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Difficulty: HardProvision for Unrealized Profit on Closing Inventory

Danbatta Manufacturing Company transfers finished goods from its factory to its retail shop at a transfer price that includes a mark-up of 25%25\% on manufacturing cost. At the end of the accounting year on 31 December 2025, the entity's records show:

- Finished goods inventory (1 January 2025 at transfer price): ₦60,000\text{₦}60,000
- Finished goods inventory (31 December 2025 at transfer price): ₦100,000\text{₦}100,000

What is the net adjustment (increase in provision for unrealized profit) to be debited to the Profit and Loss Account for the year ended 31 December 2025?

Answer: 8000 ₦

Answer

The net increase in provision for unrealized profit to be debited to the Profit and Loss Account is ₦8,000.
The profit element contained in finished goods inventory transferred at cost plus 25%25\% mark-up is 25125=20%\frac{25}{125} = 20\% of the transfer value. The unrealized profit in opening inventory is 20%×₦60,000=₦12,00020\% \times \text{₦}60,000 = \text{₦}12,000 and in closing inventory is 20%×₦100,000=₦20,00020\% \times \text{₦}100,000 = \text{₦}20,000. The net adjustment (increase) to be charged to the Profit and Loss Account is ₦20,000−₦12,000=₦8,000\text{₦}20,000 - \text{₦}12,000 = \text{₦}8,000.

Step-by-Step Solution

1
Convert mark-up on cost to profit margin on transfer value.
Margin = 25100+25=25125=15=20%\frac{25}{100 + 25} = \frac{25}{125} = \frac{1}{5} = 20\%.
Because inventory is valued at transfer price (cost plus mark-up), the profit component embedded in the transfer price must be calculated using the margin fraction.
2
Compute the provision for unrealized profit in the opening inventory of finished goods.
Opening Provision = 15×₦60,000=₦12,000\frac{1}{5} \times \text{₦}60,000 = \text{₦}12,000.
To determine the profit element carried forward from the previous year.
3
Compute the required provision for unrealized profit in the closing inventory of finished goods.
Closing Provision = 15×₦100,000=₦20,000\frac{1}{5} \times \text{₦}100,000 = \text{₦}20,000.
To eliminate the internal profit on unsold manufactured goods remaining at the end of the current period.
4
Calculate the net change in provision required for the current period.
Net Increase = ₦20,000−₦12,000=₦8,000\text{₦}20,000 - \text{₦}12,000 = \text{₦}8,000.
Only the change (increase or decrease) between the required closing provision and existing opening provision is adjusted in the Profit and Loss Account.

Key Concept

Provision for Unrealized Profit on Closing Inventory
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Provision for Unrealized Profit on Closing Inventory

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