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Difficulty: MediumProvision for Unrealized Profit on Closing Inventory

Zaria Industrial Ltd transfers finished goods from its factory to its trading section at cost plus a 20%20\% mark-up. At the beginning of the financial year, the stock of finished goods held at transfer price was ₦30,000\text{₦}30,000. At the end of the financial year, the stock of finished goods at transfer price was ₦45,000\text{₦}45,000. What is the net adjustment required in the Profit and Loss Account for the provision for unrealized profit?

  1. An increase of ₦2,500\text{₦}2,500 debited to the Profit and Loss AccountAnswer
  2. B
    An increase of ₦3,000\text{₦}3,000 debited to the Profit and Loss Account
  3. C
    An increase of ₦7,500\text{₦}7,500 debited to the Profit and Loss Account
  4. D
    A decrease of ₦2,500\text{₦}2,500 credited to the Profit and Loss Account

Answer

An increase of ₦2,500\text{₦}2,500 debited to the Profit and Loss Account
When finished goods are transferred at a profit, unrealized profit contained in closing inventory must be eliminated using a provision account. With a 20%20\% mark-up on cost (15\frac{1}{5}), the margin on transfer price is 16\frac{1}{6}. The opening provision is 16×₦30,000=₦5,000\frac{1}{6} \times \text{₦}30,000 = \text{₦}5,000, and the required closing provision is 16×₦45,000=₦7,500\frac{1}{6} \times \text{₦}45,000 = \text{₦}7,500. The net increase of ₦2,500\text{₦}2,500 is debited to the Profit and Loss Account.

Step-by-Step Solution

1
Convert the mark-up percentage to a margin fraction
Mark-up of 20%=1520\% = \frac{1}{5}. Profit margin on transfer price =1/51+1/5=16= \frac{1/5}{1 + 1/5} = \frac{1}{6}.
Because finished inventory values are given at transfer price (cost + profit), margin must be applied to extract the unrealized profit element.
2
Calculate the opening provision for unrealized profit
Opening provision =16×₦30,000=₦5,000= \frac{1}{6} \times \text{₦}30,000 = \text{₦}5,000.
Determines the existing balance in the Provision for Unrealized Profit account.
3
Calculate the closing provision for unrealized profit
Closing provision =16×₦45,000=₦7,500= \frac{1}{6} \times \text{₦}45,000 = \text{₦}7,500.
Determines the required closing balance for unrealized profit in ending inventory.
4
Determine the net adjustment for the Profit and Loss Account
Increase in provision =₦7,500−₦5,000=₦2,500= \text{₦}7,500 - \text{₦}5,000 = \text{₦}2,500 (debit to Profit and Loss Account).
An increase in provision represents an additional expense charged against profits.

Key Concept

Provision for Unrealized Profit on Closing Inventory
Estimated Time:1m 30s
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Provision for Unrealized Profit on Closing Inventory

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