NEED FOR RECONCILIATION
The two systems of accounting viz. financial and cost accounts co-exist in the same organisation and they deal with same basic transactions say, purchases, consumption of materials, wages and other expenses. But the difference of purpose calls for a difference in approach in collection, analysis and presentation of data to meet the objective of 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 provided for ascertaining the profit or loss made by manufacturing or product divisions/products for cost comparison and preparation and use of variety of cost statements.
The difference in purpose and approach more often than not results in a different profit from what is disclosed by the financial accounts and this establishes the need for a reconciliation of profit between cost accounts and financial accounts due to following reasons only in case of Non – Integrated system.
- 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 ensures 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.
CAUSES OF DIFFERENCES
The vital differences between the two branches of accounting are manifested in the variation of the profit figure of one from the other through the cumulative impact of the following factors:s
- ITEMS SHOWN ONLY IN FINANCIAL ACCOUNTS
There are certain items which are included in financial accounts but find no place in cost accounts. These may be items of income or expenditure or appropriation of profit:
(A) PURELY FINANCIAL CHARGES:
(i) Loss on sale of fixed assets/ investments. (ii) Discount on issue of shares. (iii) Interest on bank loan, mortgages, debentures etc. (iv) Expenses of the company’s share transfer office. (v) Damages payable. (vi) Penalty and fines. (vii) Losses due to scrapping of machinery. (viii) Remuneration paid to the proprietor in excess of a fair reward for services rendered.
(B) PURELY FINANCIAL INCOME:
(i) Profit made on sale of investments, fixed assets etc. (ii) Interest received on bank deposits. (iii) Transfer fees received. (iv) Interest, dividends etc. received on investments. (v) Brokerage, discount & commission received. (vi) Rent receivable, (when rent is receivable from subletting part of business premises – then it can also be included in cost accounts).
(C) APPROPRIATION OF PROFITS:
(i) Donations and charities paid. (ii) Taxes on income and profits. (iii) Dividend paid. (iv) Transfer to reserves and sinking fund. (v) Additional provision for depreciation of building, plant etc. and for bad debts. (vi) Amount written off as goodwill, preliminary expenses, underwriting commission, discount on debentures issued, organization expenses etc. (vi) Capital expenditure; specifically charged to revenue.
- ITEMS INCLUDED IN COST ACCOUNTS ONLY
(i) Interest on capital employed in production but upon which no interest is actually paid. It is included in cost books in order to show the nominal (notional) cost of employing the capital rather than investing it outside the business.
(ii) Charge in lieu of rent where premises are owned.
(iii) Depreciation on asset even when the book value of the asset is reduced to negligible figure or nil.
(iv) Salary of the proprietor where he works but does not charge salary.
III. OVER OR UNDER ABSORPTION OF OVERHEADS
- In cost accounts, recovery of overheads is based on an estimate or pre-determined ratio e.g. percentage on prime cost or material cost or labour cost etc. which may be more or less than the actual amount incurred.
- In financial accounting the actual expenses of overheads are recorded.
- If overheads are not fully absorbed i.e. the amount in cost accounts is less than the actual amount, the short fall is called under absorption.
- On the other hand, if overhead expenses in cost accounts are more than the actual, it is called over-absorption.
- This under or over absorption of overheads leads to difference in two sets of accounts.
- The under recovery or over recovery of overheads may be carried forward to the next period or may be charged by a supplementary rate (positive or negative) or transferred to costing profit and loss account.
- In case, the under recovery or over recovery of overheads has been carried forward to the next period, the profit as shown by the cost accounts will be different from the profit as shown by the financial books and adjustments will have to be made on this account.
- Some cases, selling and distribution expenses are ignored in cost accounts and as such costing profit will be higher and thus requiring reconciliation.
- ADOPTION OF DIFFERENT BASIS OF VALUATION OF STOCK
(a) Raw Material: In financial accounts, stocks 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.
(b) 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.
(c) 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 METHODS OF CHARGING DEPRECIATION
The methods of charging depreciation may be different in cost books as well as in financial books. The method of providing depreciation under financial accounting is totally governed by Companies Act or tax provisions so that diminishing balance method or fixed instalment method is generally followed. However in cost accounts machine hour rate or production hour or unit method may have been followed.
- ABNORMAL GAINS AND LOSSES
Abnormal gains or losses may completely be excluded from cost accounts or may be taken to costing profit and loss account. If it is excluded, costing profit/loss will differ from financial profit/loss and adjustment will be required.
In case, if these are transferred to costing profit and loss account, the profit or loss shown by cost accounts will agree with the profit or loss of financial accounts. In such a case no adjustment will be required.
Examples of such abnormal gains and losses are, abnormal wastage of materials by theft or fire etc., cost of abnormal idle time, cost of abnormal idle facilities, exceptional bad debts, abnormal gain in manufacturing through processes etc.
PREPARATION OF RECONCILIATION STATEMENT OR MEMORANDUM RECONCILIATION ACCOUNT
A Reconciliation Statement or a Memorandum Reconciliation Account should be drawn up for reconciling profits shown by two set of books. Results shown by any set of books may be taken as the base and necessary adjustments 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 same as done for Bank Reconciliation System:
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
- Ascertain the various reasons of disagreement (as discussed above) between the profits disclosed by two sets of books of accounts.
- If profit as per cost accounts (or loss as per financial accounts) is taken as the base.
(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.
III. 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 above shall be deducted and items to be deducted shall be added i.e. the procedure discussed above shall be reversed.
MEMORANDUM RECONCILIATION ACCOUNT
It is basically presentation of Reconciliation Statement in T format. It is not a part of double entry system because all items posted to this account do not have corresponding debits / credits in books of accounts.