Financial Accounts and Costing 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 financial 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 know as the Memorandum ReconciliationAccount. Differences between the profit figures in the cost books and the financial books are caused by factors such as

  1. 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.

(a) 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 etc)
  • Losses on investment
  • Interest on bank loans
  • Discounts on bonds and debentures.
  • Dividends received
  • Profits arising from sale of fixed asset
  • 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.

(b) 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.

  1. Different bases of Stock Valuation

Stocks are valued differently, in cost accounts and financial accounts; the financial stock is valued at the lower of 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.

  1. 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.