 1,840

Capital 2,800

Stock

1,750

820

3,000

Debtors 1,460BankCash 60

Add Net Profit 1,950Less Drawings

000

2,3404,180

4,750

Creditors 1,1804,180

Sole Proprietorship’s Financial Statement

Balance Sheet – Adjustments (Notes to TB)• Accumulated Depreciation – Total depreciation

provided to date on assets owned by the business.• The total depreciation is deducted from Assets at Cost in

order to derive net book value of assets.• This is done as follows:

Balance Sheet (Extract) Fixed Assets Cost

$Acc Dep

$NBV

$

Furniture & Fittings 1,840 340 1,500

Sole Proprietorship’s Financial Statement

Balance Sheet – Adjustments (Notes to TB)• Provision for bad debt – The annual provision made for

the likely hood that some of the firm’s debts will not be paid.

• The current year’s provision for bad debt is deducted in order to derive Net Debtors.

• This is done as follows:Balance Sheet (Extract)

Current Assets $ $ $

Debtors 1,460(460)

1,000Less Prov. for Bad Debt

Sole Proprietorship’s Financial Statement

Balance Sheet – Additions (Notes to TB)• Prepayments

– Expenses paid for in advance at the end of the accounting period and are recorded as current assets.

– Income received in advance at the end of the accounting period and are recorded as current liabilities.

• Accruals– Expenses owing or outstanding at the end of the

accounting period and are recorded as current liabilities.– Income owing or outstanding at the end of the

accounting period and are recorded as current assets.

K WilliamsTrading and Profit and Loss Account

For the period ended December 31, 2003

$ $

Add Purchases

(6,500)

Sales 61,250

Insurance

(26,300)

Net Profit c/d(12,725)

Less Cost of Goods Sold

Less Expenses

Less Return Inwards (400)Net Sales 60,850

Opening Stock 4,50028,500

Less Return Outwards (200)Net Purchases 28,300Total Stock Available 32,800Less Closing StockCost of Goods SoldGross Profit 34,550

Less Prepaid Expenses

450

(25) 400Salaries 9,950

(550) 1,600

Add Commission Received 80035,350

Discount Allowed425

RentAdd Rent Owing

2,150

Bad Debt 325Total Expenses

22,625