Trading Account
A sole trader will set up two types of income determination or final accounts. These are the trading account and the profit and loss account. The trading account is concerned with finding gross profit or gross loss.
Trading account is computed as sales, less, cost of a sale which is equal to Gross profit.
The gross profit is obtained by deducting the cost price of gods or services that have been sold during the accounting period from the sales figure, which is the income generated from trading activities.
The cost of sales can be computed by opening stock, add, purchases, less, closing stock which is equal to cost of goods sold.
Profit and Loss account
The profit and loss account is set up to compute the net profit or net loss for the accounting period.
Profit and Loss Account can be computed by Gross profit, add, other income, less, expenses which is equal to net profit or net loss.
Other income and expenses
For a sole trader, the item “other income” refers to the non-trading income such as rent received, cash discount received and interest on bank deposits. The item “expenses” refers to all the operating expenses of the business such as rent paid, doubtful debts, transport, cash discount given for prompt payment and other such expenses that have to be incurred in order to keep the business running daily.
The net profit will add to the owner’s equity while net loss will reduce the owner’s equity. The financial standing of the sole trader with respect to assets, liabilities and owner’s equity of his business will be shown in the balance sheet.
We have already studied the adjustments needed to find the revenue earned and expenses incurred for a particular accounting period. We shall see how all these adjusted expenses and revenue items are matched together in the final accounts of a sole trader in order to arrive at his net profit or net loss for that accounting period.
Assets
The assets of the business are what the business owns. They can be classified as
Fixed Assets- these are purchased for use in the business, are not for resale and can last for several accounting periods, e.g. machinery, furniture, fixtures and fittings, motor vehicles and the like.
Current Assets- These are easily liquidated, i.e. they can be converted into cash during the operating cycle of a business e.g. debtors, stock and cash.). Current Assets are constantly being converted from one item to another within this category in a circular manner.
Liabilities
Liabilities represent what the business owes its external creditors. The business may use funds borrowed from the sources outside the business. These outside sources or external creditors have a claim on the assets of the business. Liabilities are classified according to their period of repayment. They are as follows:
Long-term liabilities- These are debts of the business which have a repayment period of more than one accounting period, e.g. loans and mortgages.
Current liabilities- These are short-term debts of the business that are usually settled within one accounting period, e.g. creditors and bank overdrafts.
Capital
When a proprietor invests in his business, he credits the Capital Account. Profits, since they increase capital, are credited, while drawings from capital are debited to the account as they decrease capital.
EXAMPLE:
Nat is a sole trader. The following Trial Balance was extracted from his books on 31 December 2005.
The following adjustments have to be taken into consideration before preparing the final accounts:
- The closing stock was valued at $960.
- Of the $820 rent and rates $100 was rent paid in advance.
- Allow depreciation at a rate of 10% per annum on fixtures and fittings.
- A debt of $80 is to be written off as irrecoverable.
- An amount of $30 was due for light and water.
Adjusted trial balance:
# adjusted figures
Nat’s final accounts and balance sheet will look like this:
Nat Sole Trader
Trading account for the year ended 31 December 2005
Dr Cr
Nat Sole Trader
Profit and Loss Account for the year ended 31 December 2005
Dr Cr
Nat Sole Trader
Balance Sheet as at 31 December 2005
Accounting Cycle
The accounting cycle traces the various steps leading to the preparation of the final statement and balance sheet of a sole trader:
PART B
Introduction
Before we learn how to keep proper accounting records and how to summarise and interpret the recorded information. We must be clear about certain accounting concepts.
The four accounting conventions contained in the financial statement that I’ve choose are accrual concept, accounting entity, money measurement and objectivity.
Accrual concept
Accrual concept is when a business revenue from either the sale of products or by rendering services to customer. Revenue is recognized when it is earned and expenses when they are incurred. This revenue comes in the form of an inflow of assets (e.g. cash) resulting from such business activities. Revenue is recognized and recorded as earned as soon as goods are sold or whenever services are performed. The earned revenue, whether already received or not, must be accounted for under the accrual concept of accounting. Similarly, expenses, which are cost that are incurred to produce the revenue, are considered to be incurred even though payment for those expenses has not been made yet.
Expenses owed are termed accrued expenses and are added to expenses that have been paid to give the total expenses incurred for the period under concentration. Examples of expenses are rent, wages and transport.
Accrual accounting is to be contrasted with cash accounting which recognizes revenue only when cash is received and recognizes expenses only when cash is paid.
Accounting entity
Each business is a separate entity from its owner. For accounting purposes, the business is regarded as ad accounting entity or a business entity. It exists as a unit by itself, separate from its owner. This means that all financial information relating tot eh business is recorded and reported separately from the owner’s personal financial information.
Thus if Nat Chua owned and managed a provision shop, the accounting records and reports the shop would not certain Nat’s private expenditure or personal property. Similarly, Nat’s personal accounting records will also not contain transactions of the shop.
The only time that the personal resources of the trader affect the accounting records of the business is when he brings in personal property as new capital into the business, or when he withdraws cash from the business for personal expenses.
Best recommended for a sole trader.
Money Measurement
Money is used as the basic measuring unit for financial reporting. Economic events are identified and measured in financial terms. For example, in Singapore, the measurement is in Singapore dollars and cents. If the event cannot be measured in monetary terms, it is not considered a part of accounting data. This money measurement function eliminates important information, such as the motivational level of the staff, inefficient management or poor working conditions, as they cannot be measured in monetary terms. However, the business may have to take this important information into consideration when making business decisions.
Objectivity
There must always be objective verifiable evidence for reporting any accounting information. The evidence that a business transaction has taken place and the details pertaining to that transaction are contained in a source document.
Source documents are examples of objective evidence of transactions that have taken place. These documents include receipts, invoices, cheques and vouchers.
Each source document initiates the process of recording a transaction and all accounting entries are supported by these source documents.
It is this desire for objectivity that also explains why historical cost rather than current market value forms the basis of valuation of assets.
The cost price of the purchase of an asset can be objectively verified through the documentary evidence of its purchase, either in the form of an invoice (in the case of a credit purchase) or a receipt (in the case of a cash purchase).
Conclusion
Although not every business compiles its records in exactly the same way, all business organizations observe the general accounting principles, adapting them to the special requirements of each business. The difference between the accounts of these three types of business organizations (sole proprietorship, partnership, a company) lies in the recording of the owner’s capital and the distribution of profits. The keeping of other accounts remains the same.
