Reconciliation of Cost Accounts and Financial Accounts
Cost accounts are maintained independently of financial accounts because the two accounts have different aims, namely:
- Financial accounts record expenses in a subjective form according to their nature
- Cost accounts maintain an objective form according to their purpose
The results of these accounts also differ, meaning that contrasting profits and results may arise. Such differences require reconciliation between the results, which also helps test the reliability of the accounts.
Businesses maintain cost accounts and financial accounts based on a non-integral system or integral system of accounting. The non-integral system sees cost accounts and financial accounts maintained separately.
A cost accountant maintains cost accounts 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.
Meanwhile, a financial accountant maintains financial accounts as per the principles of financial accounting to record day-to-day transactions and find out their net effect on the profitability and financial position of the business.
Thus, the aims, objects, principles, and methods of maintaining cost accounts and financial accounts differ, meaning the profits shown by the accounts may not align.
The conflicting information provided by these two sets of accounts may not help organizations make correct policy decisions. Thus, the system of costing should be capable of reconciliation with financial accounts.
Cost accounts depend upon estimates and comprise a detailed analysis of financial expenditure: failure to reconcile such analysis with financial accounts makes cost accounts unreliable.
In this connection, H.J. Wheldon posits 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.”
Reconciliation represents the process of tallying the working results or profits as shown by cost accounts with those 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 an agreement. Efforts are also made to judge the arithmetical accuracy of the profits revealed by two different sets of books.”
Thus, reconciliation identifies and accounts for the items which have led to the difference in working results as shown by cost accounts and financial accounts. The reconciliation occurs in an analytical form presented in the shape of a statement (known as the reconciliation statement) or a memorandum account (known as the memorandum reconciliation account).
Why Reconcile Cost Accounts and Financial Accounts?
Since both cost and financial accounts are maintained independently and have different purposes and accounting procedures, the profit or loss shown may also differ.
Thus, reconciling the two sets of accounts will help to determine the correct results and, at the same time, test the reliability of cost accounts.
The reconciliation of cost and financial accounts can help a company’s management personnel in the following ways:
- Identify the reasons for differences
- Ensure no leftover income or expenditure items
- Ensure the recovery of overheads are neither under nor over
- Assume there is accuracy in cost analysis, distribution, and allocation
- Align costing figures with financial records
- Test the reliability of cost figures
Causes of Disagreement of Between Cost Accounts and Financial Accounts
Under the non-integral system of accounting, which maintains cost accounts and financial accounts separately, the documents used to ascertain the amount of charged expenditure are the same.
For instance, material requisitions and wages sheets help determine the cost of materials used and labor paid.
However, differences may arise in the profits or losses shown by the two sets of accounts. These differences are typically attributable to one or more of the following reasons:
1. Under/overabsorption of overhead: Financial accounts show a firm’s actual expenditure (e.g., factory or office expenses), whereas cost accounts show an approximate charge in respect of these items based on records or the predetermined absorption rate.
2. Items of receipts/income 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 not shown in cost accounts:
- Interest allowed on loans
- Interest on capital
- Cash discount allowed
- Interest paid on debentures
- Expenses and losses on the 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, and dividends paid on shares
- Preliminary expenses and goodwill write-offs
- Donations and charity paid
4. Items of abnormal profit/loss included in financial accounts only: These various items of abnormal profit/loss are included in financial accounts but excluded from cost accounts:
- Cost of abnormal loss of materials
- Cost of workers’ abnormal idle time
- 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: These items of expenses are recorded in cost accounts only:
- Notional rent for owned premises
- Depreciation on assets that 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.
Financial accounts offer depreciation based on the diminishing balance (written-down value) method or original cost method. However, cost accounts may follow the machine hour rate or production unit method of depreciation.
7. Difference in bases for valuation of stock: Financial accounts value the stock of raw material at cost price or market price, whichever is less, while cost accounts value the stock by adopting methods such as FIFO, LIFO, and average price methods.
The stock of work-in-progress for cost accounts may be valued based on prime cost or factory cost. Financial accounts make valuations by taking office and administration expenses into account.
- The stock of finished goods in financial accounts is valued based on cost price or market price, whichever is less, while cost accounts make valuations based on the actual cost
Reconciliation of Costing and Financial Results
When differences are identified between the results in cost accounts and financial accounts, the following steps should be undertaken to identify the cause:
1. Ascertain the extent of the difference between indirect expenses as recorded in financial accounts and the charges made in cost accounts.
2. Prepare a schedule of all expenses and losses included in the trading and profit and loss account but not in cost accounts.
3. Prepare a schedule of all income and profit credited to the profit and loss account but excluded from cost accounts.
4. Prepare a schedule of all items included in cost accounts but excluded from financial accounts.
5. Ascertain the basis on which stocks of raw materials, work-in-progress, and finished goods have been valued for balance sheet purposes, and then compare it with the valuations in the cost accounts. In turn, determine the difference.
6. Ascertain all items included in cost accounts and financial accounts, even if they differ in value
7. After locating the discrepancies, prepare a reconciliation statement by starting with profit as disclosed by cost accounts. Next, add the following items 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
- Overvaluation of opening stock in cost accounts (raw materials, work-in-progress, or finished goods)
- Undervaluation of closing stock in cost accounts (raw materials, work-in-progress, or finished goods)
- Items of abnormal efficiency (abnormal savings) are shown in the financial books but not in cost accounts
8. Deduct the following items 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
- Undervaluation of opening stock (of raw material, work-in-progress, or finished goods) in cost accounts
- Overvaluation 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 disclosed by the financial accounts amounted to $46,000. According to the following information:
- Estimations placed overheads as per cost accounts at $55,555, and the charge for the year shown by the financial accounts was $50,000
- The director’s fees shown in financial accounts amounted to only $1,000
- The company allocated $2,000 as a provision for doubtful debts
- In financial accounts, depreciation was charged more in comparison with cost accounts by $3,000
- Share transfer fees received during the year amounted to $445
- Provision for income tax was $4,000
From the above, prepare a statement reconciling the figures shown by the cost and financial accounts.