The preparation of financial statements is essential for any business, including a sole proprietorship trading firm. It provides a clear picture of the firm’s financial performance and position over a specific period. For Commerce students, understanding the preparation of financial statements is critical, as it forms the foundation of accounting principles and financial analysis. In this guide, we will walk you through the steps involved in preparing financial statements for a sole proprietorship trading firm, using a simple example for better clarity.
What is a Sole Proprietorship Trading Firm?
A sole proprietorship trading firm is a business owned and operated by one individual who buys and sells goods for profit. The firm’s financial activities are recorded using basic accounting principles, and the owner is solely responsible for the profits, losses, and liabilities of the business.
The key financial statements prepared for such a business are:
- Trading Account: Shows the gross profit or loss from trading activities.
- Profit and Loss Account: Shows the net profit or loss after considering all other incomes and expenses.
- Balance Sheet: Reflects the financial position of the business on a specific date, showing assets, liabilities, and the owner’s equity.
Steps in Preparing Financial Statements for a Sole Proprietorship Trading Firm
1. Prepare the Trading Account
The Trading Account calculates the Gross Profit or Loss of the firm by accounting for the direct costs associated with trading, such as the cost of goods sold (COGS). The formula for gross profit is:
Gross Profit = Net Sales − Cost of Goods Sold
Example:
Let’s assume the following data for a trading firm:
- Net Sales: ₹2,00,000
- Opening Stock: ₹50,000
- Purchases: ₹1,20,000
- Closing Stock: ₹40,000
The Cost of Goods Sold (COGS) is calculated as:
COGS = Opening Stock + Purchases − Closing Stock
COGS = 50,000 + 1,20,000 − 40,000 = ₹1,30,000
So, the Gross Profit is: Gross Profit = Net Sales − COGS
Gross Profit = 2,00,000 − 1,30,000 = ₹70,000
Thus, the Trading Account would show a Gross Profit of ₹70,000.
2. Prepare the Profit and Loss Account
The Profit and Loss (P&L) Account calculates the Net Profit or Loss by including other indirect incomes and expenses like rent, salaries, interest, and utilities.
Example:
Continuing with the previous data, let’s assume the following additional expenses:
- Salaries: ₹15,000
- Rent: ₹10,000
- Utilities: ₹5,000
Total expenses:
Total Expenses = 15,000 + 10,000 + 5,000 = ₹30,000
Now, the Net Profit is calculated as:
Net Profit = Gross Profit − Total Expenses
Net Profit = 70,000 − 30,000 = ₹40,000
Thus, the firm’s Net Profit would be ₹40,000.
3. Prepare the Balance Sheet
The Balance Sheet shows the Assets, Liabilities, and Owner’s Equity of the firm as of a particular date.
Assets:
- Cash in hand: ₹20,000
- Closing Stock: ₹40,000
- Furniture and Fixtures: ₹30,000
Total Assets = ₹20,000 + ₹40,000 + ₹30,000 = ₹90,000
Liabilities:
- Creditors: ₹25,000
- Bank Loan: ₹20,000
Total Liabilities = ₹25,000 + ₹20,000 = ₹45,000
Owner’s Equity:
The Owner’s Equity is calculated by adding the Net Profit to the Capital (Initial Investment) and deducting any drawings.
Let’s assume the capital introduced is ₹50,000 and there are no drawings.
Owner’s Equity = Capital + Net Profit
Owner’s Equity = 50,000 + 40,000 = ₹90,000
The Balance Sheet will show total assets equal to total liabilities and owner’s equity:
Total Assets = Total Liabilities + Owner’s Equity
₹90,000 = ₹45,000 + ₹45,000
Thus, the Balance Sheet is balanced.
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