The Closing-off Procedure, Determining Profit and Preparing Financial Statements
This is the study unit where everything comes together. All the journals, ledgers and adjustments from earlier units feed into a single end-of-year process: closing the nominal accounts, calculating gross profit and net profit, and producing the three financial statements.
- Introduction — what gets closed
- Gross profit vs net profit
- Cost of sales
- Inventory systems compared
- Perpetual inventory system
- Periodic inventory system
- The closing-off sequence
- The trading account
- The profit or loss account
- The financial statements
- Gross profit percentage
- Gross profit calculator
- Worked exercises
- Quick quiz
1. Introduction — what gets closed
At the end of every financial year, all nominal accounts (income and expense accounts) must be closed off — brought to a nil balance. Their balances are transferred to either the trading account or the profit or loss account, where the financial result is determined.
The accounts that remain open after closing — assets, liabilities and equity — form the basis for the statement of financial position. Their balances become the opening balances for the next financial period.
2. Gross profit vs net profit
A trading entity calculates profit in two stages:
Net profit is what remains after all operating expenses have been deducted and other income added. It is calculated in the profit or loss account.
3. Cost of sales
The cost of sales is not simply the total purchases for the year — you must account for opening and closing inventory. The formula is:
Net purchases = Purchases − Purchases returns
Settlement discount granted reduces revenue (deducted from Sales). Settlement discount received reduces purchases (deducted from Purchases). Both are transferred to the respective accounts before closing.
4. Inventory systems compared
The accounting entries for inventory depend entirely on which system the entity uses. The system in use is identified from the trial balance: if a Purchases account exists, the periodic system is in use. If only an Inventory account is present, it is perpetual.
| Transaction | Perpetual system | Periodic system |
|---|---|---|
| Buy inventory for cash | Dr Inventory Cr Bank |
Dr Purchases Cr Bank |
| Buy inventory on credit | Dr Inventory Cr Creditors control |
Dr Purchases Cr Creditors control |
| Sell merchandise for cash | Dr Bank / Cr Sales (selling price) AND Dr Cost of sales / Cr Inventory (cost price) |
Dr Bank Cr Sales (selling price only) |
| Sell merchandise on credit | Dr Debtors control / Cr Sales AND Dr Cost of sales / Cr Inventory |
Dr Debtors control Cr Sales (selling price only) |
| Customer returns goods | Dr Sales returns / Cr Debtors AND Dr Inventory / Cr Cost of sales |
Dr Sales returns Cr Debtors control |
| Return goods to supplier | Dr Creditors control Cr Inventory |
Dr Creditors control Cr Purchases returns |
| Owner draws inventory | Dr Drawings Cr Inventory (cost price) |
Dr Drawings Cr Purchases (cost price) |
| Delivery costs on purchases | Dr Inventory Cr Bank / Creditors |
Dr Carriage on purchases Cr Bank / Creditors |
5. Perpetual inventory system
Under the perpetual system, the Inventory account is updated after every single transaction. Cost of sales is recorded simultaneously with each sale — so the business always knows its current inventory value and can determine gross profit at any time.
Calculating cost price from a mark-up
When the mark-up percentage is given, you must convert selling price to cost price before recording the cost of sales entry.
Cost price = 100%, Selling price = 125%
To find cost from selling price: Selling price × 100/125
Mark-up on selling price (e.g. 25% on selling):
Selling price = 100%, Cost price = 75%
To find cost from selling price: Selling price × 75/100
6. Periodic inventory system
Under the periodic system, purchases are debited to a Purchases account (treated as an expense). The actual inventory on hand is only determined by a physical count at year-end. Cost of sales can only be calculated after this count.
Worked example — cost of sales (periodic system)
7. The closing-off sequence
At year-end all nominal accounts are closed in a specific order. For a trading entity using the periodic system, this is the sequence:
8. The trading account — Toekela Dealers example
Using Toekela Dealers’ pre-closing trial balance (periodic system, closing inventory R8 000):
9. The profit or loss account
Once the gross profit has been transferred in, all other income accounts are credited and all expense accounts are debited to the profit or loss account. The resulting balance is the net profit (or loss) for the year, which is then transferred to Capital.
10. The financial statements — Toekela Dealers
Statement of Profit or Loss
Statement of Changes in Equity
Statement of Financial Position
11. Gross profit percentage
The gross profit percentage (GP%) is a key performance indicator for trading entities. It measures how efficiently the business turns its core buying-and-selling activity into profit. It can be expressed two ways:
GP% = (Gross profit ÷ Revenue) × 100
= (R29 100 ÷ R75 850) × 100 = 38,4%
GP% on cost price:
GP% = (Gross profit ÷ Cost of sales) × 100
= (R29 100 ÷ R46 750) × 100 = 62,2%
Management uses this percentage to set pricing policy, compare performance year-on-year, and benchmark against industry norms. A consistent GP% across periods indicates consistent pricing discipline.
12. Gross profit calculator
Enter your revenue, cost of sales, and other income/expenses to calculate gross profit, net profit and both GP% formulas.
13. Worked exercises
Closing procedure and financial statement questions in the FAC1502 exam style.
14. Quick quiz
Twelve questions on the closing-off procedure, inventory systems and financial statements.