Sole traders Revision Notes

A sole trader is an individual who owns and runs their business alone. One key advantage is full control over decision-making, allowing quick responses to business needs. Setting up is straightforward with minimal legal formalities, and the owner receives all profits directly. For example, a sole trader running a local bakery decides the product range and pricing without consultation.

However, sole traders face unlimited liability, meaning personal assets can be used to settle business debts. Raising capital is often difficult since funds rely on personal savings or loans. The sole trader also bears all responsibilities, which can be overwhelming. For instance, if the bakery incurs debts it cannot pay, the owner’s personal possessions may be at risk. Understanding these pros and cons helps in evaluating the suitability of this business form.

• Full control and simple setup.
• Owner receives all profits.
• Unlimited liability risks personal assets.
• Difficulty raising capital.
• All responsibilities rest on one person.

Income statements summarise a business’s revenues and expenses over a period, showing whether it made a profit or loss. For example, a service business providing cleaning services records income from clients and deducts expenses like wages and supplies to find net profit.

Statements of financial position (balance sheets) provide a snapshot of a business’s financial position at a specific date, listing assets, liabilities, and capital. Assets are resources owned, liabilities are obligations owed, and capital represents the owner’s interest. For example, the bakery’s statement of financial position on 31 December shows its equipment (non-current asset), cash (current asset), loans (liabilities), and owner’s capital.

These statements are essential for assessing financial health and making informed decisions.

• Income statement shows profitability over time.
• Statement of financial position shows financial position at a date.
• Assets, liabilities, and capital are key components.
• Essential for financial analysis and decision-making.

Trading businesses buy and sell goods. Their income statements include sales revenue, cost of goods sold (COGS), gross profit, and expenses. For example, a shop selling electronics records sales and subtracts the cost of purchasing stock to find gross profit before expenses.

Service businesses provide intangible services without stock. Their income statements omit COGS and show only service revenue and expenses. For example, a consultancy records fees earned and deducts expenses like salaries and rent to find net profit.

Understanding these differences ensures correct income statement preparation.

• Trading businesses sell goods; include COGS and gross profit.
• Service businesses provide services; no COGS or gross profit.
• Income statements differ in structure accordingly.
• Accurate classification affects profit calculation.

Statements of financial position classify assets and liabilities by liquidity and duration. Non-current assets (e.g., machinery) are long-term resources, intangible assets (e.g., patents) lack physical form but have value, current assets (e.g., inventory, cash) are short-term resources. Current liabilities (e.g., accounts payable) are obligations due within a year, non-current liabilities (e.g., bank loans) are long-term debts. Capital represents the owner’s equity after liabilities are deducted from assets.

These components interrelate: Assets = Liabilities + Capital. For example, if a business has £50,000 in assets and £20,000 in liabilities, capital is £30,000. Changes in one component affect the others, maintaining balance.

Recognising these relationships is vital for accurate statement preparation.

• Non-current assets: long-term physical resources.
• Intangible assets: non-physical but valuable.
• Current assets: short-term resources.
• Current liabilities: debts due within one year.
• Non-current liabilities: long-term debts.
• Capital = Assets − Liabilities; maintains balance.

Adjustments ensure financial statements reflect true financial position and performance. Depreciation allocates the cost of non-current assets over their useful life. Methods include:

Straight line: equal expense each year. Formula: (Cost − Residual value) ÷ Useful life. For example, a £10,000 machine with £2,000 residual value over 4 years: (£10,000−£2,000) ÷ 4 = £2,000 depreciation per year.

Reducing balance: higher expense initially, decreasing over time. For example, 20% reducing balance on £10,000 asset: Year 1 depreciation = £10,000 × 20% = £2,000; Year 2 = (£10,000−£2,000) × 20% = £1,600, etc., reflecting faster loss of value early on. Revaluation adjusts asset values to fair market value, increasing or decreasing carrying amount accordingly, with changes recorded in equity or profit/loss depending on circumstances. Adjustments for accrued expenses and income recognise expenses or income incurred but not yet paid or received, ensuring matching of costs and revenues to the correct period. Prepaid expenses and income represent payments made or received in advance, recorded as assets or liabilities until earned or incurred. Bad debts are amounts owed by customers unlikely to be collected; these are written off as expenses. Provisions for doubtful debts estimate potential future bad debts, reducing receivables to a realistic value. Goods taken by the owner for personal use (drawings) reduce inventory and capital, reflecting non-business use of stock. These adjustments maintain accuracy and compliance with accounting principles.

• Depreciation methods: straight line, reducing balance, revaluation.
• Accruals and prepayments match income and expenses to correct periods.
• Bad debts written off; provisions estimate doubtful debts.
• Drawings reduce inventory and owner’s capital.
• Adjustments ensure true financial position and performance.