Provision for unrealised profit

 

A business which uses factory profit may also value its inventory of finished goods on a cost plus % basis – this creates true comparisons with potential ‘replacement’ suppliers and shows the value added to the product through the transformation process.

However the retail element of the business has not sold them and thus not made any profit yet!  This creates a problem: - How should inventory be valued??

IAS 2 says that “Inventory should be valued at the lower of historic cost or Net Realizable Value”

The solution is to create a provision for unrealised profit and take it off in the balance sheet.  Otherwise profits and assets will be overstated (going against prudence and IAS 2) which prevents a true and fair view of the accounts being shown.  Since the inventory is not sold thus realisation concept means it cannot be claimed.  This is done in a similar way to the provision for doubtful debts (see here)

A Business has no opening inventory but has a closing inventory valued at £6500 plus factory cost of 10% - total value

Finished Goods + Factory Profit = Closing Inventory

Therefore £6500+650 = £7150

The unrealised profit (i.e. profit margin included in the closing inventory) is £650.  In the first year this whole amount is written off as an expense taken off the Factory/Manufacturing profit figure.  In the balance sheet the total PUP is deducted from the inventory of finished goods to give a cost figures (meeting IAS2).

What if you are not given the original figures?

Formula (revise this): -

Inventory figure (including 10% Profit)   * Profit %

                (100 + Profit %)                                                    = £ unrealised profit figure

Worked Example

                7150                       * 10 

                (100+10)                                                              = £650

What do we do in the financial statement when the PUP changes?

The following year if the cost of finished goods went up to £7500 then the provision needs to go up from £650 to £750 then only the difference needs to be written off as an expense in the IS and the FULL provision taken off in the Balance Sheet.

Nial Satis Extract from Income Statement for year ended 31^st December 2013

Manufacturing Profit                               £xxxx

Add Increase (change) in PUP                 £100

                                                                                £xxx

 

Nial Satis Balance Sheet extract at 31^st December 2013

Current Assets

Closing inventory of Raw Materials                      10,100

Closing inventory of Work in Progress                  13,400  

Closing Inventory of Finished Goods       £8250

Less Total PUP                                       £750

                                                                            £7500                                                                                                                                                                                                               31,000