In this article we will discuss about:- 1. Introduction to Reconciliation 2. Objects or Need for Reconciliation 3. Reasons for Disagreement in Profit or Loss 4. Method for Preparing Reconciliation Statement 5. Reconciliation Statement 6. Memorandum Reconciliation Account.
Contents:
- Introduction to Reconciliation
- Objects or Need for Reconciliation
- Reasons for Disagreement in Profit or Loss
- Method for Preparing Reconciliation Statement
- Reconciliation Statement
- Memorandum Reconciliation Account
1. Introduction to Reconciliation:
When a concern maintains separate sets of books for costing and financial purposes, the profit or loss shown by the cost accounts may not agree with the profit or loss shown by financial accounts for many reasons, though both the sets of accounts are prepared with the help of the same basic documents. Therefore, it becomes necessary that profit or loss shown by the two sets of accounts is reconciled.
In the words of H. G. Wheldon, “No system is complete unless it is linked up with the financial accounts, that results shown by both cost and financial accounts may be reconciled.” So the reconciliation of the profits or losses shown by the two sets of accounts is absolutely necessary.
ADVERTISEMENTS:
It is important to note that the question of reconciliation of cost and financial accounts arises only under non-integral system. However, under the integral accounts, since cost and financial accounts are integrated into one set of books and only one Profit and Loss Account is prepared, the problem of reconciliation does not arise.
2. Objects or Need for Reconciliation
:
It is true that, for some reason or the other, the profit or loss shown by the cost accounts differs from the profit or loss shown by the financial accounts. But the question is why should the profit or loss shown by the cost accounts be reconciled with that shown by the financial accounts. It is true that for the purpose of the Balance Sheet, it is the profit or loss as per financial accounts that holds good, whether there is reconciliation or not.
But the reconciliation of the results shown by the two sets of books is necessary for the following reasons:
ADVERTISEMENTS:
(1) To Ensure Reliability of Cost Accounts:
The correct ascertainment of cost of production in cost accounts depends upon proper analysis, allocation, apportionment and recording of costs. If these steps are incorrect, naturally the cost of production will be incorrect. Reconciliation with financial accounts help in checking the reliability of cost accounts.
(2) To Check the Arithmetical Accuracy of Cost Accounts:
Sometimes, some transactions in cost accounts are ignored while recording. Sometimes some items would have been wrongly recorded. This again is responsible for inaccurate results. So to check the arithmetical accuracy of cost accounts, reconciliation is necessary.
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(3) To Reveal the Variation:
Reconciliation reveals the reasons for difference in profit or loss between cost and financial accounts and the information about the reasons for the variation in results facilitates internal control.
3. Reasons for Disagreement in Profit or Loss
:
Difference in profit or loss between cost and financial accounts may arise due to the following reasons:
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1. Difference in Expenses:
Expenses like factory overheads, office overheads and selling and distribution expenses are shown in Cost Accounts at estimated price and whereas, in Financial Accounts at actual price. Under such a condition it is common to arise difference between the results if two lets of accounts.
Effects of Difference on Costing Profit:
If any overhead is undercharged in Cost Accounts in comparison to Financial Account, to the extent of difference in amount costing profit will increases on the other hand, if any overhead is over-recorded in Cost Accounts, costing profit will come down to the extent of difference in account.
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2. Items of Expenses included in the Financial Accounts but not in Cost Accounts:
There are a number of items which appear in financial accounts and not in cost accounts. While reconciling any items tinder this category must be considered.
These items are classified into three categories as under:
Purely Financial Charges:
ADVERTISEMENTS:
Under this category the following charges are considered:
(i) Interest on capital,
(ii) Expenses incurred for raising capital,
(iii) Donations,
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(iv) Loss by Obsolescence,
(v) Loss by fire or accident,
(vi) Goodwill written off,
(vii) Preliminary expenses written off,
(viii) Commission on issue of shares and debentures,
(ix) Loss on sale of fixed assets or capital assets,
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(x) Debit balance of P/L Account written off,
(xi) Excess provision for depreciation,
(xii) Discount on bonds, debentures, etc.
(xiii) Interest paid on overdraft, debenture, etc.
(xiv) Damages payable at Law,
(xv) Penalties payable at Law,
(xvi) Losses due to fire, flood, theft, pilferage, etc.
(xvii) Loss on sale of investments,
(xviii) Cash discount allowed,
(xix) Damages paid for delay in execution of contract,
(xx) Commission to partners and managing agents,
(xxi) Capital expenditure.
(xxii) Income Tex Paid,
(xxiii) Dividend Paid.
Effects on Costing Profit:
Such expenses or losses which are of purely financial nature and hence have been shown only in Financial Accounts and not in Cost Accounts, costing profit will increase to that extent as compared to financial profit.
3. Items of Incomes not included in Cost Accounts:
There are certain items of income which are shown in Financial Accounts and not in Cost Accounts.
As a result, costing profits decrease to that extent those items of income are:
A. Purely Financial Incomes:
Under this category of income the following items of income are included:
(i) Interest received on bank deposits,
(ii) Interest received on loan granted to others,
(iii) Interest and dividend received on investments,
(iv) Cash discount received,
(v) Rent received on building let out,
(vi) Damages received,
(vii) Brokerage received,
(viii) Commission received,
(ix) Share Transfer fees received,
(x) Profit on sale of investments,
(xi) Profit on sale of fixed assets,
(xii) Windfall gain,
(xiii) Capital Profit,
(xiv) Casual Income.
Effects on Costing Profit:
Such items of incomes and gains which are of purely financial nature and hence have been shown only in Financial Accounts and not in Cost Accounts, costing profit will decrease to that extent as compared to financial profit.
B. Appropriation of Profits:
This includes the following items:
(i) Dividend paid,
(ii) Income tax,
(iii) Bonus paid out of profits,
(iv) Transfer to general reserve,
(v) Creation of Depreciation Fund, Sinking Fund, Dividend Equalisation Fund, Workmen’s Compensation Fund, Investment Fluctuation Fund, etc.
Effects on Costing Profit:
Any item of appropriation of profit which has been taken into consideration in Financial Accounts to that extent costing profit will increase as compared to financial profit.
4. Different Bases of Stock Valuation:
In cost accounts stock are valued according to the method adopted in stores accounts i.e., FIFO, LIFO, etc. On the other hand, valuation of stock in financial accounts is invariably based on the principle of cost or market price, whichever is less. Different stock values result in some difference in profit or loss shown by the two sets of account books.
Effects on Costing Profit:
(a) Opening Stock:
If in Cost Accounting, opening stock is under-valued as compared to Financial Accounts to that extent costing profit will increase and vice-versa.
(b) Closing Stock:
If in Cost Accounting, closing stock is overvalued as compared to Financial Accounts to that extent costing profit will increase and vice-versa.
5. Different Charges for Depreciation:
The rates and methods for charging depreciation may be different in cost and financial accounts. The financial accounts may follow straight line or diminishing balance method, etc., whereas in cost accounts machine hour rate, production unit method, etc. may be adopted. This will also cause a difference in the profit or loss figures.
Effects on Costing Profit:
If the amount of depreciation is shown in excess in Cost Accounting as compared to Financial Accounting to the extent of difference costing profit will decrease and vice-versa.
6. Under or Over-Absorption of Overheads:
In cost accounts overheads are recovered at a pre-determined rate whereas in financial accounts these are recorded at actual cost. This may give rise to a difference between overheads absorbed in cost and actual overhead cost incurred. Such difference should be written off to Costing Profit and Loss Account.
However, when under or over-absorbed overheads are not written off to Costing Profit and Loss Account, it results in the amount recovered in cost accounts being different from the actual amount shown in financial accounts. In such a case, it becomes necessary to take into account this under or over-absorption while reconciling the two accounts.
Effects on Costing Profit:
If any overhead is shown in excess in Cost Accounting as compared to Financial Accounting, to the extent of difference costing profit will decrease and vice-versa.
7. Different Base of Work-in-Progress Valuation:
Under cost accounts, Work-in-progress is valued either at the stage of prime cost, works cost or cost of production. But in financial accounts, the basis followed may be quite different than that followed in cost accounts. This difference in the method of valuing Work-in-progress gives rise to preparation of reconciliation statement.
Effects on Costing Profit:
There will be same effect as in the case of stock.
Notional Charges:
(a) Rent of Own Business Premises Used for the Business:
When a concern carries on business in its own premises, it need not pay any rent for those premises, and so, the rent of own premises will not appear in the financial accounts. But the rent of own business used for the business enters into the cost of production. So a reasonable amount by way of rent may be included in cost accounts. Such a rent is called notional rent.
(b) Interest on Own Capital Used for the Business:
When a concern uses its own capital for the business, it need not pay any interest on that capital. So the interest on own capital may not be appear in the financial accounts. The interest on own capital used for the production enters into the cost of production. So sometimes, a reasonable amount by way of interest on capital may be included in the cost accounts. Such an interest is called notional interest.
Effects on Costing Profit:
Rent of own business premises used for the business is not considered in Financial Accounts but is included in cost in Cost Accounting and hence, costing profit is decreased to that extent as compared to financial profit.
4. Method for Preparing Reconciliation Statement
:
The cost and financial accounts are reconciled by preparing a Reconciliation Statement or a Memorandum Reconciliation Account.
The following procedure is adopted for preparing a Reconciliation Statement:
(1) Ascertain the reasons of difference between cost accounts and financial accounts.
(2) Start with the profit as per Cost Account.
(3) (a) Regarding Items of Expenses and Losses:
Add: Items over-charged in cost accounts
Less: Items under-charged in cost accounts
Example:
Depreciation in cost accounts Rs. 3,000 and that in financial accounts is Rs. 3,500. This has the effect of increasing costing profit by Rs. 500 as compared to financial profit, because the amount of depreciation in cost accounts has been under shown by Rs. 500 (3,500 – 3,000) and as a result costing profit will increase by Rs. 500. Then in order to reconcile Rs. 500 will be deducted from costing profit.
(b) Regarding Items of Income and Gains:
Add: Items under-recorded or not recorded in cost accounts
Less: Items over-recorded in cost accounts
Example:
Interest on investments received amounting to Rs. 2,000 is not recorded in cost accounts. This will have the effect of reducing costing profit by Rs. 2,000. Then in order to reconcile, this amount of Rs. 2,000 for interest should be added in the costing profit.
Note: If there is financial item of an income (such as, interest on investment) which has not been recorded in financial account, in such a case, no reconciliation is required.
(c) Regarding Valuation of Stock:
(i) Opening Stock:
Add: Amount of over-valuation in cost accounts
Less: Amount of under-valuation in cost accounts
(ii) Closing Stock:
Add: Amount of under-valuation in cost accounts
Less: Amount of over-valuation in cost accounts
(4) After making all the above additions and deductions in costing profit, the resulting figure shall be the profit as per financial books.
Note:
The above treatment of items will be reversed when the starting point in the Reconciliation Statement is the profit as per financial accounts or loss in place of profit or loss as per cost accounts.
5. Reconciliation Statement
:
A ‘Reconciliation Statement’ is required to be prepared on the same likes, on which a ‘Bank Reconciliation Statement’ is prepared in the financial books to tally the pass book balance with the cash book balance. In other words, the statement which is prepared to tally the results shown by Cost Accounts and Financial Accounts is known as Reconciliation Statement.
6. Memorandum Reconciliation Account:
This is an alternative to Reconciliation Statement. The only difference is that the information shown in Reconciliation Statement is shown in the form of an account. The profit as per cost account is the starting point on the credit side of this account.
All items which are added to costing profit for reconciliation are also shown on credit side. The items to be deducted from costing profit for reconciliation are shown on the debit side. The balancing figure is the profit as per financial accounts. It is only a memorandum account and does not form part of the double entry books of accounts.
