prepare statements of financial position for trading businesses and service businesses

5.1 Sole Traders – Preparing Statements of Financial Position

1. Where this topic fits in the Cambridge IGCSE Accounting (0452) syllabus

Unit	Key Content	Relevance to this lesson
Fundamentals of Accounting	Accounting equation, purpose of accounting, bookkeeping vs. accounting	Provides the basis for understanding assets = liabilities + owner’s equity
Sources & Recording of Transactions	Double‑entry, books of prime entry	Underlying the trial balance used to prepare the SFP
Verification of Transactions	Trial balance, errors, adjustments	We will adjust the trial balance for depreciation, accruals, etc.
Accounting Procedures	Journalising, posting, ledger preparation	Assumed completed before the SFP stage
Preparation of Financial Statements	Sole traders – trading & service businesses Partnerships, limited companies, clubs & societies Manufacturing accounts, incomplete records	This lesson covers the sole‑trader SFP (trading & service). Brief over‑views of the other business types are provided for context.
Analysis & Interpretation	Ratios, commentary, effect of transactions	‘What‑if’ and evaluation boxes are included after each example.
Accounting Principles & Policies	Going‑concern, accruals, prudence, consistency	Relevant when making year‑end adjustments.

2. Learning Objectives

• Identify and classify assets, liabilities and owner’s capital for a sole‑trader business.
• Prepare a Statement of Financial Position (Balance Sheet) for:
  • a trading business (buy‑sell)
  • a service business (provide services)
• Make common year‑end adjustments (depreciation, accruals, pre‑payments, doubtful‑debt provisions) and show their effect on the SFP.
• Interpret the final SFP using simple ratio analysis and comment on the financial health of the business (AO3).

3. Key Concepts

• Sole trader: an individual who owns and runs a business and is personally liable for all debts.
• Types of sole‑trader businesses:
  • Trading business – purchases goods for resale.
  • Service business – provides a service rather than selling goods.
• Other common business forms (brief overview):
  • Partnership – two or more owners share profit, loss and liability.
  • Limited company – separate legal entity; shareholders have limited liability.
  • Clubs & societies – not-for-profit; surplus retained for future activities.
  • Manufacturing accounts – include work‑in‑process and overhead allocation.
  • Incomplete records – prepare statements when only partial information is available.
• Statement of Financial Position (SFP) – a snapshot of the business at a specific date showing:
  • Assets – resources owned (cash, bank, debtors, stock, equipment, etc.).
  • Liabilities – obligations to others (creditors, overdrafts, loans).
  • Owner’s Capital (Equity) – owner’s residual interest.
• Owner’s Capital calculation (capital‑adjustment formula):
  Closing Capital = Opening Capital + Net Profit – Drawings
• Accounting equation for a sole trader:
  Assets = Liabilities + Owner’s Capital

4. Structure of the Statement of Financial Position

Assets are listed in order of liquidity (most liquid first). Liabilities are listed in order of maturity (short‑term first).

4.1 Liquidity order for assets

1. Cash
2. Bank
3. Debtors (trade receivables)
4. Closing Stock (trading only)
5. Equipment / Fixed assets (after adjustments)

4.2 Order of maturity for liabilities

1. Creditors (trade payables)
2. Bank overdraft (current liability)
3. Loans – split into current & non‑current if required

4.3 Balancing check

Before finalising, verify:

Total Assets = Total Liabilities + Owner’s Capital

5. Step‑by‑Step Procedure to Prepare a Statement of Financial Position

1. Obtain the trial balance at the end of the accounting period.
2. Make any required year‑end adjustments (depreciation, accruals, pre‑payments, doubtful‑debt provisions). Record the adjusting journal entries and update the trial balance.
3. Classify each balance as an asset, liability or capital.
4. Arrange assets in the liquidity order (Section 4.1). Include any adjusted fixed‑asset values.
5. Arrange liabilities in the maturity order (Section 4.2).
6. Calculate the closing owner’s capital using the capital‑adjustment formula.
7. Insert the figures into the appropriate SFP template (trading or service).
8. Perform the balancing check (Section 4.3). Correct any arithmetic errors.
9. Optional – compute a simple ratio (e.g., Current Ratio) and write a brief comment on the business’s financial position (AO3).

6. Year‑End Adjustments – What you need to know

Adjustment	Typical Journal Entry (Debit / Credit)	Effect on the SFP
Depreciation of equipment (straight‑line)	Depreciation Expense Dr / Accumulated Depreciation Cr	Reduces net profit (so reduces closing capital) and reduces the net book value of equipment (asset).
Accrued expenses (e.g., unpaid salaries)	Salaries Expense Dr / Salaries Payable Cr	Increases liabilities and reduces profit → lower capital.
Pre‑paid expenses (e.g., rent paid in advance)	Pre‑payments Dr / Cash Cr (at payment) Pre‑payments Cr / Rent Expense Dr (adjustment)	Reduces expense for the period, increasing profit and capital; creates a current asset (pre‑payment).
Doubtful‑debt provision	Bad Debt Expense Dr / Provision for Doubtful Debts Cr	Reduces profit and capital; creates a contra‑asset (or liability) reducing the net realizable value of debtors.

7. Statement of Financial Position Templates

7.1 Trading Business

Statement of Financial Position – Trading Business		£
Assets
Cash
Bank
Debtors
Closing Stock
Equipment (net of depreciation)
Total Assets
Liabilities
Creditors
Bank Overdraft (current)
Accrued Expenses
Total Liabilities
Owner’s Capital
Total Liabilities & Capital

7.2 Service Business

Statement of Financial Position – Service Business		£
Assets
Cash
Bank
Debtors
Pre‑payments
Total Assets
Liabilities
Creditors
Bank Overdraft (current)
Accrued Expenses
Total Liabilities
Owner’s Capital
Total Liabilities & Capital

8. Worked Example – Trading Business (including adjustments)

8.1 Trial Balance (all figures in £)

Account	Debit	Credit
Cash	3,200
Bank	5,500
Debtors	2,800
Opening Stock	4,000
Purchases	12,000
Sales		22,000
Closing Stock		3,500
Equipment – Cost	6,000
Depreciation (annual, 20 %)
Creditors		2,600
Bank Overdraft		1,200
Owner’s Capital (b/f)		3,200
Drawings	2,300

8.2 Year‑end Adjustments

• Depreciation on equipment (20 % of £6,000):
  Depreciation Expense Dr £1,200 / Accumulated Depreciation Cr £1,200

8.3 Calculate Net Profit

\[ \text{COGS}= \text{Opening Stock}+ \text{Purchases}-\text{Closing Stock}=4,000+12,000-3,500=12,500 \] \[ \text{Gross Profit}= \text{Sales}-\text{COGS}=22,000-12,500=9,500 \] \[ \text{Net Profit}= \text{Gross Profit}-\text{Depreciation}=9,500-1,200=8,300 \]

8.4 Closing Owner’s Capital

\[ \text{Closing Capital}=3,200\;(\text{opening})+8,300\;(\text{profit})-2,300\;(\text{drawings})=9,200 \]

8.5 Statement of Financial Position (as at 31 December)

Statement of Financial Position – Trading Business		£
Assets
Cash		3,200
Bank		5,500
Debtors		2,800
Closing Stock		3,500
Equipment (net)		4,800
Total Assets		20,800
Liabilities
Creditors		2,600
Bank Overdraft (current)		1,200
Total Liabilities		3,800
Owner’s Capital		9,200
Total Liabilities & Capital		13,000

8.6 Analysis & Evaluation (AO3)

• Current Ratio = (Cash + Bank + Debtors + Closing Stock) ÷ (Creditors + Overdraft) = (3,200 + 5,500 + 2,800 + 3,500) ÷ (2,600 + 1,200) = 15,000 ÷ 3,800 ≈ **3.95**. A ratio above 2 suggests good short‑term liquidity.
• Effect of higher drawings: If drawings had been £4,300 instead of £2,300, closing capital would fall to £7,200, reducing total equity and weakening the current ratio. This would indicate the owner is withdrawing too much profit, potentially jeopardising the business’s ability to meet its obligations.

9. Worked Example – Service Business (including adjustments)

9.1 Trial Balance (all figures in £)

Account	Debit	Credit
Cash	1,800
Bank	4,200
Debtors	3,600
Pre‑paid Rent (paid in advance for 3 months)	900
Service Income		18,000
Rent Expense (month of December only)	300
Salaries Expense	5,500
Accrued Salaries (unpaid at year‑end)
Creditors		1,900
Bank Overdraft		800
Owner’s Capital (b/f)		5,000
Drawings	8,200

9.2 Year‑end Adjustments

• Accrued salaries for the last week of December (£500):
  Salaries Expense Dr £500 / Salaries Payable Cr £500
• Pre‑payment adjustment: Only one month of the £900 pre‑paid rent relates to the current period.
  Rent Expense Dr £300 / Pre‑payments Cr £300

9.3 Calculate Net Profit

\[ \text{Total Expenses}= \text{Rent Expense (300)} + \text{Salaries (5,500)} + \text{Accrued Salaries (500)} = 6,300 \] \[ \text{Net Profit}= \text{Service Income} - \text{Total Expenses}=18,000-6,300=11,700 \]

9.4 Closing Owner’s Capital

\[ \text{Closing Capital}=5,000+11,700-8,200=8,500 \]

9.5 Statement of Financial Position (as at 31 December)

Statement of Financial Position – Service Business		£
Assets
Cash		1,800
Bank		4,200
Debtors		3,600
Pre‑payments (remaining 2 months)		600
Total Assets		10,200
Liabilities
Creditors		1,900
Bank Overdraft (current)		800
Accrued Salaries		500
Total Liabilities		3,200
Owner’s Capital		8,500
Total Liabilities & Capital		11,700

9.6 Analysis & Evaluation (AO3)

• Current Ratio = (Cash + Bank + Debtors + Pre‑payments) ÷ (Creditors + Overdraft + Accrued Salaries) = (1,800 + 4,200 + 3,600 + 600) ÷ (1,900 + 800 + 500) = 10,200 ÷ 3,200 ≈ **3.19**. The business appears liquid, but the high drawings (£8,200) have reduced equity considerably.
• Evaluation of drawings: Large drawings relative to profit (≈ 71 % of net profit) may limit the ability to reinvest in the business or absorb future losses. A recommendation would be to keep drawings below 30 % of profit to maintain a stronger capital base.

10. Quick‑Reference Checklist (AO1)

1. Start from a balanced trial balance.
2. Record all required year‑end adjustments and update the trial balance.
3. Classify each item as asset, liability or capital.
4. Arrange assets in liquidity order; arrange liabilities in maturity order.
5. Calculate net profit (or loss) after adjustments.
6. Compute closing owner’s capital using the capital‑adjustment formula.
7. Populate the appropriate SFP template.
8. Check that Total Assets = Total Liabilities + Owner’s Capital.
9. Optional: calculate a simple ratio (e.g., Current Ratio) and write a brief comment (AO3).