In manufacturing concerns where the system of cost accounting is reduced, it usually functions independently of financial account. When financial accounts aim at ascertainment of total profit of an enterprise cost accounting aims mainly at cost ascertainment, cost reporting, cost control and cost reduction. Hence, the approach of both systems differs and the profit or loss disclosed by cost accounts usually disagrees with that shown by the financial accounts. It is mainly due to difference in the basis of valuation of stock under or over absorption of overhead charges and items of expenses or incomes taken in one set of accounts only.
In order to check the correctness of accounts prepared by cost and financial accountants and to explain the causes for difference in profits, a statement is prepared at the end of the period either by cost accountant or by by financial accountant. Such a statement is called Profit Reconcilation. Statement is defined as “a statement prepared at the end of an accounting period either by the cost accountant or by the financial accountant in order to verify the correctness of cost and financial accounts as well as to explain the causes for disagreement in profits”.
Need for reconcilation of cost and financial profits :
- Reconciliation helps in checking the arithmetical accuracy of both the sets of accounts.
- It enables the managements to know the reasons for disagreement in profits.
- It enables in formulating uniform policies regarding valuation of stock, methods and basis of depreciation, overhead absorption, etc.
- It helps in facilitating internal control.
- It promotes coordination and cooperation between cost and financial sections of the accounting department.
- The cost data become more reliable.
Reasons for disagreement in profits.
The reasons for difference in profit or loss between cost and financial accounts may be broadly classified into the following.
1. Items appearing only in financial accounts.
Some items of expenses and incomes are taken only in financial accounts. They are not taken in cost accounts on the ground that they are non cost items and their inclusion in cost accounts might need to wrong wrong inference and unwise managerial decisions. These items are :
i. Purely financial charges.
- loss, on sale of investments and other assets.
- preliminary expenses written off.
- goodwill written off.
- discount on issue of debentures and shares.
- loss due to destruction and scraping of assets
- interest on mortgages and loans
- fines, penalties and damages payable
- charitable donations
- remuneration to proprietor in excess of a fair reward for services rendered
- bad debts written off, discount allowed, etc.
ii. Purely Financial Incomes :
- profit on sale of assets.
- interest and dividend recieved
- discount, commission, brokerage, etc. recieved
- bad debts recovered
- transfer fees received
- rent recievable
- discount allowed to customers, but later on disallowed
iii. Appreciation of Profits
- dividend paid
- transfer to reserves
- taxes on profit
- additional provision for depreciation
- capital expenditure specifically charged to revenue.
2. Items appearing only in cost accounts
There are some notational charges made by cost accountant. These are charges made in cost accounts though not payable by the concern. If such charges are not made in the cost accounts, the cost per unit of the concern will be comparatively lower than those concerns where such payments are to be made. Such items of charges are :
a) Notional interest on capital i.e, interest charged in the profit and loss account, though there is sufficient amount of owned fund and no interest is payable on it.
b) Notional rent on owned premises.
c) Salary for the proprietor where he works in the business but do not have to pay.
3. Adoption of different basis of stock valuation.
There need not necessarily be uniformity in the basis and method of stock valuation. Cost accountant may follow one system where is financial accountant may follow some other systems.
Cost accountant may value finished goods at cost of production or works cost, where as, the financial accountant values it at total cost all market value whichever is lower. Value of raw material depends on whether FIFO or LIFO or average method is adopted. Work-in-progress may be valued at Prime cost or works cost level. Thus, due to difference in valuation of stock, the profit of the two sets of book vary.
4. Under or Over absorption of overheads.
In cost accounting, the recovery of overheads is always based on estimates a predetermined ratios. It may usually be certain percentage on Prime cost, works cost, sales, etc. In financial accounts actual expenses of overheads are recorded with the result that there is either under recovery or over recovery of overheads in cost accounts. If the overhead recovered in cost accounts is less than the actual amount of overhead charged in financial accounts it is called under absorption. On the other hand, if the amount recovered in cost books is more it is called over absorption. The under recovery or over recovery of overheads may be transferred to costing profit and loss account or maybe be carried to the next period. If these differences are written off to costing profit and loss account the profit will agree, otherwise, adjustment will have to be made on this account. In some concerns, administrative and selling distribution overheads are ignored leading to greater profit in cost accounts.
6. Abnormal losses and gains taken only in one set of books.
Abnormal items such as loss of materials by fire or theft, cost of abnormal idle facilities, abnormal gains in units of production, etc. might be recorded only in one set of books leading to disagreement between profits.
Effects in profits of the items causing difference.
The different items discussed about cause either to increase or decrease the profit of one set of books. If financial profit is more due to the effects of an item, the costing profit will be less by the same amount than the financial profit. The effects of different items on costing profit are discussed below:
a. Purely financial charges : these are the expenses taken only in financial accounts. As these expenses are not taken in cost books, the costing profits will be more than the financial profit.
b. Purely financial incomes : these are the incomes taken only in financial books. As these incomes do not appear in the cost books, profit will be less than the financial profit.
c. Appropriation of profits : appropriations are made in financial accounts only after preparing the profit and loss account. In order to study the effect, we should see whether the financial profit available is one before or after the Appropriations. If the profit given is that before the appropriations, such items has no effect in the given financial profit. If the profit given is after appropriations the profit of cost account would be more by the amounts of appropriations.
d. Items appearing in cost accounts only : these being the notional charges made only in cost accounts, the costing profit would be less than the financial profit.
e. Difference in stock valuation : more value on closing stock will lead in more profit and more value on opening stock will lead to lesser amount of profit and vice versa. If value of closing stock is more in cost accounts, the costing profit will be more than the financial profits. If the value of opening stock in cost accounts is more, the profit of cost accounts will be less than the financial accounts.
f. Under or over absorption of overheads : under or over absorption takes place in cost accounts. If an overhead absorbed in cost accounts is less, the costing profit will be more. If the absorbed amount is more, the costing profit will be less.
g. Difference in depreciation : depreciation is an expensive item. If depreciation charged in one set of books is less, the profit of that said will be more.
h. Abnormal losses and gains : profit of the book in which abnormal loss is charged will be less than that of the Other books. If abnormal gain is credited in one book only, the profit of that book will be more than the other set.
Procedure of Reconcilation
Reconciliation of cost and financial profit is made by preparing a reconcilation statement or memorandum reconciliation account. Statement may be prepared:
i. Starting with profit as per cost accounts.
ii. Starting with profit as per financial accounts.
iii. Starting with loss as per cost accounts.
iv. Starting with loss as per financial accounts.
This statement is prepared by starting with profit or loss of cost or financial books as the case may be. To the ‘starting’ or ‘base’ profit or loss, adjustment Sameer while adding or deducting amounts on the basis of reasons to arrive at the amount of profit or loss of the Other set of books. Is costing profit is chosen on the base profit, the profit to be found out would be that of financial accounts and vice versa.
If a given reason had led to increase in base profits the amount should be deducted on the contrary if a given item has led to, a reduction in base profit it should be added. The following steps can be taken to prepare reconcilation statement.
1. Ascertain the various items and amounts caused for disagreement in profits.
2. If cost and profit is taken as the base:
i. Income credited to financial accounts only.
ii. Notional charges in cost accounts only.
iii. Value of closing stock taken more in financial accounts.
iv. Value of opening stock taken less in financial accounts.
v. Overheads charged more in cost accounts.
vi. Depreciation charged less in financial accounts.
vii. Abnormal gains taken only in financial accounts.
i. Items of expenses charged only in financial account.
ii. Under absorption of overhead in cost accounts.
iii. Excess depreciation in financial accounts.
iv. Closing stock valued less in financial books.
v. Opening stock valued more in financial books.
vi. Any abnormal loss recorded in financial accounts only.
vii. Appropriation made in financial books.