Contents[Hide] Chapter learning objectives Upon completion of this chapter you will be able to: 1 Financial statements There are two key elements to the financial statements of a sole trader business: The financial statements show the effects of business transactions. The main types are: If a sale is made for cash, then cash in the business will increase and a sales transaction will have also been created. The cash will be recorded in the statement of financial position and the sale will be recorded in the income statement. If a sale is made on credit, then the payment for the goods has not been made immediately. Therefore we are still owed for these items. The sale will still be recorded in the income statement, however a receivable will be recorded in the statement of financial position. If we buy inventory for cash, then we are spending money. This decrease in cash will be recorded in the statement of financial position. The increase in inventory that we now own will also be recorded as an asset in the statement of financial position. If we buy inventory on credit, then we will owe the supplier for these goods. This is called a payable. Therefore inventory will increase and also a payable will be created. Both of these are entered onto the statement of financial position. If we buy a non-current asset (e.g. a motor vehicle) then we are spending cash, so this will decrease. However, we have now gained a new asset, and both of these entries are recorded in the statement of financial position. Making this payment will reduce our cash balance and this will affect our statement of financial position. We will have created an expense which we have made the payment for, utilities. This expense belongs on the income statement. If the owner of the business introduces funds into the business, this is called capital. We have increased the capital within the business and also increased our cash or bank balances. Both of these entries are recorded on the statement of financial position. If the owner then withdraws some of these funds back out of the business again, this is known as drawings. The capital will reduce and also the amount of funds within the bank account will too. Both of these are recorded on the statement of financial position. The business entity concept Entity concept A company is both legally and for accounting purposes a separateentity distinct from its owners, the shareholders. On the other hand,the business of a sole trader is not a legal entity distinct from itsproprietor; however, for accounting purposes, the business is regardedas being a separate entity and accounts are drawn up for the businessseparately from the sole trader’s own personal financial dealings. The entity concept is essential in order to be able to account forthe business as a separate economic unit. Flows of money between thebusiness and the proprietors are also separately identified from othermoney flows. The correct terms for these cash movements are: The key link between the owner and the business is the amountstated as capital which is the amount the business owes to theproprietor. 2 Statement of financial position The vertical format of the statement of financial position is shown below: Note: This format relates to a sole trader only. The company format is looked at later within chapter 15. 3 Income statement The format of the income statement is shown below: 4 Relationship between the statement of financial position and income statement The link between the statement of financial position and income statement is shown below: 5 The accounting equation The accounting equation The statement of financial position shows the position of abusiness at one point in time. A statement of financial position willalways satisfy the accounting equation as shown above.
- Each and every transaction that the business makes or enters into has two aspects to it and has a double effect on the business and the accounting equation. This is known as the duality concept.
- The accounting equation is a simple expression of the fact that at any point in time the assets of the business will be equal to its liabilities plus the capital of the business.
- It follows that assets less liabilities equal the capital of the business. Assets less liabilities are known as net assets.
Assets and liabilities
Assets are resources an entity controls as a result ofpast events and from which future economic benefits are expected to flowto the entity. Some examples are:
- inventory, e.g. goods manufactured or purchased for resale
- receivables, e.g. money owed by credit customers, prepaid expenses
- cash
- non-current assets
- and is available for use in the business.
A liability is an entity's present obligation arising from apast event, the settlement of which will result in an outflow ofeconomic benefits from the entity. This is something owed by thebusiness to someone else, such as:
- payables, e.g. amounts owed to credit suppliers, accrued expenses
- loans.
Equity is defined as the residual interest in the entity'sassets after deducting its liabilities. You will become more familiarwith this term when you come to look at Company accounts in chapter 17.
Capital is a type of liability. This is the amount that isdue to the owner(s) of the business. It will increase each year by anynew capital injected into the business and by the profit made by thebusiness. It will decrease by any amounts withdrawn from the business bythe owner(s).
Disclosure of assets and liabilities in the statement of financial position
Test your understanding 1
Classify the following items into current and non-current assets and liabilities:
- land and buildings
- receivables
- cash
- loan repayable in two years’ time
- payables
- delivery van.
Illustration 1 – The accounting equation
This illustration involves a series of transactions using thedual effect of transactions and then the accounting equation to build upa set of financial statements. The transactions are as follows:
Day 1 Avon commences business introducing $1,000 cash.
Day 2 Buys a motor car for $400 cash.
Day 3 Buys inventory for $200 cash.
Day 4 Sells all the goods bought on Day 3 for $300 cash.
Day 5 Buys inventory for $400 on credit.
Using the accounting equation, we will draw up a statement of financial position at the end of each day’s transactions.
Solution to the accounting equation
Solution
Day 1: Avon commences business introducing $1,000 cash
The dual effect of this transaction is:
(a) the business has $1,000 of cash
(b) the business owes the owner $1,000 – this is capital.
Day 2: Buys a motor car for $400 cash
The dual effect of this transaction is:
(a) the business has an asset of $400
(b) the business has spent $400 in cash
This transaction changes the form in which the assets are held.
Note that the acquiring of an asset must lead to one of the following:
- reducing another asset by a corresponding amount (as above)
- incurring a corresponding liability (Day 5)
- increasing the capital contributed by the proprietor (Day 1).
Day 3: Buys inventory for $200 cash
The dual effect of this transaction is:
(a) the business has $200 of inventory
(b) the business has spent $200 in cash.
Again this is merely a change in the form in which the assets are held. $200 is withdrawn from cash and invested in inventory.
Day 4: Sells all the goods bought on day 3 for $300 cash
This is an important new development. It is true that one asset(inventory) is being replaced by another (cash), but the amounts do notcorrespond.
Thus total assets have increased by $100. Since there are noliabilities involved, if the fundamental equation is to remain valid thecapital must increase by $100.
Profit is the difference between purchase price and sale proceedsand it belongs to the proprietor(s) of the business. It is an increasein the capital of the business.
The dual effect of this transaction is:
(a) The business has received $300 of cash.
(b) The business has reduced inventory by $200 and made a profit of $100.
Day 5: Buys inventory for $400 on credit
The dual effect of this transaction is:
(a) The business has $400 of inventory.
(b) The business has a liability to the supplier of $400.
Assets can be increased by a corresponding increase in liabilities as follows:
Note that the payables are acting in effect as a source of finance for the business.
Test your understanding 2
Continuing from the illustration above, prepare the statement offinancial position at the end of each day after accounting for thetransactions below:
Day 6 Sells half of the goods bought on Day 5 on credit for $250.
Day 7 Pays $200 to his supplier.
Day 8 Receives $100 from a customer.
Day 9 Proprietor draws $75 in cash.
Day 10 Pays rent of $40 in cash.
Day 11 Receives a loan of $600 repayable in two years.
Day 12 Pays cash of $30 for insurance.
Your starting point is the statement of financial position at the end of Day 5, from the illustration above.
Once you have dealt with each of the transactions, prepare a statement of financial position at the end of Day 12 and an income statement for the first 12 days of trading.
Statement of comprehensive income
Later on in this textbook you will be introduced to the Statementof comprehensive income. This relates to a company and not to a soletrader.
Test your understanding answers
Test your understanding 1
- Land and buildings – non-current asset.
- Receivables – current asset.
- Cash – current asset.
- Loan repayable in two years time – non-current liability.
- Payables – current liability.
- Delivery van – non-current asset.
Test your understanding 2
Day 6: Sells half of the goods bought on Day 5 on credit for $250
This transaction introduces two new concepts:
- Sale on credit. Essentially this is the same as a sale for cash, except that the asset increased is not cash, but receivables.
- Sale of part of the inventory. In practice this is the normal situation. The important accounting requirement is to separate:
- inventory still held as an asset, from
- cost of inventory sold.
Day 7: Pays $200 to his supplier
- The dual effect of this transaction is:
(a) The business has paid out $200 in cash.
(b) The business has reduced the payable (liability) by $200.
This is simply the reduction of one liability (payables) and one asset (cash) by a corresponding amount ($200).
Day 8: Receives $100 from a customer
- The dual effect of this transaction is:
(a) The business has received $100 in cash.
(b) The receivables of the business have reduced by $100.
Day 9: Proprietor draws $75 in cash
This shows on the statement of financial position as a reduction of capital, and as a reduction of cash.
Cash or other assets taken out of the business by the owner are called ‘amounts withdrawn’, or ‘drawings’.
- The dual effect of this transaction is:
(a) The business has reduced cash by $75.
(b) The business has a drawings balance of $75 which reduces capital.
Day 10: Pays rent of $40
This is an example of a business expense.
The dual effect of this transaction is:
(a) The business pays out $40 in cash.
(b) The business has a rent expense of $40 which reduces profit.
Day 11: Receives a loan of $600 repayable in two years’ time
The dual effect of this transaction is:
(a) The business receives $600 in cash.
(b) The business has a liability of $600.
Day 12: Pays cash of $30 for insurance
The dual effect of this transaction is:
(a) the business pays out $30 in cash
(b) the business has an insurance expense of $30 which reduces profit.
This marks the end of the transactions. The financial statements for the 12 day period can now be considered.
Created at 5/24/2012 3:29 PM by System Account (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London | |
Last modified at 8/16/2012 12:57 PM by System Account (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London | |
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