The financial statements of a sole proprietorship are prepared at the end of the accounting period to measure how the business has performed and where it stands. They contain three interrelated components.
Trading Account
The trading account calculates gross profit — the difference between net sales and the cost of sales. Cost of sales is opening inventory plus net purchases minus closing inventory. This component only handles items directly tied to buying and selling goods for resale.
Profit and Loss Account
The profit and loss account begins with gross profit, adds other income (such as commission received) and deducts all business expenses (such as rent, salaries and utilities). The result is the net profit or net loss for the period.
Key idea
Gross profit = Net sales − Cost of sales. Net profit = Gross profit + Other income − Expenses.
Statement of Financial Position
The statement of financial position shows the standing of the business on one particular date. It lists assets (non-current and current), liabilities (non-current and current) and owner's equity. It obeys the accounting equation: Assets = Liabilities + Owner's Equity.
Example
Rima Enterprise has net sales of RM90,000 and cost of sales of RM54,000. Gross profit is RM90,000 − RM54,000 = RM36,000. After deducting expenses of RM21,000, net profit is RM15,000. This net profit is transferred to the capital account in the statement of financial position.
How the Components Connect
The three components must be prepared in the correct order because the result of one flows into the next. Gross profit from the trading account is carried down into the profit and loss account as its opening figure. The net profit that results is then carried into the statement of financial position, where it increases the owner's capital. Any error in computing cost of sales therefore distorts gross profit, net profit and finally the capital balance. Preparing these statements also follows MFRS reporting standards for businesses in Malaysia and forms the basis of the tax computation submitted to LHDN. For a sole proprietorship these statements are usually prepared once a year at the end of the accounting period.
Remember
The trading and profit and loss accounts cover a period; the statement of financial position is a snapshot on a date. Net profit links the two through the capital account.