RECONCILIATION OF COST AND FINANCIAL ACCOUNTS
Reconciliation of Cost and Financial Accounts: When cost accounts and financial accounts are separately maintained in two different sets of books, two profit and loss accounts will be prepared—one for costing books and second for financial books.
The profit or losses shown by the cost accounts may not agree with the profit or loss shown by financial accounts or books. Therefore, it becomes necessary that profit or loss shown by the two sets of accounts is reconciled. The whole process of reconciling the profits or losses shown differently in the cost and financial accounts is known as Reconciliation of cost and financial Accounts.
ACCORDING TO WHELDON
“No system is complete unless it is linked up with the financial accounting, that results shown by both cost and financial accounting may be reconciled.”
ACCORDING TO ERIC L KOHLER
“Reconciliation is the determination of the items necessary to bring the balances of two or more related accounts or statements, into agreement.”
NEED FOR RECONCILIATION OF ACCOUNTS
Reconciliation between the results of the two sets of books is necessary due to the following reasons:
- It finds out the reasons for the difference in the profit or loss in cost and financial accounts.
- It ensures the mathematical accuracy and reliability of cost accounts in order to have cost ascertainment, cost control and to have a check on the financial accounts.
- It contributes to the standardization of policies regarding stock valuation, depreciation and overheads.
- It facilitates more coordination and promotes better co-operation, between the activities of financial and cost sections of the accounting department.
- Reconciliation places management in better position to acquaint itself with the reasons for the variation in profits paying the way for more effective internal control.
REASONS FOR DISAGREEMENT IN THE PROFITS SHOWN BY COST AND FINANCIAL ACCOUNTS
Difference in profit or loss between cost and financial accounts may arise due to the following reasons:
ITEMS OF INCOMES SHOWN ONLY IN FINANCIAL ACCOUNTS
There are a number of items which are included in financial accounts but find no place in cost accounts. While reconciling any items under this category must be considered. Such items are classified into three categories as under:
(i) Purely Financial Charges: Under this category, the following charges or examples are considered:
- Loss on investments
- Discount on debentures and bonds
- Loss on the sale of capital assets
- Expenses of the company’s share transfer office
- Interest on bank loan and mortgages
- Capital expenditure
- Commission to partners and managing agents
- Damages payable at low
- Fines and penalties
- Goodwill written off, preliminary expenses
- Loss due to theft, fire, accident etc.
- Debit balance of profit and loss account written off
- Excess provision for depreciation
- Commission on issue of shares and debentures
- Cash discount allowed.
(ii) Purely Financial Incomes: Under this category, the following items of income are included:
- Rent receivable
- Transfer fees received
- Dividend and interest received on investments
- Profits on the sale of fixed assets
- Interest received on bank deposits
- Income tax refund
- Commission received
- Cash discount received
- Brokerage received
- Damages received.
(iii) Appropriations of Profit: Under this category, the following items are included:
- Donations and charities
- Income tax
- Dividend paid
- Transfers to reserves and sinking funds
- Any other items which appear in profit and loss appropriation account.
ITEMS SHOWN ONLY IN COST ACCOUNTS
There are certain items which are included in cost accounts but not in financial accounts.
- Nation depreciation on assets fully depreciated in the books
- National rent of the owned building and no rent is payable
- Interest on capital employed but not actually paid
- National salaries
OVER AND UNDER ABSORPTION OF OVERHEADS
Overheads absorbed in cost accounts on the basis of estimation like percentage on direct materials, percentage on direct wages, etc. may be more or less than the actual amount incurred. If overheads are not fully absorbed, i.e. the amount in cost accounts is less than the actual amount, the shortfall is called under-absorption. On the other hand, if overhead expenses in cost accounts are more than the actual, it is called over-absorption. Thus, under or over-absorption of overheads leads to difference in two accounts. Sometimes, selling and distribution expenses are ignored in cost accounts and as such costing profit will be higher and thus requires reconciliation.
DIFFERENT BASES OF STOCK VALUATION
In cost accounting, stock are valued according to the method adopted in stores accounts i.e., FIFO, LIFO, etc. On the other hand, valuation of stock in financial accounts is invariably based on the cost or market price, whichever is less. Different stock values result in some difference in profit or loss shown by the two sets of account books.
- Raw Material: In financial accounts, stock of raw material 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 value of stock may be different in both the books.
- Work-in-progress: Difference may also exist regarding the 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: In financial accounts stock of finished goods is valued at cost or market price whichever is lower. In cost accounts, finished goods are generally valued at total cost of production. Thus the method of valuation of stock gives rise to different results in the sets of books.
DIFFERENT BASES FOR DEPRECIATION
In cost accounts, the assets may be depreciated on the straight line method, whereas in financial accounts, a different method of depreciation such as reducing balance method or sinking policy method or a different method is followed. The difference in the method of depreciation followed in these systems of accounts results in a difference of profit.
ABNORMAL LOSS AND GAIN
Abnormal losses and abnormal gains are completely kept separate from cost accounts or they are transferred to costing profit and loss account. If they are not included in cost accounts then the profit shown by these two sets of book will vary and adjustment for which has to be done. If these losses are transferred to costing profit and loss account then the profit will tally with the profit as shown by financial accounts. These losses are like—theft, loss by fire, idle time loss etc.
ADVANTAGES OF RECONCILIATION
The advantages of reconciliation are as follows:
- The arithmetical accuracy can be checked in both the sets of books.
- It helps in detecting frauds as for example; any wrong entry of stock of material in stores ledger owing to theft can be brought to light by comparing with the stock of financial accounts.
- It enables to set right under or over absorption of overheads in cost accounts by making use of supplementary rates.
- Separate maintenance of cost accounts has the advantage of exemption from statutory audit as the purpose of cost accounts is to ascertain and control cost rather than ascertainment of profit.
- Reconciliation facilitates location of areas of inefficiencies.
METHODS OR PROCEDURE OF RECONCILIATION
Reconciliation statement is a popular and important method of cost accounts and financial accounts. The method or procedure of preparing reconciliation statement. The following method or procedure is recommended for preparing a Reconciliation Statement:
(i) Ascertain the reasons/points of difference between cost accounts and financial accounts.
(ii) Start with the profit as shown by the cost accounts.
(iii) (a) Regarding items of expenses and losses:
Add: Items over-charged in cost accounts.
Less: Items under-charged in cost accounts.
Example: Depreciation in cost accounts is 3,000 and that in financial accounts is 3,400. This has the effect of increasing costing profit by 400 as compared to financial profit. Then in order to reconcile, 400 will be deducted from costing profit.
(b) Regarding items of income:
Add: Items under-recorded in cost accounts.
Less: Items over-recorded in cost accounts.
Example: Interest on investments received amounting to 3,000 is not recorded in cost accounts. This will have the effect of reducing profit by 3,000. Then in order to reconcile, this amount of 3,000 for interest should be added in the costing profit.
(c) Regarding stock valuation: Opening stock
Add: Over-valuation in cost accounts.
Less: Under-valuation in cost accounts.
Add: Under-valuation in cost accounts.
Less: Over-valuation in cost accounts.
(iv) The above treatment of items will be reversed when the starting point in the reconciliation statement is the profit as per financial accounts or loss as per cost accounts.
(v) After making all the above additions and deductions in costing profit, the resulting figure shall be the profit as per financial books.
(vi) At some places, ‘Memorandum Reconciliation Account’ is prepared in place of ‘Reconciliation Statement.’
(vii) The following formula for easy reconciliation (with cost profit):
For Expenses items: Add the excess, deduct the shortage.
For Income items: Add the shortage, deduct the excess.
Proforma of Reconciliation Statement
For the year ending………..
| PROFIT AS PER COST ACCOUNTS: |
(i) Items of income included in financial accounts but not in cost accounts.
(ii) Items of expenditure (as interest on capital, rent on owned premises etc.) included in cost accounts but not in financial accounts.
(iii) Amounts by which items of expenditure have been shown in excess in cost accounts as compared to the corresponding entries in financial accounts.
(iv) Amounts by which items of income have been shown in excess in financial accounts as compared to the corresponding entries in cost accounts.
(v) Over absorption of overheads in cost accounts.
(vi) The amount by which closing stock of inventory is undervalued in cost accounts.
(vii) The amount by which the opening stock of inventory is overvalued in cost accounts.
(i) Items of income included in cost accounts but not in financial accounts.
(ii) Items of expenditure included in financial accounts but not in cost accounts. (iii) Amounts by which items of income have been shown in excess in cost accounts over the corresponding entries in financial accounts.
(iv) Amounts by which items of expenditure have been shown in excess in financial accounts over the corresponding entries in cost accounts.
(v) Under absorption of overhead in cost accounts.
(vi) The amount by which closing stock of inventory is overvalued in cost accounts. (vii) The amount by which the opening stock of inventory is undervalued in cost accounts.
PROFITS AS PER FINANCIAL ACCOUNTS
MEMORANDUM RECONCILIATION ACCOUNT
This account is presented in debit and credit form but it is not a part of double entry system of book-keeping. So it is kept as a memorandum account only.
Memorandum Reconciliation Account
|To Expenses not recorded in cost Accounts||By Profits as per cost accounts|
|To Overheads under-absorbed in cost accounts||By Incomes not recorded in cost accounts|
|To Under-valuation of opening stock in cost accounts||By Expenses not recorded in profit and loss account|
|To Over-valuation of closing stock in cost accounts||By Overheads over-absorbed in cost accounts|
|To Profits as per profit and loss accounts||By Over-valuation of opening stock in cost accounts|
|By Under-valuation of closing stock in cost accounts|