Sole Traders - Part 1

The income statement (also called the trading and profit and loss account) measures how much profit or loss a sole trader's business has made during an accounting period — typically one year. Unlike the statement of financial position, which captures a snapshot on one date, the income statement covers a full period.

It is divided into two clearly labelled sections:

Upper section — Trading account: This section focuses solely on the buying and selling of goods. It calculates the gross profit, which is the profit from trading activity before any operating expenses are deducted.

Lower section — Profit and loss account: This section takes the gross profit and then adds any other income (income not directly from sales) and subtracts all operating expenses to arrive at the net profit (or net loss).

The two sections are prepared on the same statement but the dividing line is the gross profit figure. When answering exam questions, always show both sections clearly and label them. Cambridge mark schemes award marks for the correct layout, not just the final figures.

It is important to remember that the income statement is prepared using the accruals basis — income is recognised when it is earned (not when cash is received) and expenses are recognised when they are incurred (not when cash is paid). This means you must apply year-end adjustments for accruals, prepayments, depreciation, and changes in the provision for doubtful debts before the statement can be finalised.

The upper section calculates gross profit by deducting the cost of sales from net revenue. Here is the standard Cambridge format:

                                         $          $
Revenue (Sales)                                 X
Less: Returns inwards                          (X)
Net revenue                                     X
Less: Cost of sales
  Opening inventory                    X
  Add: Purchases                       X
  Less: Returns outwards              (X)
  Add: Carriage inwards                X
  Net purchases                        X
  Cost of goods available for sale     X
  Less: Closing inventory             (X)
Cost of sales                                  (X)
Gross profit                                    X

Key items explained:

• Returns inwards (sales returns): goods returned BY customers TO the business — reduces revenue.
• Returns outwards (purchases returns): goods returned BY the business TO suppliers — reduces purchases.
• Carriage inwards: the cost of transporting purchased goods to the business's premises. It is added to the cost of purchases because it is part of the cost of obtaining those goods.
• Opening inventory: the value of unsold goods at the START of the period (closing inventory from the previous year).
• Closing inventory: the value of unsold goods at the END of the period. It is deducted from cost of goods available for sale because these goods have NOT been sold yet — their cost should not appear in this period's cost of sales.

Gross profit measures how efficiently the business buys and sells its goods. A business can have high revenue but a low gross profit if its buying costs are high.

The lower section begins with gross profit and then:

1. Adds any other income (revenue earned outside the main trading activity).
2. Deducts all business expenses for the period.

                                         $
Gross profit                             X
Add: Other income
  Rent received                          X
  Commission received                    X
  Discount received                      X
  Interest received                      X
                                         X
Less: Expenses
  Wages and salaries                     X
  Rent paid                              X
  Insurance                              X
  Motor expenses                         X
  Depreciation — fixtures and fittings   X
  Irrecoverable debts                    X
  Increase in provision for doubtful debts X
  Carriage outwards                      X
  Interest on loan                       X
  [Other named expenses]                 X
Total expenses                          (X)
Net profit / (Net loss)                  X

Other income includes: rent received (from sub-letting), commission received, discount received from suppliers. These are not part of trading — they are added separately.

Key expenses to know:

• Carriage outwards: cost of delivering goods TO customers. This is a selling expense (in the lower section), NOT part of cost of sales.
• Depreciation: a non-cash expense; the systematic allocation of a non-current asset's cost over its useful life. Added as an expense each year.
• Irrecoverable debts (bad debts): debts written off as uncollectable — an expense.
• Increase in provision for doubtful debts: an increase in the provision is charged as an expense; a decrease is treated as other income (or reduces the expense).

Cambridge exam questions almost always require you to apply year-end adjustments when preparing the income statement. These adjustments implement the accruals concept: income and expenses must be recognised in the period they occur, regardless of when cash is paid or received.

Types of adjustment:

1. Accrued expenses (accruals): An expense that has been incurred but NOT yet paid at the year end. Add the accrual to the expense figure in the income statement. Example: rent of $1 200 per year, paid $900 cash — the income statement shows $1 200 rent expense; the remaining $300 is an accrual (current liability on the SFP).

2. Prepaid expenses (prepayments): An expense that has been paid in advance for a future period. Deduct the prepayment from the expense. Example: insurance paid $800 but $200 covers next year — the income statement shows $600 insurance; $200 is a prepayment (current asset on the SFP).

3. Accrued income: Income earned but NOT yet received. Add to the income figure; also appears as a current asset (other receivables) on the SFP.

4. Income received in advance: Cash received for income that belongs to a future period. Deduct from the income figure; appears as a current liability on the SFP.

5. Depreciation: Calculated using straight-line or reducing balance method and charged as an expense each year.

6. Provision for doubtful debts: An increase in the provision is an expense; a decrease is other income (or reduction of the expense line).