Introduction of Reconciliation of Cost and Financial Accounts
Cost accounts are maintained independent of financial accounts. These two accounts have different aims to fulfill. In the financial account, expenses are recorded in a subjective form, that is, according to their nature in a strict sense of the term. On the other hand, the cost accounts are kept in an objective form, that is, according to their purpose. Their results also differ. It is, therefore, natural that difference in profits may arise and the two accounts (cost and financial) may not show the matching results. It is necessary, because of such difference, to reconcile the results of two accounts. The reconciliation also helps us to test the reliability of the accounts.
In a business concern, cost accounts and financial accounts can be maintained on the basis of a non-integral system or integral system of accounting. Under the non-integral system of accounting, cost accounts and financial accounts are maintained separately. Cost accounts are maintained by Cost Accountant as per the principles of cost accounting to ascertain the total and per-unit cost of products and jobs at different stages of production or execution.
Financial accounts are maintained by a financial accountant as per the principles of financial accounting to record the day-to-day transactions of a business with a view to find out their net effect on the profitability and financial position of the business. Thus, the aims, objects, principles and the methods of maintaining cost accounts and financial accounts are not the same. As such, the profit shown by cost accounts may not agree with the profit shown by financial accounts. The conflicting information provided by these two sets of accounts may not be helpful in taking correct policy decisions.
Thus, the system of costing should be capable of reconciliation with financial accounts. Since the cost accounts, largely dependent upon estimates, comprise a detailed analysis of financial expenditure and unless such analysis is reconciled with financial accounts, cost accounts cannot be relied upon. In this connection, H.J. Wheldon is of the opinion that “no system is complete unless it is linked up with financial accounts so that the results shown by both cost and financial accounts may be reconciled.”
Meaning of Reconciliation
Reconciliation may be expressed as the process of tallying the working results or profits as shown by cost accounts with that of financial accounts. 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. Efforts are also made to judge the arithmetical accuracy of the profits revealed by two different sets of books.”
Thus, reconciliation of cost and financial accounts involves the process of identifying and accounting for the items which have led to the difference in working results as shown by cost accounts and financial accounts. The reconciliation is made in an analytical form presented in the shape of a statement (known as Reconciliation Statement) or a memorandum account (known as Memorandum Reconciliation Account).
Need for Reconciliation of Cost and Financial Accounts
Since both cost and financial accounts are maintained independently and in fact their purpose and accounting procedure also differ, it is natural, therefore, that the profit or loss shown by one set of accounts may differ from another set of accounts. The two sets of accounts are to be reconciled in order to know the correct result and test the reliability of cost accounts.
The need for reconciliation of cost and financial accounts is there because the management is interested in:
- Finding out the reasons for the difference.
- Ensuring that no income or expenditure item has leftover.
- Ensuring that no under or over the recovery of overheads are made.
- Assuming that there is accuracy in cost analysis, distribution and allocation.
- Seeing through that costing figures in total with the financial records.
- Testing the reliability of cost figures.
Causes of disagreement of results shown by cost accounts and financial accounts
Under the non-integral system of accounting, when cost accounts and financial accounts are maintained separately, the documents used for ascertaining the amount of expenditure to be charged in respect of some of the items, are the same (e.g., cost of materials used and the cost of labour paid are to be ascertained with the help of Material Requisitions and Wages Sheets respectively), yet there may arise a difference in the profit (or loss) as shown by the two sets of accounts, due to one or more of the following reasons:
1. Under/Over-Absorption of Overhead: The financial accounts comprise the actual expenditure in respect of the factory, office, administration, and selling and distribution overheads whereas the cost accounts comprise an approximate charge in respect of these items on the basis of past records or pre-determined absorption rate. As such, overheads are generally under/over-absorbed in cost accounts.
2. Items of Receipts/lncome shown in Financial Accounts Only: The following items of receipts and income are shown or included in financial accounts but excluded from cost accounts:
- Interest and discount received.
- Rent received.
- Dividend received.
- Commission received.
- Transfer fees received.
- Profit from the sale of fixed assets and investments.
3. Items of Expenses/Losses Shown in Financial Accounts Only: The following items of expenses and losses are charged in financial accounts but are not shown in cost accounts:
- Interest allowed on loan.
- Interest on capital.
- Cash discount allowed.
- Interest paid on debentures.
- Expenses and losses on issue of shares and debentures.
- Loss on sale of fixed assets and investments.
- Items of appropriation of profit i.e., income tax paid or provision for income tax, transfer to reserves, dividends paid on shares, etc.
- Preliminary expenses written off.
- Goodwill written off.
- Donations and charity paid.
4. Items of Abnormal Profit/Loss Included in Financial Accounts Only: There are various items of abnormal profit/loss which are included in financial accounts but are excluded from cost accounts. These items are:
- Cost of abnormal loss of materials.
- Cost of abnormal idle time of workers.
- Cost of abnormal saving of materials.
- Exceptional bad debts.
- Penalties and fines paid for violation of Government rules and regulations.
5. Items of Expenses included in Cost Accounts only: The following items of expenses are recorded in cost accounts only and are not considered in financial accounts:
- Notional rent for owned premises.
- Depreciation on assets which do not carry any book value in financial accounts.
6. Difference in the Basis for Charging Depreciation on Assets: The methods for calculating depreciation on fixed assets in cost accounts and financial accounts may differ leading to a difference in working results. In financial accounts, depreciation is generally provided on the basis of diminishing balance (written-down value) method or original cost method. But in cost accounts, machine hour rate or production unit method of depreciation may be followed.
7. Difference in Bases for Valuation of Stock: The stock of raw material in financial accounts is valued at cost price or market price, whichever is less, while in cost accounts, it is valued by adopting any of the methods like FIFO, LIFO, AVERAGE price methods, etc. The stock of work-in-progress for the purpose of cost accounts may be valued on the basis of prime cost or factory cost while in financial accounts, it is valued by taking into account, a part of office and administration expenses. The stock of finished goods in financial accounts is valued on the basis of cost price or market price, whichever is less, while in cost accounts, it is valued on the basis of the actual cost.
Reconciliation of costing and financial results
Where there is a difference between the results of working as disclosed by cost accounts and as disclosed by financial accounts, the following steps should be taken to locate the reasons for such difference :
1. The extent of the difference between actual indirect expenses as recorded in financial accounts and the charges made in cost accounts should be ascertained.
2. A schedule of all expenses and losses which have been included in the Trading and Profit and Loss Account but not in cost accounts should be prepared.
3. A schedule of all income and profit which have been credited to Profit and Loss Account but excluded from cost accounts should be prepared
4. A schedule of all items which have been included in cost accounts but excluded from financial accounts should be prepared.
5. The basis on which stocks of raw materials, work-in-progress and finished goods have been valued for balance sheet purposes must be ascertained and compared with the valuations appearing in cost accounts and their difference must be ascertained.
6. Lastly, all items which have been included in cost accounts as well as financial accounts but differ in value should be ascertained.
After the discrepancies have been located, a Reconciliation Statement should be prepared by starting with profit as disclosed by cost accounts. The following items should then be added to the profit as per cost accounts :
- Indirect expenses (factory, office and administration and selling and distribution) over-absorbed or over-recovered in cost accounts or under-absorbed in financial accounts.
- Items of receipts shown in the financial books but not in cost accounts.
- Over-valuation of opening stock (of raw material, work-in-progress or finished goods) in cost accounts.
- Under-valuation of closing stock (of raw material, work-in-progress or finished goods) in cost accounts.
- Items of abnormal efficiency (abnormal saving) shown in financial books but not in cost accounts.
The following items should be deducted from profit as per cost accounts:
- Under-absorption of indirect expenses in cost accounts or over-absorption in financial accounts.
- Items of expenses shown in the financial accounts but not in cost accounts.
- Under-valuation of opening stock (of raw material, work-in-progress or finished goods) in cost accounts.
- Over-valuation of closing stock in cost accounts.
After making the above adjustments, the profit as per cost accounts will agree with the profit as per financial accounts.
Specimen of Reconciliation Statement of Cost and Financial Accounts
Profit disclosed by a company’s cost accounts for the year was $50,000 whereas the net profit as disclosed by the financial accounts was $46,000. The following information is available:
(a). Overheads as per cost accounts were estimated at $55,555. The charge for the year shown by the financial accounts was $50,000
(b). Director’s fees shown in financial accounts only $1,000
(c). The company allocated $2,000 as provision for doubtful debts.
(d). In financial accounts, depreciation was charged more in comparison with cost accounts by $3,000
(e). Share-transfer fees received during the year $445
(f). Provision for Income tax was Rs. 4,000
From the above, prepare a statement reconciling the figures shown by the cost and financial accounts.