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Reconciliation of Cost and Financial Accounting | Expenses Excluded From Cost Accounts | Expenses Shown in Cost Accounts Only

Reconciliation of Cost and Financial Accounting


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.

Table of Contents of This Article

1. Branches of Accounting

2. Follow up of both cost and financial accounting system

3. Relationship between cost and financial accounting system

4. Profits of Cost accounting is different from profit as shown by financial accounting

5. Expenses excluded from cost accounting

6. Expenses recorded in Cost accounting but not recorded in financial accounting

7. Reconciliation of Cost and Financial Accounts – Meaning

8. Reasons for Reconciliation of Cost and Financial Accounts

9. Preparation of Reconciliation statement or Memorandum Reconciliation Account

10. Comprehensive Video on Reconciliation Statement

 

Follow up of Both Cost and Financial accounting system

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.

Profits of Cost accounting is different from profit as shown by 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 recorded 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.

Reconciliation of Cost and Financial Accounts

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 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 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 ON RECONCILIATION STATEMENT OR MEMORANDUM 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.

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.

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