Reconciliation of Financial accounts and Cost accounting

Reconciliation of Cost and Financial Accounts is process to find all the reasons behind disagreement in profit which is calculated as per cost accounts and as per financial accounts. There are lots of items which are shown in the profit and loss account only when we make it as per financial accounting rules. There are lots of items which are shown in costing profit and loss account only when we calculate profit as per cost accounting.

Suppose, we have taken the profit or loss as per financial accounts, we adjust it as per cost accounts. In the end of adjustments, we see same profit as per cost accounts. If we have taken profit as per cost account, we have to adjust items as per financial accounts. For this purpose, we make reconciliation Statement.

(a) Items included only in financial accounts

There are number of items which appear only in financial accounts, and not in cost accounts, since they neither do nor relate to the manufacturing activities, such as,

(i) Purely financial charges, reducing financial profit

• Losses on capital assets
• Stamp duty and expenses on issue and transfer of stock, shares and bonds
• Loss on investments.
• Discount on debentures, bonds, etc.
• Fines and penalties,
• Interest on bank loans.

(ii) Purely financial income, increasing financial profit

• Rent received
• Profit on sale of assets
• Share transfer fee
• Share premium
• Interest on investment, bank deposits.
• Dividends received.

(iii) Appropriation of profit – donations and charities.

(b) Items included only in the cost accounts

There are very few items which appear in cost accounts, but not in financial accounts. Because, all expenditure incurred, whether for cash or credit, passes though the financial accounts, and only relevant expenses are incorporated in cost accounts. Hence, only item which can appear in cost accounts but not in financial accounts is a notional charge, such as,

• Interest on capital, which is not paid but included in cost accounts to show the notional cost of employing capital, or
• Rent i.e. charging a notional rent of premises owned by the proprietor.

(c) Items accounted for differently in cost accounting and financial accounting

(i) Overhead: In cost accounts, overheads are applied to cost units at predetermined rates based on estimates, and the amount recovered may differ from actual expenses incurred. If such under-or over-recovery of overheads are not charged off to costing profit and loss account, the profits on two sets of books will differ.

(ii) Stock valuation: In financial accounts, stock is valued at lower of cost or market value. In cost accounts, stock is valued at cost adoption one of the methods, such as FIFO, LIFO, average etc., which is suitable to the unit. Thus, there may be difference in stock valuation, which will reflect difference in profit between the two sets of books.

(iii) Depreciation: If different basis is adopted for charging depreciation in cost accounts as compared to financial accounts, the profits will vary.

1. Estimates and Actuals:

The cost can be computed either on actual or estimated basis. 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:

(a) 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.

(b) Direct Labour:

The estimated or standard cost of direct labour may be different from the actual costs because of differences in wage rates or hours of work or both. Sometimes, workers might have to be paid more due to increased dearness allowance, pay revision, bonus etc. This will cause difference between the profits shown by the two sets of books.

(c) 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.

(d) Depreciation:

Different methods of charging depreciation may be adopted in cost and financial books. In financial books depreciation may be charged according to fixed installment 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.

2. Valuation of Stocks:

(a) 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.

(b) 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 valuation is at factory cost in cost accounts. In financial accounts work-in-progress may be valued after considering a part of administrative expenses also.

(c) 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.

3. Items Included in Financial Accounts Only:

There are certain items which are included in the Financial Accounts but not in the Cost Accounts.

These include the following:

(a) Appropriation of profits e.g., provision for taxation, transfer to reserves, goodwill, preliminary expenses written off.

(b) Purely financial charges e.g., losses on sale of investments; penalties and fines, expenses on transfer of company’s office.

(c) Purely financial incomes e.g., interest received on bank deposits, profits made on the sale of investments, fixed assets, transfer fees received etc.

4. Items Included in Cost Accounts Only:

There are certain notional items which are excluded from the financial accounts but are charged in the cost accounts:

(i) Charge in lieu of rent where premises are owned.

(ii) Depreciation on an asset even when the book value of the asset is reduced to a negligible figure.

(iii) 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.

5. 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).

The need for reconciliation will not arise in case of a business where Integral or Integrated Accounting System is in use as there will be only one set of books both for financial and costing records. But where there are separate sets of books, reconciliation is imperative.

Preparation of Reconciliation Statement or Memorandum Reconciliation Account:

A Reconciliation Statement or a Memorandum Reconciliation Account should be drawn up for reconciling profits shown by the two sets of books. Results shown by any sets of books may be taken as the base and necessary adjustment should be made to arrive at the results shown by the other set of books.

The technique of preparing a Reconciliation Statement as well as a Memorandum Reconciliation account is discussed below:

The preparation of reconciliation statement involves the following steps:

(1) Profit as per any set of books (cost or financial) may be taken as the base. This is as a matter of fact the starting point for determining the profit as shown by the other set of books after making suitable adjustments taking into consideration the causes of difference.

(2) The effect of the particular cause of difference should be studied on the profits shown by the other set of books.

(3) In case, the cause has resulted in an increase in the profit shown by other set of books, the amount of such increase should be added to the profit as per the former set of books which has been taken as the base.

(4) In case, the cause has resulted in a decrease in the profit shown by other set of books, the amount of such decrease should be subtracted from the profit as per the former set of books which has been taken as the base.

A reconciliation statement can be prepared to reconcile, on the following basis, the profits shown by two sets of books:

1. 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 after taking into account the above causes of difference.
2. 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 under-recovery). 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.
3. 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, be subtracted from the base profit.
4. 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,
5. 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 as shown by the cost books.

Causes of Difference between Profit Shown by Cost Accounts and Financial Accounts:

There are certain items, which appear in financial books only and not recorded in cost accounting books. Similarly, there may be some items, which appear in cost accounts only and do not find place in the financial books.

The following items of expenditures/losses appear only in financial books:

1. Interest on bank loans, mortgage, debentures, etc.
2. Expenses on stamp duty, discount and other expenses relating to issue and transfer of shares and debentures.
3. Fines and penalties.
4. Loss on sale of fixed assets.
5. Loss on sale of investments.

The following items of incomes/gains are recorded in the financial books only:

1. Interest received on bank deposits and other investments.
2. Dividend received on investment in shares.
3. Rental income, etc.
4. Fees received on issue and transfer of shares, etc.
5. Profit on sale of fixed assets
6. Profit on sale of investments.

Besides the above, there are special or abnormal items of expenditure and income, which are not included in the cost of production. If they are included, cost ascertainment will not be correct.

These are:

1. Excessive or avoidable rejections.
2. Defective work and spoilage.
3. Heavy losses of stores.
4. Loss due to theft or pilferage.
5. Loss on account of natural calamities.
6. Abnormal idle time.
7. Unexpected large incomes and other abnormal gains.

Other reasons for the difference between the results of two sets of books are:

1. Wages: Often in cost accounts, direct wages are charged on the basis of predetermined rates whereas in financial accounts actual expenditure on wages is recorded.
2. Overheads: In cost accounts, overheads are generally absorbed on the basis of a predetermined overhead rate whereas in financial accounts actual expenditure on overheads is recorded.
3. Depreciation: Depreciation may be charged on different bases in financial and cost accounts. For example, in financial accounts, it may be charged according to written down value method recognized by the Income Tax Act whereas in cost accounts it may be charged on the basis of the life of the machine in terms of production hours.
4. Valuation of Closing Stock: Different methods of valuation of closing stock adopted in cost and financial accounts also cause difference between the results of two sets of books. In financial accounts, the method generally followed is cost or market price, whichever is less, while in cost accounts only cost is the basis.
5. Notional Charges: Sometimes, notional charges such as interest on capital, rent for own premises, salary of owner-manager, etc. are included in cost accounts. But they do not appear in financial accounts, as there are no actual out go on these items.

Procedure for Reconciliation:

The following procedure may be followed for reconciliation:

1. Ascertain items, which appear in financial accounts but not in cost accounts.
2. Ascertain items that appear in cost accounts only but not in financial accounts.
3. Determine the extent of difference between actual indirect expenses as recorded in financial books and the amount of overheads recovered in cost books.
4. Compare the figures of valuation of stock of raw materials, work-in- progress, stores and finished goods as shown in cost accounts and financial accounts and ascertain the amount of difference.
5. Ascertain other items, which are shown in cost as well as financial accounts but differ in value.
6. Prepare Reconciliation Statement, which is also called Memorandum Reconciliation Statement.
7. Start with the profit as per cost accounts and reach the profit as per financial accounts.
8. Add or deduct, as the case may be, items which differ from financial accounts, and items which are recorded in financial accounts and not in cost accounts. A brief explanation may be given in respect of each addition or deduction.
9. All items of expenditures/losses, which appear in financial accounts but not in cost accounts will be deducted and all items of income/gains appearing in financial accounts but not in cost accounts will be added. Reverse will be the treatment of items appearing in cost accounts but not appearing in financial accounts.

In the same way adjustment will be made for difference between any items appearing in both the accounts. For example, expenses overcharged in cost accounts will be added to and expenses undercharged in cost accounts will be deducted from the profit as per cost accounts to arrive at the profit as per financial accounts.

10. If reconciliation statement is started with profit as per financial accounts and ended with profit as per cost accounts, the above additions and deductions will be reversed.
11. After making necessary additions and deductions, the resultant figure is profit as per financial accounts.
12. The above reconciliation may be carried out by preparing a memorandum reconciliation account
13. In case of a memorandum reconciliation account, profit as per cost accounts will be the first item on the credit side and items that are added in the reconciliation statement will also appear on the credit side. All the items, which are deducted in the reconciliation statement, will be written on the debit side. The balancing figure will be profit as per financial accounts.

There are mainly two system of maintaining cost accounts namely:

(1) Integral System:

Under this system one set of accounts is operated which contains both financial and cost accounts. In such a system there is no need to prepare a separate reconciliation statement to reconcile the cost and financial profits,

(2) Non-Integral System of Accounting:

Under this system, separate cost and financial accounts are maintained. Hence the profit or loss disclosed by the two sets of accounts may differ. In such cases, it becomes necessary that cost and financial accounts are reconciled. If it is not reconciled, the two sets of accounts would provide conflicting information on the basis of which unwise policy decision may be taken.

Need for Reconciliation:

The need for reconciliation of profits as per Financial Accounts and profits as per Cost Accounts arises due to the following reasons:

(1) Numerical Accuracy: Reconciliation of cost and financial accounts help in checking the arithmetic accuracy of two sets of accounts.

(2) Standardisation: In the long ran standardization is achieved in policies relating to valuation of stock, depreciation or appreciation and absorption of overheads.

(3) Knowing the reasons: Reconciliation reveals the reasons for difference in profits or losses between cost and financial accounts.

(4) Effective internal control: It becomes easier for management to take effective decisions after knowing the reasons for the changes in profits/loss by reconciling the cost and financial accounts.

Reasons for Differences in Profit or Loss Shown by Cost Accounts and Profit or Loss Shown by Financial Accounts:

The causes of / reasons for differences between profit shown by financial accounts and cost accounts are:

(a) Pure financial charges included in financial accounts but excluded from cost accounts.

(b) Appropriation of profits included in financial accounts, but not included in cost accounts.

(c) Pure financial incomes and profits included in financial accounts, but not included in cost accounts.

(d) Notional charges included only in cost accounts, but not in financial accounts.

(e) Under or over absorption of overheads.

(f) Abnormal wastage/efficiency in respect of materials and labour.

(g) Difference in the rate of/methods of depreciation adopted in the two sets of accounts.

(h) Difference in the bases of stock valuation etc.

Reconciliation Statement:

Reconciliation means tallying the profits/losses reveled by both set of accounts. Reconciliation Statement is a statement which shows the reasons for the differences between profit and losses as shown by the cost accounts with that of the profits/losses as shown by the financial accounts.