0452 · 5.1Sole traders

Sole trader features and business types

0:00Nadia Cycles can have money in the bank while still owing suppliers and lenders. Some bicycles remain unsold, and some customers have not paid. This video covers the advantages and disadvantages of operating as a sole trader, and the kinds of business a sole trader can run. It then prepares both financial statements with year-end adjustments, from one complete trial balance. A sole trader is a business owned and controlled by one person.

0:23The owner receives all the profit for the year. Unlimited liability means the owner is personally responsible for all the business’s debts. Every sole trader carries this risk. Nadia could therefore have to use personal possessions to settle amounts her business cannot pay. Operating as a sole trader gives Nadia control over decisions and allows her to keep all the profit. The business is generally easy and cheap to establish, and its accounts remain private.

0:49Personal service can also build relationships with customers. However, capital is limited by the owner’s resources and available borrowing. Long hours and responsibility for every major decision can place pressure on the owner. There may be nobody to share difficult decisions or cover an absence. Continuity is uncertain because the business depends heavily on one person. These disadvantages exist alongside unlimited liability, even when the business employs other people. A sole trader can run a trading, service or manufacturing business, or a combination of these.

1:20Trading means buying goods for resale, while a service business earns income by providing services. Manufacturing means making products from materials. Nadia Cycles could sell bought-in bicycles, repair customers’ bicycles and manufacture bicycle accessories within the same business.

Financial statements and accounting equation

1:37Financial statements are summaries that show a business’s profit or loss for a period and what it owns and owes at a date. The statement of profit or loss is the financial statement that shows the revenue, expenses and profit or loss for a period. Revenue is the income a business earns from its main activity, such as selling goods or providing services. Expenses are the costs used up in running the business and earning revenue during a period.

2:02Profit for the year is the amount by which revenue exceeds expenses over one financial year. Preparing a statement of profit or loss allows Nadia to compare performance between years. Its figures reveal whether sales income covers the costs associated with those sales. Profit for the year is also the starting point for calculating tax on the owner’s business income. A statement of financial position shows assets, liabilities and owner’s equity at a particular date.

2:27Assets are resources owned or controlled by a business that bring future benefit. Liabilities are amounts the business owes to others. Owner’s equity, also called capital, is the owner’s investment in the business, or the amount the business owes the owner. Under the business entity concept, Nadia and Nadia Cycles are treated as two separate parties. The owner’s capital is therefore owed by the business to the owner. The accounting equation states that assets equal liabilities plus owner’s equity.

2:55The statement of financial position records these amounts on a specified date, rather than measuring activity throughout a year.

Cost of sales and profit

3:02For a trading business, we must separate goods purchased from goods actually sold. Inventory means goods held for resale. Opening inventory is the value of goods held for resale at the start of a financial period. The goods remaining at its end are called closing inventory. Cost of sales is the cost of inventory sold during a period. To find it, add purchases to opening inventory, then subtract closing inventory.

3:28Goods still held belong among assets because they can produce future sales. Gross profit is revenue minus cost of sales. Sales returns are goods returned by customers to the business. Subtract them from revenue to obtain revenue after returns. Purchases returns are goods returned by the business to suppliers. These reduce the cost of purchases, while carriage inwards increases it because transport brings purchased goods into the business. Carriage inwards is the cost of transporting purchased goods into the business, while carriage outwards is the cost of delivering goods to customers.

4:00Carriage outwards appears among the expenses. Other income is income from activities other than the main one, such as rent received or discount received. Add other income to gross profit, then subtract the expenses to obtain profit for the year. A service business with no goods sold has no cost of sales section. Its statement shows fees earned, adds other income and deducts expenses. A manufacturing business uses the cost of production instead of purchases when calculating the cost of its finished goods sold.

4:28The detailed calculation of production cost belongs in the video on manufacturing accounts. Suppose Nadia’s manufacturing activity starts with finished goods valued at two thousand seven hundred dollars and produces goods costing nineteen thousand dollars. Adding these gives twenty-one thousand seven hundred dollars available for sale. Closing finished goods are three thousand three hundred dollars. Subtracting them gives cost of sales of eighteen thousand four hundred dollars. For a combined business, distinguish the income earned from each activity.

4:58Nadia’s bicycle sales and repair fees both contribute to revenue. Only the trading goods and manufactured products enter the relevant cost of sales calculations. Expenses shared across the activities are then deducted in the same statement of profit or loss.

Asset classifications and depreciation

5:11Non-current assets are assets held for continuing use in the business rather than for resale. Equipment and delivery vehicles belong in this category. Intangible assets are non-current assets without physical substance, such as purchased goodwill. Goodwill is the amount paid for a business above the value of its separate assets less its liabilities. Current assets are assets expected to be turned into cash or used up within twelve months. Inventory, bank funds and cash belong here.

5:40Trade receivables are amounts owed by credit customers who have not yet paid for goods or services. Other receivables are current assets, such as amounts due to the business and payments for benefits not yet used. Current liabilities are amounts due for payment within twelve months. Trade payables are amounts owed to credit suppliers that the business has not yet paid. Unpaid expenses and money received before it is earned are grouped as other payables, which are current liabilities.

6:05Non-current liabilities are amounts due for payment after more than twelve months. A loan repayable several years later is one example. The matching or accruals concept means income and expenses are recorded in the period to which they relate, not when cash is received or paid. Year-end adjustments apply this rule before the statements are prepared. Each adjustment can affect the year’s performance and an asset or liability. We will show both destinations for every adjustment.

6:32Depreciation is the loss in value of a non-current asset over its useful life. It is an estimate that is charged as an expense in each year of use. Accumulated depreciation is the running total of depreciation charged on an asset since it was acquired. Carrying amount is the asset’s cost less its accumulated depreciation. Straight-line depreciation allocates an equal charge to each full year of use. Useful life is the estimated period for which an asset will be used by the business.

7:00Residual value is the estimated amount recoverable when the useful life ends. Subtract residual value from cost and divide by useful life, or apply the specified annual percentage to cost. Reducing balance depreciation applies a fixed percentage to the opening carrying amount. A vehicle costing sixteen thousand dollars has accumulated depreciation of four thousand dollars. Its opening carrying amount is twelve thousand dollars. Twenty-five per cent of twelve thousand dollars gives a depreciation expense of three thousand dollars.

7:29Add three thousand dollars to the previous accumulated depreciation of four thousand dollars. Closing accumulated depreciation becomes seven thousand dollars. Sixteen thousand dollars minus seven thousand dollars gives a carrying amount of nine thousand dollars. The expense reduces the year’s result, while accumulated depreciation reduces the asset’s reported amount. The revaluation method calculates depreciation from the opening valuation plus additions minus the closing valuation. Nadia’s loose tools start at sixteen hundred dollars, with additions of three hundred and fifty dollars.

8:03Their combined amount is nineteen hundred and fifty dollars. Subtract the closing valuation of twelve hundred dollars to obtain depreciation of seven hundred and fifty dollars.

Accruals, bad debts and drawings

8:12An accrued expense is a cost of the current year that is still unpaid at the year end. Add it to the expense and include it in other payables. A prepaid expense is a cost paid in advance that belongs to a future period. Subtract that amount from the current expense and include it in other receivables. Accrued income is an amount earned in the current year but not yet received at the year end.

8:35It increases this year’s income and appears in other receivables. Prepaid income is an amount received in advance for a period after the year end. That advance is taken off this year’s income and shown in other payables. Nadia receives repair fees of three thousand two hundred dollars and has earned another six hundred and fifty dollars awaiting payment. Adding these gives revenue of three thousand eight hundred and fifty dollars.

8:56Other receivables include the six hundred and fifty dollars still due. The year’s revenue includes services already provided, even though payment arrives later. Alternatively, Nadia receives four thousand nine hundred dollars, including fourteen hundred dollars for next year’s repair services. Subtracting the advance gives current revenue of three thousand five hundred dollars. The fourteen hundred dollars appears in other payables. The business still owes the customer the agreed services. Irrecoverable debts are amounts owed by customers that the business considers uncollectable.

9:29Remove these amounts from trade receivables and charge them as an expense. An allowance for irrecoverable debts is an estimate of trade receivables that may not be paid. Calculate the required allowance after removing any newly identified irrecoverable debts. The closing allowance reduces trade receivables in the statement of financial position. Only the change in an existing allowance affects the current statement of profit or loss. An increase is an additional expense, while a decrease reduces the expenses.

9:57When there is no opening allowance, the entire new allowance is charged for the year. Drawings are money or goods taken from the business by its owner for private use. They are not a business expense, so they never reduce the profit for the year. Drawings reduce owner’s equity. Goods taken by Nadia are recorded at cost, deducted from purchases and added to drawings. Double entry means every transaction is recorded as a debit in one account and a credit of the same amount in another.

10:24A debit is an entry on the left side of an account, while a credit belongs on the right. Purchases records the cost of goods bought for resale and normally has a debit balance. For goods taken privately, debit drawings and credit purchases because private use rises and goods available for business sales decrease. Other assets taken by the owner must also leave the business’s records. A journal entry is a dated record showing accounts to debit and credit, amounts and an explanatory narrative.

10:52Furniture costing four thousand five hundred dollars has accumulated depreciation of two thousand six hundred dollars, so its carrying amount is nineteen hundred dollars. Debit drawings with nineteen hundred dollars and accumulated depreciation of furniture with two thousand six hundred dollars, then credit furniture with its full cost. The drawings debit records Nadia’s private benefit, while the other entries remove the furniture’s cost and accumulated depreciation. Total debits and total credits both equal four thousand five hundred dollars.

11:20If the business pays Nadia’s private expenses, add those payments to drawings. For a direct private payment, debit drawings and credit bank because private use rises and business funds fall. A private expense already included among business expenses must be reclassified. Debit drawings and credit the expense account concerned. This removes a private cost from the calculation of business performance. Drawings still reduce owner’s equity and never reduce the profit for the year.

Worked financial statements and exam skills

11:48Our complete worked example starts with a trial balance. A balance is the difference between the debit and credit totals of an account. A trial balance lists every ledger account balance at a date, with debit balances in one column and credit balances in the other. The following boards show Nadia Cycles on the thirty-first of December. The debit column begins with goodwill of five thousand dollars and equipment at a cost of eighteen thousand dollars.

12:13Opening inventory is four thousand two hundred dollars and purchases are twenty-three thousand six hundred dollars. Sales returns come to fifteen hundred dollars. The two carriage balances are one thousand dollars inwards and eleven hundred dollars outwards. Trade receivables are eight thousand six hundred dollars, and the bank balance is eight thousand four hundred dollars. Rent of six thousand dollars, wages of nine thousand four hundred dollars and electricity of two thousand five hundred dollars are expense balances.

12:40Drawings stand at seventeen hundred dollars. The debit column totals ninety-one thousand dollars. In the credit column, accumulated depreciation of equipment is three thousand six hundred dollars and revenue is fifty-two thousand dollars. Purchases returns total thirteen hundred dollars. Discount received is income because the business settles its liability for less than the amount owed. Its balance is seven hundred dollars, and last year’s allowance for irrecoverable debts is one hundred dollars.

13:08Trade payables are six thousand seven hundred dollars, and a loan of ten thousand dollars is repayable after more than twelve months. Capital at the first of January is fourteen thousand six hundred dollars. Capital introduced is extra money or other assets that the owner puts into the business. Nadia introduced two thousand dollars. The credit column totals ninety-one thousand dollars, which equals the debit total of ninety-one thousand dollars.

13:32Seven notes follow the trial balance. Closing inventory is valued at six thousand three hundred dollars. Equipment is depreciated by the straight-line method at ten per cent of cost. Wages of eight hundred dollars are unpaid, while five hundred dollars of the rent paid covers next year. Irrecoverable debts of six hundred dollars must be written off. The allowance must then equal five per cent of the remaining trade receivables.

13:56Nadia took goods costing nine hundred dollars for her own use. The electricity balance also includes two hundred dollars for her home, paid from the business bank account. Ten per cent of eighteen thousand dollars gives equipment depreciation of eighteen hundred dollars. Three thousand six hundred dollars plus eighteen hundred dollars makes accumulated depreciation of five thousand four hundred dollars. Eighteen thousand dollars minus five thousand four hundred dollars leaves a carrying amount of twelve thousand six hundred dollars.

14:24Wages become nine thousand four hundred dollars plus eight hundred dollars, which is ten thousand two hundred dollars. Rent expense is six thousand dollars minus five hundred dollars, so it is five thousand five hundred dollars. Eight thousand six hundred dollars minus six hundred dollars leaves trade receivables of eight thousand dollars. Five per cent of that gives a closing allowance of four hundred dollars. The opening allowance was one hundred dollars, so only the increase of three hundred dollars is an expense this year.

14:51Trade receivables of eight thousand dollars minus the allowance give seven thousand six hundred dollars. Goods taken privately reduce purchases from twenty-three thousand six hundred dollars to twenty-two thousand seven hundred dollars. Nadia’s home electricity is a private expense, so electricity expense falls from two thousand five hundred dollars to two thousand three hundred dollars. Both private amounts are added to drawings. Seventeen hundred dollars plus nine hundred dollars plus two hundred dollars gives total drawings of two thousand eight hundred dollars.

15:20None of these drawings is an expense, so none of them reduces the profit for the year. The statement of profit or loss starts with revenue of fifty-two thousand dollars minus sales returns of fifteen hundred dollars. That leaves fifty thousand five hundred dollars. Purchases of twenty-two thousand seven hundred dollars minus purchases returns of thirteen hundred dollars give twenty-one thousand four hundred dollars. Adding carriage inwards of one thousand dollars makes net purchases of twenty-two thousand four hundred dollars.

15:48Opening inventory of four thousand two hundred dollars plus net purchases of twenty-two thousand four hundred dollars gives twenty-six thousand six hundred dollars. Subtracting closing inventory of six thousand three hundred dollars leaves cost of sales of twenty thousand three hundred dollars. Fifty thousand five hundred dollars minus that cost gives gross profit of thirty thousand two hundred dollars. Adding discount received of seven hundred dollars as other income makes thirty thousand nine hundred dollars.

16:15The expenses start with carriage outwards of eleven hundred dollars and rent of five thousand five hundred dollars. Wages of ten thousand two hundred dollars and electricity of two thousand three hundred dollars come next. Depreciation of equipment is eighteen hundred dollars, irrecoverable debts are six hundred dollars and the allowance increase is three hundred dollars. These expenses total twenty-one thousand eight hundred dollars. Thirty thousand nine hundred dollars minus twenty-one thousand eight hundred dollars gives profit for the year of nine thousand one hundred dollars.

16:46The statement of financial position lists goodwill of five thousand dollars as an intangible non-current asset. Equipment at eighteen thousand dollars less accumulated depreciation of five thousand four hundred dollars has a carrying amount of twelve thousand six hundred dollars. Five thousand dollars plus twelve thousand six hundred dollars gives total non-current assets of seventeen thousand six hundred dollars. Current assets begin with closing inventory of six thousand three hundred dollars.

17:13Trade receivables of eight thousand dollars less the allowance of four hundred dollars give seven thousand six hundred dollars. Prepaid rent of five hundred dollars is shown in other receivables, and the bank balance is eight thousand four hundred dollars. Current assets total twenty-two thousand eight hundred dollars. Adding the non-current assets gives total assets of forty thousand four hundred dollars. Current liabilities are trade payables of six thousand seven hundred dollars plus accrued wages of eight hundred dollars in other payables.

17:42Together they make seven thousand five hundred dollars. The loan of ten thousand dollars is a non-current liability. Total liabilities are therefore seventeen thousand five hundred dollars. Opening capital is fourteen thousand six hundred dollars. Adding capital introduced of two thousand dollars and profit for the year of nine thousand one hundred dollars gives twenty-five thousand seven hundred dollars. Subtracting drawings of two thousand eight hundred dollars leaves closing capital of twenty-two thousand nine hundred dollars.

18:10Assets of forty thousand four hundred dollars equal liabilities of seventeen thousand five hundred dollars plus capital of twenty-two thousand nine hundred dollars. The statement’s categories remain the same for trading, service and manufacturing sole traders, but their assets differ. A manufacturer may show raw materials and work in progress as well as finished goods. A service business may have no inventory at all. A change in one account balance can affect several figures across both statements.

18:37A higher accrued expense increases expenses and other payables. The lower profit then reduces closing capital by the same amount. Higher closing inventory reduces cost of sales, increases gross profit and raises both current assets and closing capital. Each accrual or prepayment belongs in both statements. Accrued expenses are added to the expense and shown in other payables, while prepaid expenses are subtracted and shown in other receivables. Apply the allowance percentage after removing irrecoverable debts.

19:08Keep drawings outside expenses, and distinguish the annual depreciation charge from accumulated depreciation. Paper One contains forty multiple-choice questions, while Paper Two contains five compulsory structured questions. Prepare means present information in a suitable format. Calculate means work out from given figures, and explain means give reasons why and how, supported by evidence. A preparation question therefore needs suitable headings, correctly classified items and visible workings. Consider an exam question about omitting Nadia’s accrued wages adjustment.

19:41A figure recorded too high is overstated, and one recorded too low is understated. Wages expense would be understated by eight hundred dollars, so profit for the year would show nine thousand nine hundred dollars. Other payables would be understated by eight hundred dollars, and closing capital would be overstated by eight hundred dollars. A sole trader receives all the profit but also carries personal responsibility for unpaid business debts.

20:06The statement of profit or loss measures performance over a period, while the statement of financial position records resources and claims at a date. Adjustments place income, expenses, assets and liabilities in the correct period. Profit increases capital, drawings reduce it, and assets equal liabilities plus owner’s equity.