AUDITORS’ REPORT (iSA 700) NOTES
THE AUDITOR AND THE COMPANIES ACT-Introduction
Integrated Accounting System
A system of accounting where the cost and financial accounts are kept in the same set of books. This system avoids the need for separate set of books for financial and costing purposes
Interlocking Accounting System
this is an accounting system where separate cost accounting and financial accounting books are maintained although both use the same basic accounting data
COST ACCOUNTING SYSTEMS
There are two types
Interlocking Cost Accounting System:
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.
In the financial Systems, the required ledgers are:
- The General Ledger
- Debtors Ledger (or Sales ledger)
- Creditors Ledger (or Purchases ledger)
In the cost book-keeping system, the required ledgers are:
- 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.
- 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.
- Work in Progress Ledger Control Account: It shows the total work in progress at any particular time.
- 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.
- Production Overheads Control Account: It gives the total production overheads incurred in the manufacture or production of goods in question.
- Wages Control Account: It shows the total wages incurred in the production of goods.
- 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.
- 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.
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;
- Recording information directly from the financial ledger
- Recording the information analysis in the cost accounting system operation
- Finally, transferring of balances to costing financial statements
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 |
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.
Stores ledger control a/c
| FLC a/c Wages | x co | WIP a/c ntrol a/c | x |
| FLC a/c Production O | X verh | WIP a/c ead control a/c | X |
FLC a/c X WIP a/c X
Work in process a/c
| Stores ledger Control a/c | x | |
| Wages Control a/c | X | |
| Production OH Ctrl a/c | X |
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;
Dr: Production overheads a/c (total) x
CR: Stores ledger control a/c x
Wages control a/c x
Wages control a/c
WIP a/c
Production Overhead control a/c
Production Overhead control a/c
| FLC a/c | X | WIP a/c | X |
| Stores ledger Control a/c | X |
Wages Control a/c X
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:
Dr: Sundry losses a/c x
Cr Stores ledger control a/c x
The balance in the Sundry losses account will be charged to the costing profit and loss account by passing the following journal entry;
Dr: Costing profit and loss a/c x
Cr Sundry losses a/c x
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;
Dr: Under absorption a/c x
Cr Production overhead control a/c x
The balance in the under absorption account is closed off in the costing profit and loss statement by passing the following journal entry;
Dr: Costing profit and loss a/c x
Cr Under absorption a/c x
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:
Stores ledger control account
| Financial ledger control a/c | x | Work in progress a/c | x |
| Sundry losses a/c | x | ||
| Wages | co | Production overheads a/c ntrol account | x |
Financial ledger control a/c x Work in Progress a/c x
Production overheads a/c x
Production overhead control account
| Financial ledger control a/c | x | Work in progress a/c | x |
| Stores ledger control a/c | x | Under absorption a/c | x |
| Wages ledger control a/c | x | ||
| Over absorption a/c | x |
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
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(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;
Costing Profit and Loss a/c
The final trial balance in the cost ledger will show:
| DR | CR | ||
| Stores ledger control a/c | x | ||
| W.I.P Control a/c | x | ||
| Finished goods control a/c | x | ||
| Costing profit and loss a/c | x | ||
| Financial Ledger Control a/c | x |
The debit and credit total should be equal. Any difference should be investigated and corrected.
(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:
| In the Financial Books | In the Costing Books |
| Purchases on Credit: Dr Purchases a/c | Dr Stores Ledger Control a/c |
| Cr Creditors a/c | Cr General Ledger Adjustment a/c |
| Return of Materials to Suppliers Dr Creditors a/c | Dr. General Ledger Adjustment a/c |
| Cr. Purchases a/c | Cr. Stores Ledger Control a/c |
| Purchases of Materials in Cash Dr. Purchases a/c | Dr. Stores Ledger Control a/c |
| Cr. Cash a/c | Cr. General Ledger Adjustment a/c |
The following entries of material transactions affect only the cost of books because they are merely transfers in the cost ledger:
| Wages paid in cash Wages incurred as direct labor orIndirect labor | |
| In the Financial Books | In the Costing Books |
Wages Paid in cash:
Dr. Wages Account Dr. Wages Control a/c
Cr. Cash a/c Cr. General ledger adjustment a/c
Wages incurred as direct labour
Not distinguished as direct labour Dr. Work in process a/ c
Cr. Wages Control a/ c
Wages incurred as indirect labour
Not distinguished as indirect labour Dr. Work in Process a/ c
Cr. Production Overheads Control a/ c
Tutorial Note
A cost account ledger system is required to analyze accounting information in order that costs may be accumulated for individual cost centers and charged to cost units. The information in the cost ledger will be used for a range of planning, control and decision making purpose.
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:
- 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.
- 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:
DR CR
Stores ledger control a/c x
W.I.P Control a/c x
Finished goods control a/c x
Costing profit and loss a/c x
Financial Ledger Control a/c x
Reconciliation of profits disclosed by Financial Accounts and Cost Accounts in an interlocking system
| Fast forward; Costing accounting profits can always be reconciled by identifying the items causing the difference in the numbers. |
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.
- 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.
- 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.
The following are the final accounts of XYZ Limited for the year ending 31st December 1999
Manufacturing Trading Profit and Loss Appropriation Account
| Total Factory Costs c/ d | 311,000 | Sales | 480,000 |
| Finished goods; opening stock | 20,000 | ||
| Cost of goods manufactured and transferred b/d | 311,000 | ||
| Less closing stock | (22,000) | ||
| 309,000 | |||
| Gross profit c/d | 171,000 | ______ | |
| 480,000 | 480,000 | ||
| Expenses | |||
| Office Salaries | 35,000 | Gross profit b/f | 171,000 |
| Office Expenses | 20,000 | Dividends received | 3,000 |
| Salesmen Commissions | 18,000 | Interest on bank deposits | 1,000 |
| Selling Expenses | 15,000 | ||
| Loss on sale of land | 1,000 | ||
| Distribution expenses | 13,000 | ||
| Interest on mortgage | 2,000 | ||
| Fines | 1,000 | ||
| Net Profit c/d | 70,000 | ______ | |
| 175,000 | 175,000 | ||
| Taxation | 24,000 | Net Profit b/d | 70,000 |
| Transfers to general reserve | 9,000 | Retained profit c/f | 36,000 |
| Ordinary share dividend | 18,000 | ||
| Preference dividend | 11,000 | ||
| Goodwill written off | 7,000 | ||
| Retained Earnings c/f | 37,000 | ______ | |
| 106,000 | 106,000 | ||
| Retained earnings b/f |
The cost accounting records show the following:
(i). Profits were Shs.114,000. Office salaries and office expenses provided for as (in the financial books)
(ii). Stocks were as follows:
Opening Stocks: Raw Materials 26,000
Work in process 21,000
Finished goods 23,000
Closing stock Raw materials 30,000
Work in process 20,000 Finished goods 24,000
Required:
Prepare a Memorandum Reconciliation account
Solution
Memorandum Reconciliation account
| Profit as per cost books 114,000 | |||
| Items not Debited in cost a/c | Items not credited in cost a/c | ||
| Stock difference: | Dividend received | 3,000 | |
| Closing finished goods difference | 1,000 | Interest received | 1,000 |
| Closing WIP difference | 2,000 | ||
| Opening finished goods difference | 3,000 | Difference in stocks | |
| Closing raw materials difference | 1,000 | Opening WIP difference | 8000 |
| Other costs | Opening raw materials | 1,000 | |
| Salesman Commission | 18,000 | ||
| Selling expenses | 15,000 | ||
| Loss on sale of land | 1,000 | ||
| Distribution Expenses | 13,000 | ||
| Interest on mortgage | 2,000 | ||
| Fines | 1,000 | ||
| Net profit as per the financial books | 70,000 | ______ | |
| 127,000 | 127,000 |
Workings
| Financial a/c | Cost a/c | Difference | |
| Work in progress: opening stocks: | 29,000 | 21,000 | 8,000 CR |
| Finished goods: opening stocks: | 20,000 | 23,000 | 3,000 DR |
| Raw materials: opening stocks: | 27,000 | 26,000 | 1,000 CR |
| Raw materials: closing stocks: | 21,000 | 20,000 | 1,000 DR |
| Work in progress: closing stock | 22,000 | 24,000 | 2,000 DR |
| Finished goods: closing stock | 29,000 | 30,000 | 1,000 DR |
THE NATURE OF INTEGRATED ACCOUNTS
In integrated account, ledger system has a number of features which may be viewed as preferable to the interlocking ledger system. In the recent decade, there has in fact been a move towards greater integration of accounting information requirements in a single unified system (an integrated ledger system). Such an integrated ledger system has the following advantages:
- There is only one set of accounting records which is kept with sufficient analysis to enable the preparation of financial and cost accounting statements and to facilitate the control mechanisms undertaken by financial and management accountants.
- There is only one profit and loss account. This removes the possibility of senior management confusion and frustration from the production of two seemingly different profit figures.
- There is no requirement to reconcile cost and financial accounting records.
- There is a removal of the duplication of effort and cost which arises when separate ledgers are maintained.
The integrated ledger system fits in with the use of computer based information systems and a database approach to information availability and use.
Entries in the Integrated ledger system
The integrated ledger system contains most of the entries in the interlocking ledger system. The financial ledger control account is no longer in use. The range of asset and liability accounts required for financial control purposes and for the preparation of financial accounting statements will incorporate the entries, which would have appeared in the financial ledger control account.
