1.34 Query Accounting for internally manufactured spares.
1.A public sector undertaking, has six business groups, whose performance is evaluated separately. ABC is one of the above six groups. Each group is again having 1 to 3 divisions; for example, ABC consists of three divisions viz., (a) Production Division; (b) Marketing Division; and (c) Servicing and Maintenance Division.
2.The function of the Manufacturing Division is to manufacture computers, based on the orders procured by the Marketing Division. Immediately, on supply of the system to the customer, sales credit is taken in the books of account. The Production Division has also to manufacture spares required for warranty maintenance or maintenance beyond warranty period. Presently, the spares manufactured for the purpose of warranty and post-warranty maintenance are transferred to Servicing Division by the Production Division. Whenever Servicing Division enters into contracts with various customers for maintenance, necessary sale invoices are raised and sales credit as ‘Income from services’ is taken into account. Wherever spares are sold, they are also accounted for as sales (Income from sale of spares).
3.The Production Division is insisting on giving sales credit for the spares produced and supplied by them to the Servicing Division by saying it as “internal sales”, which has not been agreed to by the Accounts Department, as this amounts to giving double sales credit, i.e., once as internal sales whenever spares produced by the Manufacturing Division are transferred to Servicing Division and second time when the Servicing Division raises the sales invoice for the installation, commissioning and post-warranty maintenance contracts and also when spares are sold.
4.The Production Division is not gearing up to the requirements of necessary spares on the pretext that their production activity has not been reflected in the books of account viz., Profit and Loss Account / Balance Sheet under the head ‘Internal Sales’.
5. The undertaking has internal audits, statutory audit and also audit by the Comptroller & Auditor General of India. The Accounts Division is effecting the following entries in respect of the above transactions:
(i) The cost of spares manufactured is booked to primary heads, i.e., material consumption, salaries & wages and factory expenses. On production of spares, Finished Goods Despatch Notes (FGDN) are raised and the spares are sent with such documents to the “spares stores” of the Servicing Division and the following Journal Entry is effected:
(iii) When spares are sold:
(iv) When maintenance contracts are executed with customers:
At the year end the balance lying under the account “Transfer to Other Accounts” [Under (1) above] is transferred to Profit and Loss Account by the following Journal Voucher:
With the above, the expenditure booked under primary heads gets reduced to the extent of spares manufactured. ‘Transfer to Other Accounts’ is a control account to monitor the production of spares.
6. The group wants the following treatment instead of the above described in para 5 above;
(i) On production of spares, the FGDNs are raised and the spares are sent with such documents to the spares stores of the Servicing Division and the following Journal entry is passed:
(ii) When spares are consumed, the following entry is made:
(iii) When spares are sold:
(iv) When maintenance contracts are executed with customers:
7. With the procedure being followed by Accounts Division, the expenditure for producing the spares is reduced and necessary credit/debit to Profit & Loss Account is given as and when these spares are sold or expended for warranty purposes. As against this method, according to the querist, if the Group’s requirement is to be met, there will be double sales/production credit and double expenditure, i.e., once as internal sales whenever spares produced by the manufacturing division are transferred to servicing division and second time when the servicing division raises the sales invoices when maintenance contracts are executed and the spares are sold. The effect of the two alternative procedures on the profit & loss account and the balance sheet, with imaginary figures, is given in Annexures I & II.
8.The querist has sought the opinion of the Expert Advisory Committee as to whether the procedure presently being followed by the Accounts Division is correct (para 5 above). In case the procedure desired by the Production Division (i.e., at para 6 above), can be followed, whether it will be in accordance with the standard accounting procedures and practices, so that the auditors may not object to the same.
Opinion May 24, 1989
The Committee notes that the profit and loss account of an entity is prepared to reflect its final operating result pertaining to the relevant accounting period. In view of this, the internal divisional transactions should not be reflected in the profit and loss account of the entity. In the present case, therefore, the profit and loss account should be debited only with the expenses incurred in respect of production of stores and spares, i.e., salaries, wages, material consumption etc. only. Similarly, the profit and loss account should be credited with the revenue from sale of spares and from execution of maintenance contracts. The internal transfers should be recorded by keeping divisional accounts. Also, the motivational problems of the Production Department, as mentioned in para 4 of the query, can be solved by having an appropriate management accounting system, e.g., responsibility accounting system, whereby the divisional managers’ performance is evaluated on the basis of the performance of the respective divisions, rather than through disclosure of internal transfers in the final accounts by either of the methods described in the query. The Committee is, however, of the opinion that in case the company in question does not intend to establish a separate management accounting system, then the procedure presently followed by the company is appropriate as it does not disclose separately income form internal transfers in the profit and loss account.
ANNEXURE-I
The effect of the procedure as per para 5 of the query on Profit and Loss Account and Balance Sheet for the production of 10 units, sale of 5 units and consumption of 5 units in the warranty period is shown below with imaginary values:
Profit and Loss Account --------------------------------------------------------------------------------------------------------------------- Expenditure Amount Income Amount
Balance Sheet ----------------------------------------------------------------------------------------------------------
ANNEXURE-II
The effect of the procedure as per para 6 of the query on Profit & Loss Account and Balance Sheet for the production of 10 units, sale of 5 units and consumption of 5 units in the warranty period is given below with imaginary values:
Profit and Loss Account --------------------------------------------------------------------------------------------------------------------- Expenditure Amount Income Amount
Balance Sheet -----------------------------------------------------------------------------------------------
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