The Closing-off Procedure, Determining Profit of an Entity and Preparing Financial Statements

The Closing-off Procedure, Determining Profit of an Entity and Preparing Financial Statements

Overview of the Closing-off Procedure

The closing-off procedure is essential for determining the profit or loss of an entity at the end of a financial period. This process involves closing all nominal accounts, which include income and expenditure accounts, and transferring their balances to the profit or loss account. The trading account is also closed to determine the gross profit.

Understanding Financial Performance

To assess the financial performance of an entity, it is crucial to calculate gross profit and profit for the year. This is done by analysing the income and expenses over a specific financial period, usually a year.

Gross Profit

Gross profit is calculated as the difference between sales and the cost price of sales. The formula is:

Gross Profit = Sales - Cost of Sales

For example, if an entity sells goods for R100,000 and the cost price of those goods is R60,000, the gross profit would be:

Gross Profit = R100,000 - R60,000 = R40,000

Profit for the Year/Period

Profit for the year is calculated by subtracting all necessary expenses from the gross profit and adding any other income. The formula is:

Profit for the Year = Gross Profit - Total Expenses + Other Income

For instance, if the gross profit is R40,000, total expenses are R20,000, and other income is R5,000, the profit for the year would be:

Profit for the Year = R40,000 - R20,000 + R5,000 = R25,000

Cost Price of Sales

The cost price of sales includes the cost of inventory sold during the financial period. To calculate the cost price of sales, you need to consider opening inventory, purchases made during the period, and closing inventory. The formula is:

Cost Price of Sales = Opening Inventory + Purchases - Closing Inventory

For example, if the opening inventory is R10,000, purchases during the year are R50,000, and closing inventory is R20,000, the cost price of sales would be:

Cost Price of Sales = R10,000 + R50,000 - R20,000 = R40,000

Inventory Systems

Entities can use either a perpetual (continuous) or periodic inventory system to track inventory. The perpetual system records inventory purchases directly in the inventory account, while the periodic system uses a purchases account and determines cost of sales at the end of the period.

Perpetual Inventory System

In the perpetual inventory system, every purchase and sale of inventory is recorded immediately. For example, if an entity purchases inventory for R40,000, the accounting entries would be:

Dr Inventory R40,000
Cr Bank R40,000

When the inventory is sold for R60,000, the entries would be:

Dr Bank R60,000
Cr Sales R60,000
Dr Cost of Sales R40,000
Cr Inventory R40,000

Periodic Inventory System

In the periodic inventory system, purchases are recorded in a purchases account. At the end of the financial period, a physical inventory count is conducted to determine closing inventory. For example, if purchases total R50,000 and closing inventory is R20,000, the cost price of sales is calculated as follows:

Cost Price of Sales = Opening Inventory + Purchases - Closing Inventory
Cost Price of Sales = R10,000 + R50,000 - R20,000 = R40,000

Closing-off Nominal Accounts

At the end of the accounting period, all nominal accounts must be closed off. This includes transferring the balances to the trading account or profit or loss account. The following steps are involved:

1. Close sales accounts by debiting the sales account and crediting the trading account.
2. Close cost of sales accounts by crediting the cost of sales account and debiting the trading account.
3. Transfer the gross profit from the trading account to the profit or loss account.
4. Close all other income and expense accounts to determine the final profit or loss.

For example, if the trading account shows a gross profit of R20,000, the entries would be:

Dr Trading Account R20,000
Cr Profit or Loss R20,000

Preparation of Financial Statements

Financial statements are prepared from the information in the accounts after the closing-off procedure. The main financial statements include:

• The statement of profit or loss and other comprehensive income
• The statement of changes in equity
• The statement of financial position

Statement of Profit or Loss and Other Comprehensive Income

This statement summarises the revenue, cost of sales, gross profit, expenses, and profit for the year. For example, if revenue is R75,850, cost of sales is R46,750, and total expenses are R11,950, the statement would look like this:

Revenue: R75,850
Cost of Sales: (R46,750)
Gross Profit: R29,100
Expenses: (R11,950)
Profit for the Year: R17,750

Statement of Changes in Equity

This statement reflects changes in the equity of the entity, including profits and losses, drawings, and additional investments. For example:

Balance at 1 February 20.0: R103,400
Total Comprehensive Income for the Year: R17,750
Balance at 31 January 20.1: R121,150

Statement of Financial Position

This statement shows the assets, liabilities, and equity of the entity at a specific date. For example:

Assets:
- Inventory: R8,000
- Bank: R4,250
- Trade Receivables: R10,100
Total Assets: R22,350

Liabilities:
- Trade Payables: R14,700

Equity:
- Capital: R121,150

Conclusion

The closing-off procedure is vital for determining the profit or loss of an entity and preparing accurate financial statements. By understanding the components of financial performance and following the correct accounting procedures, you can effectively assess the financial health of a business.

Check your understanding

• What is the formula for calculating gross profit?
• How do you determine the cost price of sales using the periodic inventory system?
• What are the steps involved in closing off nominal accounts?
• What information is included in the statement of profit or loss and other comprehensive income?