Financial Statements of Sole Proprietors

The full picture

Imagine you run a stationery shop near your school. You bought goods, sold goods, paid rent and salaries, and now the financial year has ended on 31 March. Your ledger has dozens of accounts — purchases, sales, rent, debtors, machinery — but none of them, on their own, tells you whether you made money this year or how healthy your business really is. That is exactly the problem that final accounts (also called financial statements) solve. They reorganise every ledger balance into three well-defined statements that any banker, tax officer, or future partner can understand at a glance.

The first statement is the Trading Account. Its only job is to measure gross profit — the profit from buying and selling goods before any operating costs are considered. On the debit side you record opening stock and net purchases (purchases minus purchase returns). On the credit side you record net sales (sales minus sales returns) and closing stock. The difference is gross profit (if credit side is larger) or gross loss (if debit side is larger). Closing stock appears here on the credit side because it represents goods that were bought but not yet sold — it reduces your cost of goods sold. This gross profit figure is then carried forward to the next statement.

The second statement is the Profit and Loss Account. It begins with the gross profit transferred from the Trading Account and then lists all indirect expenses — rent, salaries, advertising, depreciation, bad debts — on the debit side. Other incomes such as commission received or interest earned are shown on the credit side. When you subtract total expenses from gross profit and add other income, you get net profit (or net loss). Net profit is the true reward for running the business. It is then added to the owner's capital in the Balance Sheet.

The third statement is the Balance Sheet. Unlike the Trading Account and P&L, the Balance Sheet is not an account — it is a position statement. It shows what the business owns (assets) on the right and what it owes (liabilities) plus what the owner has invested (capital) on the left, as on the last day of the accounting year. Current assets (cash, debtors, closing stock) and fixed assets (machinery, furniture, land) go on the right. On the left, capital is shown after adding net profit (and deducting drawings, if any) so it reflects the owner's updated stake. Creditors and loans appear below capital. Both sides must be equal — this equality is the living proof of double-entry bookkeeping.

Adjustments already recorded in the adjusted trial balance flow straight into these statements — you do not create them again. Depreciation on machinery? It appears as an expense in P&L and the machinery is shown at its reduced book value in the Balance Sheet. Prepaid insurance? It is a current asset in the Balance Sheet, not an expense in P&L. Outstanding salary? It is an expense in P&L and a current liability in the Balance Sheet. Each adjusted item has one correct home; placing it in the wrong statement is the most common source of exam marks lost.

One important rule to memorise: revenue expenses (paying for day-to-day running of the business — rent, stationery, salaries) belong in the P&L Account. Capital expenses (buying long-lived assets — machinery, vehicles, computers) belong in the Balance Sheet as assets, not in P&L. Confusing these two is a classification error that will make your Balance Sheet fail to balance. When you see a new item in a question, ask yourself: 'Is this something used up this year, or something that will benefit the business for many years?' The answer decides where it goes.

An Indian example

Anitha runs a small saree shop in Thrissur. This is her first year in business (so opening stock is nil). In the year ending 31 March, she bought sarees worth ₹8,00,000 and sold them for ₹11,50,000. She had ₹60,000 worth of sarees left unsold at year-end (closing stock). She paid ₹1,20,000 in shop rent, ₹60,000 in salaries to one helper, and charged ₹20,000 depreciation on her display racks. Her Trading Account shows: Opening Stock ₹0 + Purchases ₹8,00,000 − Closing Stock ₹60,000 = Cost of Goods Sold ₹7,40,000; Gross Profit = Sales ₹11,50,000 − COGS ₹7,40,000 = ₹4,10,000. Her P&L Account then deducts rent ₹1,20,000, salaries ₹60,000, and depreciation ₹20,000 — total ₹2,00,000 — leaving a Net Profit of ₹2,10,000. Her Balance Sheet adds this ₹2,10,000 to her opening capital, shows the closing stock ₹60,000 as a current asset, and lists her display racks at their depreciated value. Both sides of her Balance Sheet balance perfectly — and she now has a document she can take to a bank for a loan or submit with her GST return.

Common misconceptions to watch for

• Closing stock should be shown in the Profit & Loss Account because it reduces profit. This is wrong: closing stock goes on the credit side of the Trading Account (reducing cost of goods sold) and as a current asset in the Balance Sheet. It never enters the P&L Account, which deals only with indirect income and expenses, not the buying-selling cycle.
• Depreciation is added back in the Balance Sheet because it is a non-cash expense and no money actually leaves the business. This is wrong: depreciation is deducted in the P&L Account as a genuine expense (the asset is being used up). In the Balance Sheet, the fixed asset is simply shown at its reduced book value (cost minus accumulated depreciation). There is no 'adding back' anywhere in final accounts.
• If a business shows a net profit, it must have more assets than liabilities. This is wrong: net profit (from P&L) and solvency (assets exceeding liabilities, from Balance Sheet) measure completely different things. A business can earn profit this year but still have negative capital if it carries large losses from previous years or heavy long-term loans — the Balance Sheet will show liabilities exceeding assets even while the P&L shows a profit.