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Statement of financial
position and income
statement
Chapter learning objectives
Upon completion of this chapter you will be able to:
explain the main elements of financial statements:
- statement of financial position
- income statement
There are two key elements to the financial statements of a sole trader business:
Statement of financial position, showing the financial position of a business at a
point in time, and
Income statement, showing the financial performance of a business over a period of
time.
The financial statements show the effects of business transactions. The main types are:
sales of goods (either for cash or on credit)
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 a non-current asset (eg: a motor vehicle) then we are spending cash, so this will
decrease. However, we have now gained a new asset, and both of these entires are recorded
in 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 states that financial accounting information relates only to
the activities of the business entity and not to the activities of its owner.
The business entity is treated as separate from its owners.
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A company is both legally and for accounting purposes a separate entity distinct from its
owners, the shareholders. On the other hand, the business of a sole trader is not a legal entity
distinct from its proprietor; however, for accounting purposes, the business is regarded as
being a separate entity and accounts are drawn up for the business separately from the sole
trader’s own personal financial dealings.
The key link between the owner and the business is the amount stated as capital which is the
amount the business owes to the proprietor.
The top half of the statement of financial position shows the assets of the business.
The bottom half of the statement of financial position shows the capital and liabilities of
the business.
3 Income statement
The link between the statement of financial position and income statement is shown below:
The statement of financial position are not isolated statements; they are linked over
time with the income statement.
As the business records a profit in the income statement, that profit is added to the
capital section of the statement of financial position, along with any capital introduced.
Cash taken out of the business by the proprietor, called drawings, is deducted.
The statement of financial position shows the position of a business at one point in time. A
statement of financial position will always 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 are resources an entity controls as a result of past events and from which future
economic benefits are expected to flow to the entity. Some examples are:
A liability is an entity's present obligation arising from a past event, the settlement of which
will result in an outflow of economic benefits from the entity. This is something owed by the
business to someone else, such as:
Equity is defined as the residual interest in the entity's assets after deducting its liabilities.
You will become more familiar with this term when you come to look at Company accounts in
chapter 17.
Capital is a type of liability. This is the amount that is due to the owner(s) of the business. It
will increase each year by any new capital injected into the business and by the profit made
Classify the following items into current and non-current assets and liabilities:
This illustration involves a series of transactions using the dual effect of transactions
and then the accounting equation to build up a set of financial statements. The
transactions are as follows:
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Day 1: Avon commences business introducing $1,000 cash
This transaction changes the form in which the assets are held.
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 not correspond.
$
Cash acquired (sale proceeds) 300
Asset relinquished (inventory) 200
–––––
Difference (= profit) 100
–––––
Thus total assets have increased by $100. Since there are no liabilities involved, if
the fundamental equation is to remain valid the capital must increase by $100.
Day 6 Sells half of the goods bought on Day 5 on credit for $250.
Day 7 Pays $200 to his supplier.
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.
Later on in this textbook you will be introduced to the Statement of comprehensive income.
This relates to a company and not to a sole trader.
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.
Statement of financial position for Day 6
$ $
Assets Capital and liabilities
Motor car 400 Capital introduced 1,000
Inventory 200 Add: Profit to date
Receivables 250 ($100 + $50) 150
Cash 700
–––––
1,150
Payables 400
––––– –––––
1,550 1,550
––––– –––––
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).
Cash or other assets taken out of the business by the owner are called ‘amounts
withdrawn’, or ‘drawings’.