Financial Statements of a Sole Proprietor

Financial statements: meaning and uses

Financial statements are the final reports of the accounting process: the trading and profit and loss account (statement of profit or loss for a period) and the balance sheet (statement of financial position on a date).

Uses

• Find the profit or loss for the period.
• Show assets, liabilities and capital on the closing date.
• Help owners plan and managers control costs.
• Support loan applications and tax returns.
• Allow comparison over years and with other firms.

Capital and revenue: expenditure and receipts

• Capital expenditure: gets or improves a fixed asset; benefit for more than a year (machinery, building extension, installation). Shown in the balance sheet.
• Revenue expenditure: running costs whose benefit ends in the year (wages, rent, repairs). Charged to trading or P&L.
• Capital receipts: not from normal trade; change the long-term structure (capital introduced, loan taken, sale of a fixed asset). Shown in the balance sheet (profit on sale of asset goes to P&L).
• Revenue receipts: from normal business (sales, commission, rent, interest received). Credited to trading or P&L.

Deferred revenue expenditure

A revenue expense that is very large and whose benefit lasts several years, for example a heavy advertising campaign to launch a new product or heavy research. Only the part for the current year is charged to P&L; the unwritten balance is shown in the balance sheet until fully written off. (Under current Accounting Standards most such costs are written off at once; at Class 11 level we learn the idea of spreading.)

Example: advert ₹90,000, benefit 3 years → ₹30,000 to P&L each year; ₹60,000 shown as not yet written off after year 1.

Opening entry

At the start of a new year, the balances of assets, liabilities and capital from last year's balance sheet are brought into the new books by the opening entry in journal proper:

Sundry Assets A/c Dr (each asset) ; To Sundry Liabilities A/c (each liability) ; To Capital A/c (balancing figure = assets − liabilities).

Nominal accounts (expenses, incomes) are not brought forward, because they were closed to the P&L account.

Trading and profit and loss account

Trading account (Dr | Cr)

Dr: opening stock, purchases (less returns), direct expenses — wages, carriage inwards, freight, fuel and power, import duty, manufacturing expenses. Cr: sales (less returns), closing stock. Balance = gross profit (Cr bigger) or gross loss.

Closing entries

Trading A/c Dr; To Opening Stock, To Purchases, To Direct Expenses. Sales A/c Dr; To Trading A/c. Closing Stock A/c Dr; To Trading A/c.

Profit and loss account

Dr: gross loss (if any), indirect expenses — office and administration (salaries, rent, printing), selling and distribution (advertising, carriage outwards, discount allowed, bad debts), financial (interest paid), depreciation, abnormal losses. Cr: gross profit, other incomes (commission, rent, interest, discount received). Balance = net profit, transferred to Capital A/c (P&L A/c Dr; To Capital A/c).

Gross profit, operating profit and net profit

• Gross profit = Net sales − Cost of goods sold; Cost of goods sold = Opening stock + Net purchases + Direct expenses − Closing stock.
• Operating profit = Gross profit − Operating expenses (office, administration, selling and distribution, depreciation) + Operating incomes. It shows profit from the main business activity.
• Net profit = Operating profit + Non-operating incomes (interest, dividend, profit on sale of asset) − Non-operating expenses and losses (interest on loan, loss by fire, loss on sale of asset).

Balance sheet: grouping and marshalling

The balance sheet shows capital and liabilities on one side and assets on the other on the closing date. Capital is shown as: opening capital + net profit (or − net loss) + fresh capital − drawings.

Grouping

Putting similar items together under headings: non-current assets (tangible, intangible, long-term investments), current assets (stock, debtors, bills receivable, cash, bank, prepaid expenses); capital, long-term liabilities (loans), current liabilities (creditors, bills payable, outstanding expenses).

Marshalling

Arranging the groups in a set order:

• Order of liquidity: most liquid first — cash, bank, debtors, stock … land last; current liabilities first, capital last.
• Order of permanence: most permanent first — land, building, machinery … cash last; capital first, current liabilities last (used by companies).

Key formulas and definitions

• Cost of goods sold = Opening stock + Net purchases + Direct expenses − Closing stock
• Gross profit = Net sales − Cost of goods sold
• Operating profit = Gross profit − Operating expenses + Operating incomes
• Net profit = Operating profit + Non-operating incomes − Non-operating expenses
• Closing capital = Opening capital + Net profit + Fresh capital − Drawings
• Assets = Liabilities + Capital (balance sheet)

Worked examples

Common mistakes

• Putting carriage outwards in the trading account. It is a selling expense (P&L).
• Adding closing stock to purchases instead of subtracting it in cost of goods sold.
• Showing drawings as an expense in P&L. Deduct it from capital in the balance sheet.
• Mixing up order of liquidity and permanence when marshalling.