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 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 standardization of policies regarding stock valuation, depreciation and overheads.
4. Reconciliation helps the management in exercising a more effective internal control.
Reasons for disagreement between Profits as per financial accounting and Profits as per cost accounting
The difference in the profitability of cost and financial records may be due to the following reasons.
1. Items included in the financial accounts but not in cost accounts.
• Purely financial income: such as interest received on bank deposits, interest and dividend on investments, rent receivables, transfer fee received, profit on the sale of assets etc.
• Purely financial charges: such as losses due to scraping of machinery, losses on the sale of investments and assets, interest paid on the bank loans, mortgages, debentures etc., expenses of company’s transfer office, damages payable at law etc.
• Appropriation of profit: the appropriation of profit is again a matter which concerns only financial accounts. Items like payment of income tax and dividends transfer to reserve, heavy donations, writing off of preliminary expenses, goodwill and patents appear only in profit and loss appropriation account and the costing profit and loss a/c is not affected.
2. Items included in cost accounts only: There are certain items which are included in cost accounts but not in financial accounts. They are: Charges in lieu of rent where premises are owned, interest on capital employed in production but upon which no interest is actually paid.
3. Under/Over absorption of overhead expenses: In cost accounts, overheads are absorbed at predetermined rates which are based on past data. In the financial accounts the actual amount incurred is taken into account. There arise a difference between the actual expenses and the predetermined overheads charged to product or job.
If overheads are not fully recovered, which means that the amount of overheads absorbed in cost accounts is less than the actual amount, the shortfall is called as under recovery or under absorption. If overhead expenses recovered in cost accounts are more than that of the actually incurred, it is called over absorption. Thus, both the over and under recovery may cause the difference in the profits of both the records.
4. Different basis of stock valuation: In cost accounts, the stock of finished goods is valued at cost by FIFO, LIFO, average rate, etc. But, in financial accounts stocks are valued either at cost or market price, whichever is less.
The valuation of work-in-progress may also lead to variation. In financial books only prime cost may be taken into account for this purpose whereas in cost accounts, it may be valued at prime cost plus factory overhead.
5. Different basis of depreciation adopted: The rates and methods of charging depreciation may be different in two sets of accounts.
Preparation on Reconciliation Statement or Memoran 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:
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:
1. Ascertain the various reasons of disagreement (as discussed above) between the profits disclosed by two sets of books of accounts.
2. If profit as per cost accounts (or loss as per financial accounts) are taken as the base:
ADD:
(i) Items of income included in financial accounts but not in cost accounts.
(ii) Items of expenditures (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 under-valued in cost accounts.
(vii) The amount by which the opening stock of inventory is over-valued in cost accounts.
DEDUCT:
(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 item 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 overheads in cost accounts.
(vi) The amount by which closing stock of inventory is over-valued in cost accounts.
(vii) The amount b which the opening stock of inventory is under -valued in cost accounts.
3. After making all the above additions and deductions, the resulting figure will be profit as per financial accounts.