🔄 Reconciliation of Cost and Financial Accounting – Comprehensive Notes
This article provides you a detailed explanation of the reconciliation process between cost accounting and financial accounting, their differences, reasons for profit variation, and the preparation of reconciliation statements. It also includes important theory questions.
📑 Table of Contents
- Branches of Accounting
- Relationship Between Cost and Financial Accounting
- Reasons for Difference in Profits Shown in cost Accounting and Financial Accounting
- a) Items Excluded from Cost Accounting
- b) Items Not Recorded in Financial Accounting
- Meaning of Reconciliation of cost and financial accounting
- Reasons for Reconciliation of Cost and Financial Accoutning
- Preparation of Reconciliation Statement
- Important Questions
📘 Branches of Accounting
There are three branches of accounting but out of three financial and cost accounting is more popular than management accounting. Financial accounting is a necessity for medium and large trading organisation and cost accounting system is essential for manufacturing entities. First of all, we have to understand the meaning of these three accounting systems:
a) Financial Accounting:
It is the original form of accounting. It is mainly concerned with the preparation of financial statements for the use of outsiders like creditors, debenture holders, investors and financial institutions. Its main aim is to find the operating efficiency and financial position of a firm at the end of the accounting year. It starts with the recording of transactions and ends with the preparation and presentation of financial statements.
b) Cost Accounting:
It is that branch of accounting which is concerned with the accumulation and assignment of historical costs to units of product and department, primarily for the purpose of valuation of stock and measurement of profits. It is the method of accounting for cost. I.C.M.A. has defined cost accounting as follows: “The process of accounting for cost from the point at which expenditure is incurred or committed to the establishment of its ultimate relationship with cost centers and cost units. In its widest usage, it embraces the preparation of statistical data, the application of cost control methods, and the ascertainment of the profitability of activities carried out or planned”.
c) Management Accounting:
It is accounting for the management i.e., accounting which provides necessary information to the management for discharging its functions.
🔗 Relationship Between Cost and Financial Accounting
It is a common practice in every manufacturing entity to maintain both cost and financial accounting. Cost accounting is needed to ascertain the cost of production and also helps in the fixation of the selling price. Financial accounting is needed for a manufacturing firm to determine the operating efficiency and financial position.
But the main problem of maintaining two accounting systems is that both accounting systems show differences in profits or loss. So there is a need for reconciliation of cost and financial accounting system. First of all, understand the relationship between these two accounting systems.
Relationship between Cost and Financial Accounting
Cost accounting is very closely related to financial accounting. Some authorities on the subject consider cost accounting to be the branch of financial accounting. But it may be said that cost accounts are complementary to financial accounts, i.e., a subject which is necessary to make financial accounts whole or complete. Financial accounts and cost accounts are both similar in certain respects. But in some other respects, they differ from one another. These points of similarities and enumerated below:
1) The fundamental principles of double-entry are applicable in both the systems of accounts.
2) The invoices and vouchers constitute the common basis for recording transactions under both the systems of accounts.
3) The results of the business are revealed by both the systems of accounts.
4) The causes for losses and wastages of a business are provided by both these systems of accounts.
5) The determination of future business policy is guided by both these systems of accounts.
6) A the basis for comparison of expenses is being provided by both the accounting systems.
7) Accuracy of accounts is maintained under both the systems by means of exercising check over errors and commissions which might creep in either of the accounts.
💹 Reasons for Difference in Profits Shown in Cost Accounting and Financial Accounting
Though both the accounting system are closely related and followed by various manufacturing entities, but profits shown by both the accounting system are different. The main reason for this is that there are certain items which are shown in financial accounting but not taken into consideration in cost accounting. Also there are certain items which are recorded in cost accounting but recorded in financial accounting. These items are listed below:
❌ Expenses Excluded from Cost Accounting
Items which recorded in Financial Accounting but excluded from Cost sheet are listed below:
· Donation,
· Income tax,
· Profit or loss on the sale of assets,
· Provision for income tax and bad debts, etc.,
· Transfer to reserves,
· Goodwill and intangible assets written off,
· Preliminary expenses,
· Discount of issue of shares and debentures,
· Dividend,
· Cash discount,
· Advance income tax,
· Debenture interest, interest on loan and overdrafts,
· Any income received,
· Over depreciation,
· Abnormal bad debt,
· Interest on capital,
· Capital losses,
· Fines and penalties,
· Discount allowed and received,
· Brokerage and underwriting commission,
· Guesthouse expenses and incomes,
· Sales Tax.
🧾 Expenses recorded in Cost accounting but Not in Financial Accounting
There are a few items which are shown in cost accounts only. All expenses incurred, whether for cash or on credit, appear in financial accounts. But there are some notional items which are shown in cost accounts only:
a) Interest on own capital: Such interest is never actually incurred, but is considered for the purpose of ascertaining cost. If the capital would have been employed in outside investment, some interest could have been earned. This interest is often regarded as an item of cost. This is termed as opportunity cost.
b) Rent of own building: Often rent of own building is considered as an item of cost in order to facilitate the comparison of the cost of production of a factory having own building with that of a factory occupying building on rent.
🔄 Meaning of Reconciliation of Cost and Financial Accounting
In a non-integral accounting system, cost accounts and financial accounts are maintained in two different sets of books and profits shown by both the system may not agree due to difference in both the accounting system. So, there is a need to reconcile the profit of both the sets of account. But under the integral system of accounting, where there are no separate cost and financial accounts, the problem of reconciliation does not arise.
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
a) It helps to find out the reasons for the difference in the profit or loss shown by both the accounting system.
b) It checks the arithmetical accuracy and reliability of cost accounts and financial accounts.
c) It contributes to the standardization of policies regarding stock valuation, depreciation and overheads.
d) More effective internal control can be exercised with the help of reconciliation statement.
📌 Reasons for Disagreement between Profits shows in Cost accounting and In financial 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 as mentioned above.
2) Items included in cost accounts only as mentioned above.
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, simple average etc. But, in financial accounts stocks are valued either at cost or market price, whichever is lower. The valuation of WIP may also lead to variation. In financial books WIP is valued at prime cost whereas in cost accounts, it may be valued at prime cost plus factory overhead.
5) Different basis of charging depreciation: The rates and methods of charging depreciation may be different in two sets of accounts.
📝 Preparation of Reconciliation Statement
A memorandum reconciliation
account is a type of account that is used to reconcile or adjust the profit or
loss as shown by cost accounting and financial accounting. It is used when
there are differences between the profit or loss as calculated using cost
accounting principles and the profit or loss as reported in the financial
statements.
To prepare a memorandum
reconciliation account, the company would first calculate the profit or loss
using cost accounting principles. This would involve identifying the cost of
goods sold, the gross profit, and the operating expenses. The company would
then compare this amount to the profit or loss as reported in the financial
statements.
If there are differences
between the two amounts, the company would use a memorandum reconciliation
account to reconcile the differences. For example, if the profit as calculated
using cost accounting principles is greater than the profit reported in the
financial statements, the company would debit the memorandum reconciliation
account and credit the profit and loss account for the difference. This would
adjust the profit and loss account to reflect the correct profit or loss as
calculated using cost accounting principles.
The memorandum
reconciliation account is typically a temporary account that is used to make
adjustments to the profit and loss account and is closed at the end of the
accounting period. It can be used to reconcile a variety of differences between
cost accounting and financial accounting, including differences in the
treatment of expenses, differences in the valuation of inventory, and
differences in the calculation of depreciation.
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
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 by 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.
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.
🧾 Important Questions – Unit 5
Important Questions for Upcoming Exams: job, Contract and Process Costing
Q. Explain the features, advantages and disadvantages of job costing.
Q. What is process costing? What are the fundamental principles of Process Costing? Point out the advantages and limitations of Process costing. 2019
- Preparation of process accounts together with normal, abnormal loss and abnormal gain account, preparation of profit and loss account and costing profit and loss account, treatment of process finished stock and stock of raw material in process accounts. Follow examples of BASU AND DAS COST ACCOUNTING BOOK. 2013, 2016, 2018
- Preparation of contract account