Under this system, separate cost accounting and financial accounting books are maintained although both use the same basic accounting data. The financial accounting books have the normal and credit entries within themselves. In addition, a memorandum account, also known as Cost Ledger Control account is maintained and all the items to be transferred to the cost accounts are posted in this account.
Cost accounting books on the other hand contain impersonal accounts necessary for costing purposes in addition to a Financial Ledger Control Account, also known as Cost Ledger Control Account which enables the financial and Cost Ledger to be interlocked. The interlocking cost accounting system, costing and financial profit differ and have therefore to be reconciled at the end of the financial year.
Required Ledgers
In the financial Systems, the required ledgers are:
a) The General Ledger
b) Debtors Ledger (or Sales ledger)
c) Creditors Ledger (or Purchases ledger)
In the cost book-keeping system, the required ledgers are:
(i) General Ledger Adjustment Account: It is sometimes called the cost ledger account. All the items extracted from the financial account are recorded in this account. The balance in this account represents the total of all the balances of the impersonal accounts extracted from the financial books. It completes the double entry in the cost accounts.
(ii) Stores Ledger Control Account: This account shows all the transaction of materials
e.g. purchases, issuance of materials, returns to suppliers, e.t.c.. The balance of this account represents in total the detailed balance of the stores account.
(iii) Work in Progress Ledger Control Account: It shows the total work in progress at any particular time.
(iv) Finished Goods Ledger Control Account: Receipts from production and transfer to distribution department are entered in this account and the balance of this account shows the total value of finished goods in stock.
(v) Production Overheads Control Account: It gives the total production overheads incurred in the manufacture or production of goods in question.
(vi) Wages Control Account: It shows the total wages incurred in the production of goods.
(vii) Selling and Distribution Overheads Control Accounts: It gives the overheads incurred in marketing the goods produced. Examples of such costs will include advertising costs, sales commission, repairs made to the distribution van e.t.c.
(viii) Administrative Overheads Control Accounts: This will give the total of administrative overheads incurred in the organization. These costs are not related to production. Such costs will include salary to the general manager, salary to accounts department staff, e.t.c.
Link Between Cost And Financial Books
The link between the two sets of books is achieved by operating a cost ledger control account and a financial ledger control account (Cost Ledger Contra Account) in the financial and cost books respectively. In the cost ledger control account, all the items which affect the costs accounts are recorded, the same items are recorded in the financial ledger control accounts, but on the opposite side of the account hence the account completes the double entry. The Cost Ledger Control Account is just a memorandum entry and is, therefore, made in addition to the normal entries in the financial books of account.
To come up with a set of cost accounts from the financial accounts, a three stage approach is
used;
(i) Recording information directly from the financial ledger
(ii) Recording the information analysis in the cost accounting system operation
(iii) Finally, transferring of balances to costing financial statements
(i) Recording information directly from the financial ledger
In here, information relating to material procurement, labour costs (salaries and wages), sales revenue and overheads for the period is captured. The set of accounts opened is as shown;
The compound journal entry to be passed shall be:
Dr Stores ledger control account(i) x Wages control account (ii) x Production overheads control account (iii) x
Non production overheads control account (iv) x
Financial ledger control account (Sales A/c Figure)
Cr Sales account x
Financial ledger control account (i+ii+iii+iv) x
(ii) Recording the information analysis in the cost accounting system operation
In here, information obtained from the financial ledger is analyzed within the cost ledger. The analysis mainly involves the major accounts drawn from the financial accounting system. In addition to the accounts, additional adjusting accounts are drawn to effect the analysis. These accounts include; Over/under-absorption account and Sundry losses account.
The three major accounts, stores ledger control account, wages control account and production overheads control account, have credit entries which are equivalent to the debit entries in the work in progress account. They represent direct materials issued, direct labour and production overhead cost incurred.
What constitutes production overhead are indirect materials issued for production and indirect labour; these will be credited to the stores ledger control account and wages control account respectively and the equivalent debit entries made to the production overheads account as follows;
So far, one can identify the items that appear in each of the accounts and the corresponding entry. In addition, there may be material losses through evaporation, pilferage or theft while in store. Such an adjustment will be done in the stores ledger control account and the adjusting entry will be as follows:
Fixed Overhead costs are normally absorbed into the units of production by use of a predetermined rate, which is based on standard or budgeted output. The actual output may be less or more than the budgeted thus translating to an over or under absorption of the fixed production overheads.
Under absorption of overheads is adjusted in the production overhead control account as follows;
In case of an over absorption, the journal entry above will be reversed and the balance in the
over absorption account will be closed off in the costing profit and loss account.
The three major accounts so far are as follows:
Finalized goods from the manufacturing process are transferred to the finished goods control account. The journal entry passed is;
Dr: Finished goods a/c x
Cr: Work in Progress a/c x
(iii) Transferring balances to Costing profit and Loss account
As discussed above, balances for the under absorption a/c and Sundry losses account are closed to the Costing Profit and loss account by debiting the later and crediting the individual accounts. A similar treatment is rendered to non production overheads balance.
To determine the profit earned, one needs to determine the cost of goods sold, which shall be subtracted from the sales revenue to obtain gross profit.
To transfer the cost of goods sold into cost of sales, the following journal entry is passed;
Dr Cost of sales a/c x
Cr Finished goods a/c x
The Cost of sales a/c balance is closed off in the costing profit and loss account by passing the
following journal entry;
Dr Costing profit and loss a/c x
Cr Cost of sales a/c x
The Costing profit and loss a/c shall appear as below;
The final trial balance in the cost ledger will show:
The debit and credit total should be equal. Any difference should be investigated and corrected.
Focus on financial and cost accounts in relation to Materials Transaction
(i) Purchase of Materials on Credit
(ii) Return of Materials to Suppliers
(iii) Purchase of Materials in Cash.
The above transactions affect both the financial accounts and cost accounts and the entries in the two sets of books will appear as follows:
The following entries of material transactions affect only the cost of books because they are merely transfers in the cost ledger:
Focus on financial and cost accounts in relation to labor transactions
(i) Wages paid in cash
(ii) Wages incurred as
a) direct labor or
b) Indirect labor
The cost ledger control account in the financial ledger is a memorandum account which records the financial information, which has been extracted for use in the cost ledger. The financial ledger control in the cost ledger has two main purposes:
(i) It makes the cost ledger self-balancing: It takes the place of an asset liability accounts in which one leg of the double entry would appear in the financial ledger for each transaction e.g. the purchase of material on credit would be credited to Sundry creditors control account in the financial ledger. In the cost ledger, it is credited to the financial ledger control account.
(ii) It enables an internal check to be performed by comparing its balances with that of the cost ledger control account in the financial ledger. Both should record a balance which represents stock balances (Raw material, W.I.P and financial goods) the net profit, when all other transactions have been completed. Any difference should be investigated and reconciled. Thus the final trial balance in the cost ledger will show:
>>> Illustration of the book keeping entries in a job costing system
Reconciliation of profits disclosed by Financial Accounts and Cost Accounts in an interlocking
system
When interlocking cost accounting system is applied, there will always be differences between the profit shown in the financial accounts and that shown in the Cost accounts even if there are no errors in either accounts. This disparity in profits is caused by the different ways of recording accounting entries in the cost books and the financial books. For this reason, the two profit figures in the set of the two accounts should be periodically reconciled if they are to be meaningful. This reconciliation is done using an account known as the Memorandum Reconciliation Account.
Differences between the profit figures in the cost books and the financial books are caused by factors such as
(i) Items shown only by one set of accounts i.e. Items appearing in the financial accounts and not in the cost books and vice versa.
Item shown only in the financial books include:
• Losses on disposal of assets
• Stamp duty and other expenses on issues and transfers of capital stock (shares, bonds, debentures, e.t.c.)
• Losses on investment
• Interest on bank loans
• Discounts on bonds and debentures
• Dividends received
• Profits arising from sale of fixed assets
• Dividends paid
• Rent receivable but excluding that portion receivable from sub-letting part of the business premises if it has been included in the cost accounts.
Items shown only in the cost books: These are normally notional charges therefore not real. They include:
• Interest on capital employed in production
• Notional rental charges of premises owned
The above two notional costs represents the opportunity cost of employing the capital in the
business rather than investing it outside the business.
(ii) Different bases of Stock Valuation
Stocks are valued differently, in cost accounts and financial accounts; the financial stock is valued at the lower cost and net realizable value (mark value). The valuation of stocks in cost accounts is either based on LIFO, FIFO or weighted average. This use of different bases in valuing stocks will affect the profit/losses shown in the financial or cost accounts hence the need for reconciliation of the two.
(iii) Different Treatment of Overheads
In cost accounts, indirect expenses are recovered as overheads based on estimated expenditure and aligned with the estimated level of production. This results in under or over-absorption of overheads and this must be taken into account when reconciling the profits of the two sets of accounts. In the financial accounts, however, indirect expenses are recorded at the actual cost and charged to the production account.
>>> Illustration
The following are the final accounts of XYZ Limited for the year ending 31st December 1999
Required:
Prepare a Memorandum Reconciliation account
Workings
