Sole Traders

PREPARING FINANCIAL STATEMENTS FOR DIFFERENT FORMS OF BUSINESS ENTITY

There are a number of different forms of business entity.  These are:

  • Sole-trader e.g. shop-keeper
  • Companies, limited by shares or by guarantee
  • Companies, unlimited

A number of substantial differences exist between all of these. These are:

  • The business of the sole trader is not governed by one identifiable Act but is subject to provisions of customary / common law and other acts related to commercial activities..
  • A sole trader operates as a single individual. A private company must have a minimum of two members and a maximum of one hundred, while a public company must have a

minimum of seven members with no maximum number of members. (Companies Act

7/2009 , Article 6)

  • A sole trader operates his business on a personal basis; a company is a separate legal entity, distinct from its members.
  • The sole trader has the capacity to enter into binding contracts. The management of a company must act within the terms outlined in the Memorandum and Articles of Association of the company and is deemed to be an agent of the company.
  • A sole trader may commence trading without much formality. A company must complete a number of formalities before business can commence. Such legal documents include memorandum and articles of association.
  • A sole trader is liable for the debts of his business without limit.

Company Limited by Guarantee

Company formed on the principle of having the liability of its members limited by its constitution to such amount as the members may respectively undertake to contribute to the assets of the company in the event of its being wound up.

Company Limited by Shares

Company in which the liability of shareholders is limited to the number of subscribed shares, whether paid or not.

 

Company Limited by Shares & Guarantee

Is a Company formed on the principle of having the following liability of its members limited to:-

  • the amount paid by shareholders or the amount agreed to pay on the shares respectively held by them, if any;
  • the security issued by shareholders equivalent to the amount agreed as surety in case of liquidations.

         Reference: Companies Act Law No 07/2009 of 27/04/09

  • Payables of a sole trader’s business have a right of action against the sole trader The payables of a company have a right of action against the company itself and not against its members.
  • The property of a sole trader belongs to the individual himself and may be used for his own purposes, irrespective of whether for business or private use. The assets of the company do not belong to the members but rather to the company in its own separate legal right.
  • A sole trader often experiences difficulty in negotiating loans as lending institutions seek security on such a loan by way of charges on assets. A company has that capacity as the shareholders do not have the capacity to remove the assets for their own personal use.
  • On death, the business of the sole trader ceases. The business of a company is unaffected by death of a member.
  • A sole trader may sell his business to another (the original owner is liable for all debts up to the date of sale).
  • The accounts of sole traders need not be filed with any public office except possibly the Rwandan Revenue Authority for Income tax purposes. Subsequently, those accounts are not available for inspection by other interested parties.  A company, on the other hand, must make annual returns to the Office of Registrar General and these are available for inspection.

When preparing financial statements for any of the above, the principles of double-entry still apply.  However, each will have their own individual requirements.

SOLE TRADER ACCOUNTS – INTRODUCTION

The business activities of a sole trader should be separate from his personal transactions.  To assist in preparing the accounts, the sole trader should operate two bank accounts – one for the business and one for personal expenses.  Any money put into the business from the sole trader’s private resources are treated as capital.  Any assets withdrawn from the business during the course of the year is known as drawings e.g. stock taken for own use, cash, motor vehicle.  Drawings are not included as expenses in the Statement of Comprehensive Income .  Rather, the drawings are debited to the capital account in the Statement of Financial Position.  The profit at the end of the period belongs solely to the trader.  At the end of the accounting period, the profit is credited to the capital account in the Statement of Financial Position while a loss is debited.

One major disadvantage of being a sole trader is that the sole trader has not got limited liability; i.e. should the business incur debts and there are insufficient resources in the business to pay all the payables, the sole trader must pay the payables from private funds.  In some instances, the sole trader’s private assets i.e. house, may have to be sold to pay the debts involved.

When preparing the accounts of sole traders or other small businesses, the books or records may fall short of a complete system of double entry.  Such situations may vary from cases where virtually no records or bank accounts are maintained to cases where bank accounts and some record of transactions are maintained.  Such accounting records, which fall short of a system of complete double entry, are known as incomplete records.

 

The approach of the accountant in preparing accounts from incomplete records will depend on the extent of the incompleteness of the records.  However, in all cases he will be attempting to:

  •  Compute an Statement of Comprehensive Income  for the accounting period
  •  Prepare a Statement of Financial Position at the end of the accounting period

 

  TWO APPROACHES IN PREPARING ACCOUNTS

Incomplete records can be divided into two types and there are, therefore, two methods of preparing accounts from such records.  These are:

  • Double Entry Approach

In cases where the double entry approach is used, bank statements will exist and probably some other record of transactions for the year – possibly cash records and cheque books.  The approach here is prepare an opening statement of affairs, to establish the balance on the capital account and then to open ledger accounts and complete the double entry for the year.  A final trial balance at the year-end will then be prepared and from this, a trading, an Statement of Comprehensive Income , together with a Statement of Financial Position can be completed.

  • Single Entry Approach

 In cases where the single entry approach is used, no bank account will have been maintained which means that it will not be possible to prepare a cash account for the year.  In such cases, the accountant will prepare a statement of affairs as at the beginning and end of the accounting period, showing the total assets, total liabilities and net worth of the business at each of those dates.  The increase in net worth i.e. net assets will be adjusted for cash introduced and drawings during the year and the resulting balance will represent the profit or loss for the year.  In such cases, it will not be possible to prepare an Statement of Comprehensive Income  for the year.

DOUBLE ENTRY APPROACH 

The followings are the steps that should be taken in preparing final accounts under the double entry approach.

 

  • Opening Statement of Affairs

A statement of affairs should be prepared as at the commencement of the accounting period.  This will include a list of all the balances on the asset and liability accounts at that date and the resulting balance of net assets will represent the opening balance of the capital account for the period.

 

Each of the different classes of assets and liabilities will then be posted to the relevant ledger account as an opening balance.

 

  • Preparation of Cash Account

Using the bank statements, lodgement dockets and cheque stubs, all of the receipts and payments should be analysed for the year.  In practice, ruled analysis sheets will be used in the preparation of such an analysis of expenditure.  A cash account will then be prepared for the year showing the different classes of income received and expenditure incurred during the year.  It is important to include in the cash account, cash receipts during the year which were not lodged and which may have been taken as drawings or used to purchase further goods or pay for expenses in cash.

  • Trade Receivables Control Account

The next step is the preparation of the trade receivables control account.  This account should already contain an opening debit balance, which will be the figure posted from the statement of affairs.  It will also contain a credit entry being the cash received from trade receivables during the year.

A listing of the outstanding trade receivables at the end of the accounting period should now be prepared and posted to the credit of the account as the closing balance.  No adjustment should be made in the trade receivables control account for bad debts.

The balancing debit figure in the account will represent the value of sales during the period.

  • Trade Payables Control Account

Similarly, a trade payables control account will be prepared for the year.  This account will show an opening credit balance being the trade payables transferred from the statement of affairs and a debit entry being the payments made to trade payables during the year.  A list of credit balances will be prepared and posted to the debit of the account as a closing balance.  The value of cash purchases will also be posted to the debit of the account.

    The balance on the account will now represent the value of purchases during the year.

  • Accruals and Prepayments

At the end of the accounting period, a list of accruals and prepayments should be prepared, journalised and posted to the appropriate ledger account.  Example of accounts on which accruals and prepayments might arise are:

  • Rent Account
  • Rates Account
  • Electricity Account
  • Subscription Account
  • Other asset and liability accounts

Postings should now be made on any other asset or liability accounts which affect the financial results of the business and which are not included above i.e. provision accounts.  Examples:

  • Provision for depreciation

DR      Depreciation account

CR        Accumulated depreciation account/provision for depreciation account

 

  • Provision for bad debts

DR      Bad debts account

CR      Provision for bad debts account

  • Preparation of final accounts
    • An inventory figure at the end of the accounting period will be calculated.
    • Transfer from the various accounts will be made to the Statement of Comprehensive Income . Accounts should be balanced and balances carried down to the next period.
    • A Statement of Financial Position will be prepared from the list of closing balances. The balance on the Statement of Comprehensive Income  will be added to the capital account.  Having adjusted this account for drawings during the year, the closing balance will represent the capital of the business at the end of the accounting period.

 

  • Reasonableness check on results for year

A reasonableness check on the results for the year could be carried out, by comparing the gross profit ratios extracted from the accounts with:

  • The gross profit ratio in previous accounting periods

And/or

  • Gross profit ratios produced by similar business concerns.

A divergence in this ratio from the expected figure might raise doubts about accuracy of the stock figure or whether stock has been drawn from business for private use.

  • Inventory for Private use

The owner of the business may take goods for private use.  This is accounted for by the following journal entry:

Debit  Drawings Account Credit  Purchases Account

SINGLE ENTRY APPROACH

 Introduction

In certain cases, owing to the deficiency of the records, it will be impossible to complete double entry accounts as described above.  This might occur because no bank accounts were maintained and the records of the cash received and payments made were insufficient to give details of the transactions entered into.

In order to establish the profit for the year and the financial position at the year end, the following steps should be taken: –

  • An opening statement of affairs should be prepared as described above.
  • A statement of affairs at the end of the accounting period should be prepared.
  • The net increase in capital for the year can then be found by subtracting the balances on the capital accounts in 1 and 2 above from one another. This net increase in capital will then be reduced by the capital introduced during the year, increased by the drawings during the year and the resulting balance will represent the profit or loss for the year.

USE OF RATIOS

Occasionally, ratios may be required to complete the question.  Two key ratios are used – Mark-up and margin.

 

Margin

 

 

=

 

 

Gross Profit

Sales

 

 

x 100

 

 

Often referred to as the Gross Profit

Percentage

 

Mark

Up

 

=

 

Gross Profit

Cost of

Sales

 

x 100

 

 

 

These two ratios are examined in a number of ways.  Therefore, it is important to be fully familiar with them.

 

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