RECONCILIATION OF COST AND FINANCIAL ACCOUNTS NOTES

When cost accounts and financial accounts are maintained in two different sets of books, there will be prepared two Profit and Loss Accounts one for costing books and the other for financial books. The profit or loss shown by costing books may not agree with that shown by financial books. Such a system is termed as ‘Non-Integral System’ whereas under the integral system of accounting, there are no separate cost and financial accounts. Consequently, the problem of reconciliation does not arise under the integral system. However, where two sets of accounting systems, namely, financial accounting and cost accounting are being maintained, the profit shown by the two sets of accounts may not agree with each other. Although both deal with the same basic transactions like purchases, consumption of materials, wages and other expenses, the difference of purpose leads to a difference in approach in a collection, analysis and presentation of data to meet the objective of the individual system. Financial accounts are concerned with the ascertainment of profit or loss for the whole operation of the organisation for a relatively long period, usually a year, without being too much concerned with cost computation, whereas cost accounts are concerned with the ascertainment of profit or loss made by manufacturing divisions or products for cost comparison and preparation and use of a variety of cost statements. The difference in purpose and approach in cost accounting generally results in a different profit figure from what is disclosed by the financial accounts and thus arises the need for the reconciliation of profit figures given by the cost accounts and financial accounts. The reconciliation of the profit figures of the two sets of books is necessary due to the following reasons :

  1. It helps to identity the reasons for the difference in the profit or loss shown by cost and financial accounts.
  2. It ensures the arithmetical accuracy and reliability of cost accounts.
  3. It contributes to the standardisation of policies regarding stock valuation, depreciation and overheads.
  4. Reconciliation helps the management in exercising a more effective internal control.

17.2    REASONS FOR DISAGREEMENT IN PROFITS

Difference in profit or loss between cost and financial accounts

may arise due to following reasons :

  1. Items shown only in financial accounts

There are a number of items which are included in financial accounts but find no place in cost accounts. These may be items of expenditure or appropriation of profit or items of income. The former reduces the profit while the latter have the reverse effect. The items may be classified as under :

  • Pure financial charges : (i) Loss arising from the sale of fixed assets, (ii) Loss on investments, (iii) Discount on debentures, (iv) Interest on bank loan, mortgages and debentures, (v) Expenses of the company’s share transfer office.
  • Appropriation of Profit : (i) Donations and Charities, (ii) Incometax, (iii) Dividend paid, (iv) Transfers to reserves and sinking funds.
  • Purely financial incomes : (i) Rent receivable, (ii) Profits on the sale of fixed assets, (iii) Transfer fees received, (iv) Interest received on bank deposits, (v) Dividend received.
  • Writing off intangible and fictitious assets : (i) Goodwill, Patents and copyrights, (ii) Advertisement, preliminary expenses, organisation expenses, etc.
  1. Items shown only in cost accounts

There are certain items which are included in cost accounts but not in financial accounts.

  • Charge in lieu of rent where premises are owned.
  • Depreciation on an asset even when the book value of the asset is reduced to a negligible figure.
  • Interest on capital employed in production but upon which no interest is actually paid (this will be the case when the firm decides to include interest in the overheads).

The above items will reduce the profits in Cost Accounts as

compared to that in Financial Accounts.

  1. Estimates and actuals

Since cost accounts are meant to function as a control device it

will be appropriate to adopt estimated costing or preferably standard costing system while preparing cost accounts. Estimates or standards can be nearer to the actuals but in most cases they cannot be the same. This necessarily means that the profit shown by the cost accounts is bound to be different from the profit shown by the financial accounts.

Following are some of the important items the costs of which

may be different in financial books and costing books :

  • Direct materials : The estimated or standard cost of the direct materials purchased or consumed in the production process may be different from the actual costs. This difference will be due to change in price or quantity or both.
  • Direct Labour : The estimated or standard cost of direct labour may be different from the actual costs because of difference in wage rates or hours of work or both. Sometimes, workers might have to be paid more due to increased dearness allowance, pay revisions, bonus etc. This will cause difference between the profits shown by the two sets of books.
  • Overheads : In cost accounts the recovery of overheads is generally based on estimates while in financial accounts the actual expenses incurred are recorded. This results in under or over-recovery of overheads.

The under-recovery or over-recovery of overheads may be carried

forward to the next period or may be charged by a supplementary rate (positive or negative) or transferred to Costing Profit and Loss Account. In case the under-recovery or over-recovery of overheads has been carried forward to the next period, the profit as shown by the costing books will be different from the profit as shown by the financial books. Such variation may be due to over or under charging of factory, office or selling and distribution overheads.

  • Depreciation : Different methods of charging depreciation may be adopted in cost and financial books. In financial books, depreciation may be charged according to fixed instalment method or diminishing balance method etc. while in cost accounts machine hour rate or any other method may be used. This is also an item of overheads and may be one of the reasons of difference between the overheads charged in financial accounts and overheads charged in cost accounts.
  1. Valuation of stocks
  • Raw materials : In financial accounts stock of raw materials is valued at cost or market price, whichever is less, while in cost accounts stock can be valued on the basis of FIFO or LIFO or any other method . Thus, the figure of stock may be inflated in cost or financial accounts.
  • Work-in-progress : Difference may also exist regarding mode of valuation of work-in-progress. It may be valued at prime cost or factory cost or cost of production. The most appropriate mode of valuing is at factory cost in cost accounts. In financial accounts, work-in-progress may be valued after considering a part of administrative expenses also.
  • Finished goods : Under financial accounts, stock of finished goods is valued at cost or market price whichever is lower. In cost accounts, finished stock is generally valued at total cost of production. If the circumstances warrant, prime cost or factory cost may also be taken as the basis for valuing the stock of finished goods.

Thus, mode of valuation of stocks gives rise to different results

in the two sets of books. Greater valuation of opening stocks in cost accounts means less profit as per cost accounts and vice versa. Greater valuation of closing stocks in cost accounts means more profit as per cost accounts and vice versa.

  1. Abnormal gains and losses

Abnormal gains or losses may completely be excluded from cost

accounts or may be taken to Costing Profit and Loss Account. In financial accounts such gains and losses are taken to Profit and Loss Account. As such, in the former case costing profit/loss will differ from financial profit/loss and adjustment will be required. In the latter case, there will be no difference on this account between costing profit or loss and financial profit or loss. Therefore, no adjustment will be required on this account. Examples of such abnormal gains and losses are abnormal wastage of materials e.g. by theft or fire etc., cost of abnormal idle time, cost of abnormal idle facilities, exceptional bad debts, abnormal gain in manufacturing through processes (when actual production exceeds normal production).

17.3    EFFECT OF VARIOUS ITEMS ON PROFIT

Now, let’s examine the effect of various items, discussed above

on the profit figures revealed by cost accounts and financial accounts.

Causes of Differences Effect on Effect on
  Profit as per Profit as per
  Cost Accounts Financial Accounts
1. Expenses/Losses included in More Less
financial accounts only

2. Pure Financial Charges

More Less
3. Incomes and gains credited in financial accounts only Less More
4. Items shown in Cost accounts only Less More
5. Under-recovery of overheads More Less
in cost accounts

6. Over-recovery of overheads in cost accounts

Less More
7. Stock Valuation :

Higher value of op. stock and/or lower value of closing stock in cost books when compared to financial books

Less More
Lower value of op. stock and/or higher value of closing stock in cost books when compared to financial books More Less
8. Depreciation Methods : Excess depreciation in cost books when compared to financial books Less More
Excess depreciation in financial books More Less

17.4    RECONCILIATION PROCEDURE

Reconciliation of cost and financial accounts is done on the

principle of bank reconciliation statement. One may begin with profit as per the financial books or cost books and thereafter items causing differences in profit may be added or deducted depending on the circumstances. After all such items have been considered, profit as per other books may be arrived at.

This reconciliation may be achieved through a mere statement (Reconciliation Statement) or preparing a Memorandum Reconciliation Account. Both these approaches are discussed below :

(a)         Preparation of Reconciliation Statement

When there is a difference between the profits disclosed by cost

accounts and financial accounts, the following steps shall be taken to prepare a Reconciliation Statement :

  • Ascertain the various reasons of disagreement (as discussed above) between the profits disclosed by two sets of books of accounts.
  • If profit as per cost accounts (or loss as per financial accounts) is taken as the base :

ADD :

  • Items of income included in financial accounts but not in cost accounts.
  • Items of expenditure (as interest on capital, rent on owned premises, etc.) included in cost accounts but not in financial accounts.
  • Amounts by which items of expenditure have been shown in excess in cost accounts as compared to the corresponding entries in financial accounts.
  • Amounts by which items of income have been shown in excess in financial accounts as compared to the corresponding entries in cost accounts.
  • Over-absorption of overheads in cost accounts.
  • The amount by which closing stock of inventory is under-valued in cost accounts.
  • The amount by which the opening stock of inventory is over-valued in cost accounts.

DEDUCT :

  • Items of income included in cost accounts but not in financial accounts.
  • Items of expenditure included in financial accounts but not in cost accounts.
  • Amounts by which item of income have been shown in excess in cost accounts over the corresponding entries in financial accounts.
  • Amounts by which items of expenditure have been shown in excess in financial accounts over the corresponding entries in cost accounts.
  • Under absorption of overheads in cost accounts.
  • The amount by which closing stock of inventory is over-valued in cost accounts.
  • The amount by which the opening stock of inventory is undervalued in cost accounts.
  1. After making all the above additions and deductions, the resulting figure will be profit as per financial accounts.

Note : If profit as per financial accounts (or loss as per cost accounts) is taken as the base, then items added shall be deducted and items to be deducted shall be added, i.e., the procedure shall be reversed.

 

  • Profit as per cost accounts may be taken as the base. In other words, the profit as shown by the financial books can be found out if suitable adjustments are made in this figure of profit and after taking it account the above causes of difference.
  • Works overheads have been charged more in financial accounts than those in cost accounts. This means profit as shown by the financial accounts is less than the profit as shown by the cost accounts by Rs. 500 (the amount of underrecovery). Since profit as per cost accounts has been taken as the base, the amount of Rs. 500 should be subtracted from this base profit to arrive at the profit as shown by the financial accounts.
  • The inclusion of interest on capital as an expense has resulted in decrease in profits as shown by financial books. In other words, the profit as shown by the cost books is more than the profit as shown by the financial books by Rs. 500 (the amount of interest). The amount should, therefore, the subtracted from the base profit.
  • Dividend received has been credited in financial books. This means the profit as shown by the financial books is more than the profit as shown by the cost books by Rs. 1,000. The amount should, therefore, be added to the profit as shown by the cost books.
  • No charge is made in financial books for rent on owned buildings. The amount has however been charged in the cost books. It means the profit as shown by the financial books is higher than the profit as shown by the cost books by this amount. The amount, therefore, should be added to the profit.

 

Preparation of Memorandum Reconciliation Account

This reconciliation procedure is in the form of account. The debit

side (Dr.) of the Memorandum Reconciliation Account shows items to be deducted from the profit as per any set of books taken as a starting point. The credit side of the this account shows profit figure accepted as a starting point as well as items to be added to this profit figure. The difference between the credit side and debit side will give profit as per the other set of books. A proforma of Memorandum Reconciliation Account is shown as follows:

Memorandum Reconciliation Account

Dr.                                                                                                          Cr.

To Financial Expenses                 Rs.           By Profit as per Cost Accounts     Rs.
Discount By Financial Income
Bank interest Rent
Donations Interest
Underwriter’s commission Transfer fees
Fine & penalties Profit on sale of investments
Loss on sale of assets Goodwill written off By items charged in Cost Accounts
To under-absorption of overheads Rent of own Building
To under-valuation of opening Interest on Capital
Stock in Cost Accounts To Over-valuation of closing

Stock in Cost Accounts

To Profit as per Financial Accounts

By over-absorption of overheads

By over-valuation of opening Stock in Cost Accounts

By under valuation of closing Stock Cost Accounts

 

SUMMARY

In case of Non-Integral system, separate books of accounts are

maintained for costing and financial transaction. Normally under this system profit shown by the two sets of the books will be different. However, it is possible per chance, that the overall profit shown by the two sets of the books is the same. Nonetheless in such a case also the items and/or amounts incorporated will be different. Hence, the results shown by two sets of books are always required to be reconciled to identify the causes of difference and to establish the accuracy of both sets of books. A reconciliation statement is prepared simply to identify such causes. In case such reconciliation brings out certain errors or discrepancies, they have to be separately rectified. However, it is necessary that the classification of income and expenses both for financial and cost accounts is on the same basis so that it is possible to compile them on the same lines in both cases.

17.6   KEYWORDS

Non-integral system: When separate books of accounts are maintained for costing and financial transaction, it is known as non-integral system.

Reconciliation statement: It is a statement prepared to know the reasons for differences in financial and cost accounts.

17.7    SELF ASSESSMENT QUESTIONS

  1. “Reconciliation of Cost and Financial Accounts in the modern computer age is relevant”. Comment.
  2. Why is it necessary to reconcile the profit shown by Cost Accounts and Financial Accounts ? What is the procedure to be adopted for their reconciliation ?
  3. What is the purpose of reconciling Cost and Financial Accounts ? Indicate the possible reasons for differences between profit shown in the Cost Accounts and that shown in the Financial Accounts of a concern.
  4. “An efficient system of costing will not necessarily produce accounts which in their results will agree with the financial accounts”. Comment upon the statement.
  5. At the end of an accounting period, it is found that the profit as shown by the Financial Accounts falls considerably short of the profit according to the Cost Accounts. Indicate how the discrepancy might have arisen.
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