Reasons for differences in Profit or Loss shown by Cost Accounts and Profit or Loss shown by Financial Accounts

12/05/2021 0 By indiafreenotes
  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.

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.

2. 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.

  1. 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. 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.