generating and will appear in the Profit and Loss Account. We can now go down the Trial Balance on the credit side.
Capital. Is this something the business owes? Yes, capital is what the busi- ness owes to the owner of the business. Remember that although a sole trader as a person and his or her own business are treated as the same entity, the books of the business will not record any transactions that are for personal use. A sole trader is not paid a wage or a salary, but rather is taxed on the profits his or her business makes, but will still get the per- sonal and other allowances given to salaried or waged employees based on their personal circumstances. However, a sole trader has unlimited liability, which means that if the business cannot meet all its debts, then the sole trader will have to sell personal assets to make good. Will the business owe capital to the owner of the business for a year or more?
Well, the owner of the business will certainly hope to stay in business for a year or more, so capital is a fixed liability.
Loan. This is the amount that the business owes to the bank and as the intention is to pay it off over 5 years, it is another fixed liability.
Trade creditors. Is it something the business owes? Yes, so it must be a liability. Will the business still owe what will appear in the Balance Sheet in a year’s time? No, because creditors are people the business owes money to and they will certainly expect to be paid within 12 months. Therefore, creditors are classified as current liabilities.
Sales. Is it something the business owes? No, so sales must be income generating and therefore will appear in the Profit and Loss Account.
Accruals. They relate to goods and services received by the Balance Sheet date, but not put through the books as a permanent entry at the Balance Sheet date. Accruals are regarded as creditors and are therefore classified as current liabilities.
So, now we have classified each item in the Trial Balance as either going to the Profit and Loss Account or Balance Sheet; we can prepare these two statements.
made and where costs exceed sales or income a loss had been incurred. Sales relate to goods, while income (fees charged by an accountant or a solicitor, for example) relates to services.
With the exception of certain businesses such as banks, insurance companies and investment trusts (dealt with in chapter five), the Profit and Loss Account is usually produced in the standard format:
Manufacturer Retailer Service Provider
Sales Sales Income
Less: direct production costs Purchases Direct cost (time spent at cost)
= Gross margin Gross margin Gross margin
Less: Indirect production costs Product
modifications ---
= Gross profit Gross profit Gross profit
Less: Distribution costs Distribution costs
Administration costs Administration Administration
costs costs
= Profit before exceptional (as manufacturer) (as manufacturer) items
Less: exceptional items (if any) (as manufacturer) (as manufacturer)
= Operating profit Operating profit Operating profit
Less: Interest Interest Interest
= Net profit Net profit Net profit
In the case of a sole trader, the net profit will be added to the capital, which will be reduced by the sole trader’s drawings. The sole trader’s tax will be paid out of his or her drawings. For a partnership, each partner has a capital account and a current account and all adjustments are made to the current account. If there is no partnership agreement, then profits will be shared as determined by the Partnership Acts of 1890 and 1909.
A ‘sleeping partner’ is one who puts capital into a business, but does not work in it. Under the partnership agreement they have signed, profits/losses are to be shared on the following basis and in the following order:
(1) The partners shall receive ‘notional’ interest at the rate of 10%.
(2) A shall receive a ‘notional’ salary of £40 000 and B shall receive a
‘notional’ salary of £25 000.
(3) Any remaining profits will be shared equally.
(4) In the event a loss is made, ‘notional’ interest will be paid, but ‘notional’
salaries will not be paid and remaining losses will be shared equally.
The word ‘notional’ means that it is not real in the sense that it is only being used as a mechanism to divide up the profits. If the partnership does not make a profit, then there is no share out. If the interest is ‘real’ rather than notional, then each partner would receive interest in full even if the partnership made a loss.
Based on the partnership agreement, we can work out the share of the profits if (say) the partnership made a profit of £89 000, £9000 and £44 500, respectively, or a loss of (£21 000):
A (£) B (£) C (£) Total (£)
Profit
Notional interest Notional salaries Profit share
2000 40 000 4000 46 000
4000 25 000 4000 33 000
6000 Nil 4000 10 000
89 000 (12 000)
77 000 65 000 12 000 12 000 89 000
A (£) B (£) C (£) Total (£)
Profit
Notional interest 1500 1500
3000 3000
4500 4500
9000 (9000)
9000
A (£) B (£) C (£) Total (£) Profit
Notional interest Notional salaries
2000 20 000 22 000
4000 12 500 16 500
6000 Nil 6000
44 500 (12 000)
32 500 (32 500)
44 500
A (£) B (£) C (£) Total (£)
Loss
Notional interest Share of losses
2000 (11 000)
(9000)
4000 (11 000)
(7000)
6000 (11 000)
(5000)
(21 000) (12 000) (33 000) 33 000 (21 000) Partners, like sole traders, have unlimited liability. This means that if the partnership makes a loss, each partner must make good their share of the loss out of their own personal assets. Each partner is also responsible for paying their own income tax. If the partnership pays a particular partner’s income tax, then it counts as drawings and comes out of their current account.
Partnerships work on the basis that each partner is jointly and severally liable to meet the partnership’s liabilities. Suppose, for example, the ABC Partnership had liabilities of £21 000, which equated to the loss of £21 000 they made in the year, and B was declared bankrupt. He was, therefore, unable to make good his loss of £7000. In such a case, this loss would be allocated to A and C in proportion to their own liabilities. So A would have to find an additional £4500 and C’s share would be £2500.
However, it is possible, in certain circumstances, to form limited partnerships where each partner has a limited liability. Such partnerships are governed by the Limited Liability Partnership Act 2000.
In the case of a partnership, the Profit and Loss Account would be completed by reducing the net profit down to nil, as shown below:
Manufacturer Retailer Service Provider
Net profit Net profit Net profit
Less: transfer to the Partner’s
current account (as manufacturer) (as manufacturer)
Nil Nil Nil
In the case of a limited company, ‘net profit’ would be replaced by ‘profit before tax’ and the Profit and Loss Account would carry on as below:
Manufacturer Retailer Service Provider
Profit before tax Profit before tax Profit before tax Less:
= Less:
=
Corporation tax Earnings
(proposed) dividends Retained earnings
Corporation tax Earnings
(proposed) dividends Retained earnings
Corporation tax Earnings
(proposed) dividends Retained earnings
The Profit and Loss Account for Amanda is shown in Figure 1.3.
Amanda Profit & Loss Account for 12 months ended December 31 2004
£ £
Sales 480,000
Less: cost of sales 384,000
Gross margin 96,000
Warehouse rent 6,000
Wages 10,800
National insurance 1,200
Stock losses 239 18,239
Gross profit 77,761
Samples 2,000
Debtor insurances 10,000
Legal costs 5,000
Rent (office) 10,000
Delivery costs 16,500
Stationery 600
General insurances 1,500
Bank charges 15,300
Depreciation 6,250
Accounting and audit expenses 1,200 68,350
Profit before exceptional 9,411
items and interest
Setting up costs 12,000
Goodwill impairment 15,000 27,000
Loss before interest (17,589)
Interest 20,000
Net loss (37,589)
Figure 1.3 Case study – Amanda Profit and Loss Account