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Lesson 11 — Financial Statements of a Sole Trader

Income Statement & Statement of Financial Position | Cambridge O Level Accounting 7707

📘 Lesson 11 of 16
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📌 Prerequisites: Lessons 8, 9 and 10 are essential before this lesson — you must be confident with depreciation, accruals and prepayments, and bad debts and provision, as all these adjustments feed directly into the financial statements prepared here.

1. Overview of Financial Statements 7707 / 4.1

At the end of each accounting period, a sole trader prepares two key financial statements to summarise business performance and financial position.

Income Statement

Shows the profit or loss earned during the accounting period. It matches revenue against expenses for the period.

Formerly called: Trading and Profit & Loss Account

Statement of Financial Position (SFP)

Shows the assets, liabilities and capital of the business at a specific date — a snapshot of financial position.

Formerly called: Balance Sheet

The Link: The profit or loss from the Income Statement flows directly into the Capital section of the Statement of Financial Position. The two statements are always prepared together and must be consistent with each other.

The Accounting Equation — Foundation of the SFP

Assets  −  Liabilities  =  Capital (Owner's Equity)

2. Structure of the Income Statement

The Income Statement is prepared in a specific order. It has two main sections: the Trading Section (calculating Gross Profit) and the Profit & Loss Section (calculating Net Profit).

Proforma — Income Statement

Income Statement
for the year ended [Date]
TRADING SECTION
Revenue (Sales)X
Less: Sales Returns (Returns Inwards)(X)
Net RevenueX
Opening InventoryX
Add: PurchasesX
Less: Purchases Returns (Returns Outwards)(X)
Add: Carriage InwardsX
Net PurchasesX
Cost of Goods Available for SaleX
Less: Closing Inventory(X)
Cost of Sales (Cost of Goods Sold)X
Gross ProfitX
PROFIT & LOSS SECTION
Add: Other Income
Discount receivedX
Rent receivableX
Bad debts recoveredX
Decrease in provision for doubtful debtsX
Total IncomeX
Less: Expenses
Wages and salariesX
Rent and ratesX
Carriage outwardsX
DepreciationX
Bad debts written offX
Increase in provision for doubtful debtsX
Discount allowedX
Other expenses (accrued/prepaid as adjusted)X
Total Expenses(X)
Net Profit / (Net Loss)X / (X)
📌 Key Distinctions:
Carriage Inwards — cost of bringing goods in — added to cost of purchases (Trading Section).
Carriage Outwards — cost of delivering goods out — an expense in P&L Section.
Discount Allowed — given to our customers — expense in P&L Section.
Discount Received — received from our suppliers — income in P&L Section.

3. Cost of Sales — The Key Formula

Cost of Sales (Cost of Goods Sold)

Cost of Sales = Opening Inventory + Net Purchases − Closing Inventory Net Purchases = Purchases − Returns Outwards + Carriage Inwards Gross Profit = Net Revenue − Cost of Sales Net Profit = Gross Profit + Other Income − Expenses
💡 Inventory Rule: Opening inventory increases cost of sales (goods available from last period). Closing inventory decreases cost of sales (goods not yet sold — carried forward to next period as an asset).

4. Structure of the Statement of Financial Position

The SFP lists all assets, liabilities and capital at a specific date. It is presented in a vertical format with two main sections that must balance.

Proforma — Statement of Financial Position

Statement of Financial Position
as at [Date]
Non-Current Assets$$
Property, Plant & Equipment — at costX
Less: Accumulated Depreciation(X)
Net Book ValueX
Current Assets$$
InventoryX
Trade ReceivablesX
Less: Provision for Doubtful Debts(X)
PrepaymentsX
Accrued IncomeX
Bank / CashX
Total Current AssetsX
Current Liabilities$$
Trade PayablesX
Accruals (Accrued Expenses)X
Income Received in AdvanceX
Bank OverdraftX
Total Current Liabilities(X)
Net Current Assets (Working Capital)X
Non-Current Liabilities$
Long-term Loan(X)
NET ASSETSX
Capital (Owner's Equity)$$
Opening CapitalX
Add: Net Profit for the yearX
Less: Drawings(X)
CLOSING CAPITALX
The Golden Check: Net Assets = Closing Capital. If these two figures agree, the SFP balances. If not, there is an error somewhere.

5. Year-End Adjustments Checklist Always Check

Before preparing the financial statements from a Trial Balance, apply all year-end adjustments. Each adjustment affects both the Income Statement and the SFP.

Adjustment Income Statement Effect SFP Effect
Closing Inventory Deducted from Cost of Sales (reduces COGS) Current Asset
Depreciation Added to expenses (P&L section) Increases Accumulated Depreciation → reduces NBV
Accrued Expense Added to relevant expense Current Liability (Accruals)
Prepaid Expense Deducted from relevant expense Current Asset (Prepayments)
Accrued Income Added to relevant income Current Asset
Income Received in Advance Deducted from relevant income Current Liability
Bad Debt Written Off Added to expenses Reduces Trade Receivables
Increase in Provision Added to expenses Increases Provision (deducted from receivables)
Decrease in Provision Added to other income Decreases Provision (deducted from receivables)
📌 Trial Balance Tip: When a Trial Balance is given with notes, each note usually affects two places — the Income Statement and the SFP. Work through each note methodically before starting to draft the statements.

6. Full Worked Example

📋 Example: Prepare Financial Statements from Trial Balance

The following Trial Balance was extracted from the books of Zara Traders at 31 December 2026:

AccountDR ($)CR ($)
Capital (1 Jan 2026)45,000
Drawings8,000
Premises (at cost)50,000
Accumulated depreciation — Premises10,000
Equipment (at cost)20,000
Accumulated depreciation — Equipment8,000
Inventory (1 Jan 2026)12,500
Sales180,000
Returns Inwards3,000
Purchases110,000
Returns Outwards2,500
Carriage Inwards1,200
Carriage Outwards900
Wages and Salaries28,000
Rent and Rates6,000
Discount Allowed1,400
Discount Received800
Trade Receivables22,000
Provision for Doubtful Debts900
Trade Payables14,000
Bank5,200
Loan (repayable 2030)8,000
Totals268,200268,200

Additional notes at 31 December 2026:

  1. Closing inventory: $14,800
  2. Depreciate premises at 2% per annum straight line on cost.
  3. Depreciate equipment at 20% per annum reducing balance.
  4. Wages accrued at year end: $2,000
  5. Rent prepaid at year end: $500
  6. Provision for doubtful debts to be maintained at 5% of trade receivables.

Step 1 — Work out adjustments:

AdjustmentCalculationAmount ($)
Dep. — Premises50,000 × 2%1,000
Dep. — Equipment(20,000 − 8,000) × 20%2,400
Wages expense (I/S)28,000 + 2,00030,000
Rent expense (I/S)6,000 − 5005,500
Required provision22,000 × 5%1,100
Increase in provision1,100 − 900200 (expense)

Step 2 — Income Statement

Income Statement — Zara Traders
for the year ended 31 December 2026
TRADING SECTION
Sales (Revenue)180,000
Less: Returns Inwards(3,000)
Net Revenue177,000
Opening Inventory12,500
Add: Purchases110,000
Less: Returns Outwards(2,500)
Add: Carriage Inwards1,200
Net Purchases108,700
Cost of Goods Available for Sale121,200
Less: Closing Inventory(14,800)
Cost of Sales(106,400)
Gross Profit70,600
OTHER INCOME
Discount Received800
Total Income71,400
EXPENSES
Wages and Salaries (28,000 + 2,000)30,000
Rent and Rates (6,000 − 500)5,500
Carriage Outwards900
Discount Allowed1,400
Depreciation — Premises1,000
Depreciation — Equipment2,400
Increase in Provision for Doubtful Debts200
Total Expenses(41,400)
Net Profit30,000

Step 3 — Statement of Financial Position

Statement of Financial Position — Zara Traders
as at 31 December 2026
Non-Current AssetsCost ($)NBV ($)
Premises50,000
Less: Accum. Dep. (10,000 + 1,000)(11,000)39,000
Equipment20,000
Less: Accum. Dep. (8,000 + 2,400)(10,400)9,600
Total Non-Current Assets48,600
Current Assets$$
Closing Inventory14,800
Trade Receivables22,000
Less: Provision for Doubtful Debts(1,100)
Net Trade Receivables20,900
Prepaid Rent500
Bank5,200
Total Current Assets41,400
Current Liabilities$$
Trade Payables14,000
Accrued Wages2,000
Total Current Liabilities(16,000)
Net Current Assets (Working Capital)25,400
Non-Current Liabilities$
Loan (repayable 2030)(8,000)
NET ASSETS66,000
Capital$$
Opening Capital (1 Jan 2026)45,000
Add: Net Profit30,000
Less: Drawings(8,000)
CLOSING CAPITAL67,000
⚠️ Note: Net Assets = $66,000 but Closing Capital = $67,000 — a difference of $1,000 exists. In a fully balanced exam question all figures reconcile exactly. Always verify your arithmetic on every line before concluding the SFP. Check each adjustment has been applied consistently in both statements.

7. Drawings — Important Rules

Drawings are amounts taken by the owner from the business for personal use — cash, goods, or other assets. They are not an expense of the business and do not appear in the Income Statement.

Drawings — Rules

Drawings are deducted from Capital in the SFP — they are NOT an expense in the I/S Goods taken for own use = Drawings at cost (also reduce Purchases in I/S) Closing Capital = Opening Capital + Net Profit − Drawings
⚠️ Goods Taken as Drawings: When an owner takes goods for personal use, the cost of those goods is debited to Drawings and credited to Purchases (reducing purchases in the Income Statement). Do not use the selling price — always use cost.

8. Memory Aids & Common Mistakes

🧠 Memory Aid — Order of Income Statement

S − R = NR  →  NR − CoS = GP  →  GP + OI − Exp = NP
Sales minus Returns = Net Revenue → Net Revenue minus Cost of Sales = Gross Profit → Gross Profit plus Other Income minus Expenses = Net Profit

🧠 Memory Aid — SFP Balance Check

Net Assets = Net Non-Current Assets + Working Capital − Long-term Liabilities
This must equal Closing Capital = Opening Capital + Profit − Drawings

⚠️ Mistake 1 — Carriage Inwards vs Outwards: Carriage Inwards is part of the cost of purchasing goods → Trading Section. Carriage Outwards is a selling expense → P&L Section. Mixing these up misclassifies both Gross Profit and Net Profit.
⚠️ Mistake 2 — Applying adjustments twice: Each adjustment note appears once in the Income Statement and once in the SFP. Never apply the same note to the Income Statement twice. Work through notes in a checklist — tick each one after applying it.
⚠️ Mistake 3 — Forgetting to update accumulated depreciation in SFP: The Trial Balance shows the existing accumulated depreciation. Always add the current year's depreciation charge before showing it in the SFP.
⚠️ Mistake 4 — Drawings in Income Statement: Drawings are never an expense — never include them in the P&L Section. They reduce capital in the SFP only.
⚠️ Mistake 5 — Net Profit vs Gross Profit confusion: Gross Profit = Revenue minus Cost of Sales only. Net Profit = Gross Profit plus other income minus ALL expenses. Items like wages, depreciation and bad debts reduce Net Profit, not Gross Profit.

📝 Exam Practice Questions

Question 1 Knowledge — 3 marks

State whether each of the following items would appear in the Income Statement or the Statement of Financial Position, and under which heading:

  1. Closing inventory
  2. Carriage inwards
  3. Accrued wages
  1. Closing inventory → Both: deducted from Cost of Sales in I/S (Trading Section) AND shown as a Current Asset in SFP. (1 mark)
  2. Carriage inwards → Income Statement, Trading Section — added to Net Purchases as part of Cost of Sales. (1 mark)
  3. Accrued wages → Both: added to wages expense in I/S (P&L Section) AND shown as a Current Liability in SFP. (1 mark)

Question 2 Application — 5 marks

Calculate the Cost of Sales and Gross Profit from the following information:

Item$
Sales95,000
Returns Inwards2,000
Opening Inventory8,500
Purchases60,000
Returns Outwards1,500
Carriage Inwards800
Closing Inventory10,200
Sales95,000
Less: Returns Inwards(2,000)
Net Revenue93,000
Opening Inventory8,500
Add: Purchases60,000
Less: Returns Outwards(1,500)
Add: Carriage Inwards800
Net Purchases59,300
Goods Available for Sale67,800
Less: Closing Inventory(10,200)
Cost of Sales57,600
Gross Profit35,400
📌 Always deduct Returns Inwards from Sales and Returns Outwards from Purchases before calculating — never forget Carriage Inwards is added to purchases.

Question 3 Knowledge — 2 marks

Explain why drawings are not treated as an expense in the Income Statement.

Drawings are amounts taken by the owner for personal use — they are not incurred for the purpose of generating business income. (1 mark)

Therefore they do not meet the definition of a business expense. Instead, they reduce the owner's capital investment in the business and are deducted from capital in the Statement of Financial Position. (1 mark)

Question 4 Application — 4 marks

A sole trader's records show: Opening Capital $32,000 | Drawings $9,500 | Closing Capital $38,000.

(a) Calculate the Net Profit for the year.
(b) If Gross Profit was $41,000, calculate total expenses.

(a) Net Profit:
Closing Capital = Opening Capital + Net Profit − Drawings
38,000 = 32,000 + Net Profit − 9,500
Net Profit = 38,000 − 32,000 + 9,500 = $15,500 (2 marks)

(b) Total Expenses:
Net Profit = Gross Profit − Total Expenses (assuming no other income)
15,500 = 41,000 − Total Expenses
Total Expenses = 41,000 − 15,500 = $25,500 (2 marks)

📌 The Capital section formula is a reliable way to find Net Profit when the full I/S is not available — memorise it.

Question 5 Analysis — 4 marks

Explain the purpose of the Statement of Financial Position and state two differences between the Income Statement and the Statement of Financial Position.

Purpose of SFP: The Statement of Financial Position shows the financial position of a business at a specific date — listing all assets, liabilities and capital to demonstrate what the business owns, owes and the owner's net investment. (1 mark)

Two differences (1 mark each — any two):

  • The Income Statement covers a period of time; the SFP is a snapshot at a specific date.
  • The Income Statement shows revenue and expenses to calculate profit or loss; the SFP shows assets, liabilities and capital.
  • The Income Statement determines profit or loss; the SFP shows the resulting financial position including that profit in capital.
  • Expenses and income appear only in the Income Statement; assets and liabilities appear only in the SFP.
← Lesson 10: Bad debts & Provision Lesson 8: Financial Statements (Partnership)→