understand that statements of financial position record assets and liabilities on a specified date

Topic 5.1 – Sole Traders (Cambridge IGCSE 0452)

Learning Objective (AO1‑AO3)

Understand that a Statement of Financial Position (SFP) records a sole‑trader’s assets, liabilities and owner’s equity on a specified date, shows the relationship between them and links to the Income Statement.

1. What is a Sole Trader?

• A business owned and run by one individual.
• The owner has unlimited liability – personal assets are liable for business debts.
• All profits belong to the owner after expenses and tax.

2. Trading Business vs. Service Business

• Trading business: buys goods for resale. The Income Statement includes Cost of Goods Sold (COGS) and a gross profit margin.
• Service business: provides a service directly. There is no COGS; revenue is recognised when the service is performed.
• The SFP is the same for both – only the Income Statement differs.

3. Advantages and Disadvantages of a Sole Trader

4. Why Both an Income Statement and a Statement of Financial Position are Needed

• The Income Statement (Profit & Loss Account) shows performance over a period (e.g., 1 Jan – 31 Dec).
• The Statement of Financial Position gives a “snapshot” of the financial position on a single date (e.g., 31 Dec 2025).
• Net profit from the Income Statement is transferred to the SFP as part of Owner’s Equity – Closing Capital.
• Together they enable users to assess profitability, liquidity and solvency.

5. Key Accounting Terms

• Asset – resources owned or controlled by the business expected to generate future economic benefit.
• Liability – present obligations to transfer cash or services to another party.
• Owner’s Equity (Capital) – residual interest of the owner after deducting liabilities from assets.
• Current – expected to be realised or settled within 12 months.
• Non‑current – expected to be realised or settled after 12 months.
• Capital account – a ledger account that records the opening balance, profit added, drawings withdrawn and the closing balance.

6. The Accounting Equation for a Sole Trader

Assets = Liabilities + Owner’s Equity

This equation must balance on the date the SFP is prepared.

7. Standard Format of a Statement of Financial Position (Balance Sheet)

8. Steps to Prepare a Statement of Financial Position (AO2)

1. Identify the “as at” date for the SFP (e.g., 31 Dec 2025).
2. Classify and value all assets:
   • Current assets – use cash price or amount receivable.
   • Non‑current assets – use net book value (cost − accumulated depreciation).
3. Classify and value all liabilities as current or non‑current.
4. Update the Capital account:

   Closing Capital = Opening Capital + Net profit – Drawings

   (record the three journal entries in the capital ledger – see box below).
5. Enter the figures into the standard format shown in section 7.
6. Check the accounting equation. If Total Assets ≠ Total Liabilities + Owner’s Equity, locate the error (omission, double‑counting, wrong valuation, etc.).

Journal Entry – Drawings

When the owner withdraws cash (or other assets) for personal use:

Drawings      Dr   XXX
    Cash               Cr   XXX

This reduces the Capital account and the relevant asset.

9. Worked Example (AO3 – Application)

John’s bakery – data as at 31 December 2025

• Cash: $2,000
• Bank: $5,000
• Debtors: $3,000
• Stock (ingredients): $4,000
• Equipment – cost $10,000, accumulated depreciation $2,000
• Motor vehicle – cost $8,000, accumulated depreciation $3,000
• Creditors: $2,500
• Bank overdraft: $1,200
• Bank loan (non‑current): $5,000
• Opening capital: $15,000
• Net profit for the year: $6,800
• Drawings: $3,500

Calculations

Balancing the Equation

The totals now match: Total Assets = $27,000 = Total Liabilities + Owner’s Equity. The earlier mismatch in the draft was caused by omitting the net value of the motor vehicle – a non‑current asset. No change to capital was required.

Corrected Statement of Financial Position (excerpt)

10. Common Mistakes to Avoid (AO2)

• Using original cost of assets instead of net book value (cost − depreciation).
• Leaving out any non‑current asset or liability (e.g., long‑term loan).
• Forgetting to deduct drawings when calculating closing capital.
• Not stating the exact “as at” date – the SFP is a snapshot, not a period.
• Mis‑classifying an item as current when it should be non‑current (or vice‑versa).
• Including personal assets or liabilities of the owner that do not belong to the business.

11. Summary (AO1)

• The Statement of Financial Position records a sole trader’s assets, liabilities and owner’s equity on a specific date.
• It follows the accounting equation: Assets = Liabilities + Owner’s Equity.
• Assets and liabilities are classified as current (≤ 12 months) or non‑current (> 12 months).
• Owner’s equity is derived from the capital ledger: opening capital + net profit − drawings.
• Balancing the equation is the final check for accuracy.

12. Practice Questions

1. Explain why a Statement of Financial Position must be prepared for a specific date rather than for a period.
2. Using the data below, prepare a full Statement of Financial Position for a sole trader as at 30 June 2025.
   
   • Cash $1,200
   • Bank $3,500
   • Debtors $2,800
   • Stock $4,200
   • Equipment – cost $9,000, accumulated depreciation $1,500
   • Creditors $2,000
   • Bank loan (non‑current) $5,000
   • Opening capital $12,000
   • Net profit $4,500
   • Drawings $2,200
3. Identify three possible reasons for a discrepancy between Total Assets and Total Liabilities + Owner’s Equity after you have completed a draft SFP.