An Overview
The need for reconciling accounts and financial accounts arise due to discrepancy between cost accounts and financial account. The process of correcting these accounts is known as the reconciliation of cost and financial accounts. When prepared following financial accounting regulations, numerous things are only included in the profit and loss account.
If the profit or loss were calculated using financial accounts, it would be adjusted using cost accounts. We see a similar profit as per cost accounting after modifications. If we calculated profit using the cost account, we must change the items to reflect the financial accounts. We create a reconciliation statement with this goal in mind.
Reconciliation Meaning
The profit or loss shown by one set of books may differ from that indicated by the other when cost accounts and financial accounts are handled separately in two separate sets of books. As a result, it becomes important to regularly reconcile the profit or loss indicated by the two sets of accounting.
The reasons for the discrepancy between the data reported by each system are detailed in a note of reconciliation. It is done to look through both sets of accounts' mathematical precision and look for any errors that may have been made.
Reconciliation of Cost and Financial Statements
Need for Reconciliation
Several factors call for a reconciliation between the two books:
It explains the causes of the profit or loss discrepancy between cost and financial statements.
It guarantees that no revenue or expense item has been left off the books and that overhead costs are not being under or over-recovered.
It assists in verifying the mathematical precision of both sets of accounts.
It guarantees the accuracy of cost accounting to properly determine the cost of manufacturing.
By emphasising the fluctuations contributing to an increase or reduction in profit, it facilitates internal management.
It encourages coordination and cooperation between cost and financial accounting divisions to provide accurate and trustworthy accounting data.
It allows management to create rules for expenses, depreciation, and stock valuation.
It guarantees managerial judgement.
Need of Reconciliation
Items Accounted for Differently in Cost Accounting and Financial Accounting
Overhead - Cost accounts apply fixed rates of overheads to cost units based on projections, and the amount recovered may differ from the actual costs spent. The profits on two sets of books will differ if such under or over-recovery of overheads is not carried off to the costs profit and loss account.
Stock vVluation - Stocks are evaluated in financial accounts at a lower cost or market value. In cost accounting, the stock is valued at cost using a technique that is appropriate to the unit, such as FIFO, LIFO, average, etc. As a result, stock value may change, which will indicate a profit discrepancy between the two sets of books.
Depreciation - The profits will change if a different methodology is used to calculate depreciation in cost accounts compared to financial accounts.
Items Accounted for differently in Cost Accounting and Financial Accounting
Procedure of Preparing Reconciliation
Step 1 - Start by determining any one of the profit/loss figures (either based on cost books or financial books), which is sometimes referred to as the basic profit figure.
Step 2 - Next, the numerous discrepancies between the profits reported by two sets of books in a certain instance are determined (as explained in the prior section).
Step 3 - Increase the basic profit number (from which we started in Step 1) by the items of difference that have the impact of raising earnings in another set of books. These things are sometimes referred to as "+" items.
Step 4 - Subtract the items of disagreement that have the impact of reducing earnings in other sets of books from the basic profit calculation. (Such goods may be referred to as "-" items).
Reconciliation Procedure
If all of the calculations are accurate mathematically and computationally, the final amount after all the aforementioned changes will be the profit or loss according to another set of books.
Proforma Reconciliation Statement - Assuming that base earnings are calculated using cost accounts, the reconciliation statement can be shown or presented as shown below.
Conclusion
The practice of reconciling the functional outcomes or profits as revealed by cost accounts with those of financial accounts is known as reconciliation. Reconciliation is the process of identifying the items required to bring the balances of two or more connected accounts or statements into an agreement, according to Eric L. Kohler. Additionally, an attempt is made to evaluate the mathematical precision of the profits reported in two separate books. Consequently, reconciliation locates and accounts for the factors contributing to the discrepancy between the functional outcomes reported by cost accounts and financial accounts.
FAQs on Reconciling Cost and Financial Statements
1. What is meant by the reconciliation of cost and financial statements in Accountancy?
Reconciliation of cost and financial statements is the process of identifying and explaining the reasons for any difference between the profit or loss shown by the cost accounts and the financial accounts. Since both sets of books are maintained differently, discrepancies arise. This process ensures the reliability and accuracy of both accounting systems by creating a statement that brings the two profit figures into agreement.
2. Why is it important for a business to prepare a Reconciliation Statement?
Preparing a Reconciliation Statement is crucial for several reasons as per the CBSE syllabus for the 2025-26 session. Its importance lies in:
- Pinpointing the exact causes of disagreement between the profits calculated under cost and financial accounting.
- Verifying the mathematical accuracy of both sets of accounts and helps in detecting errors.
- Ensuring that overheads are not significantly under or over-absorbed in cost accounts.
- Facilitating better coordination between the cost and finance departments.
- Providing management with reliable data for decision-making and policy formulation regarding stock valuation, depreciation, and expense allocation.
3. What are the common items that cause a difference between the profits shown by cost and financial accounts?
The main items that cause differences in profit are categorised as follows:
- Items in Financial Accounts only: These include purely financial incomes (e.g., interest on investments, profit on sale of assets) and purely financial expenses (e.g., goodwill written off, preliminary expenses, loss on sale of assets).
- Items in Cost Accounts only: These are notional charges, such as notional rent on company-owned premises or notional interest on capital, which are not recorded in financial accounts.
- Different Basis of Valuation: Key examples include differences in the valuation of opening and closing stock (e.g., LIFO/FIFO in cost vs. cost or market price, whichever is lower in financial) and different methods of charging depreciation.
- Under or Over-absorption of Overheads: Overheads are included in cost accounts at a predetermined rate, while financial accounts record the actual amount. The difference between these two is a major reason for discrepancy.
4. How does the method of stock valuation differ between cost and financial accounting, and why is it a significant factor in reconciliation?
The difference in stock valuation is a significant factor because it directly impacts the reported profit for a period. In cost accounting, closing stock is typically valued at cost, using methods like FIFO (First-In, First-Out) or LIFO (Last-In, First-Out) to reflect production cost. However, in financial accounting, the principle of prudence requires stock to be valued at cost or net realisable value (market price), whichever is lower. This difference in valuation leads to different closing stock figures, which in turn results in different profit calculations that must be reconciled.
5. What is the step-by-step procedure for preparing a Reconciliation Statement?
The procedure for preparing a Reconciliation Statement involves a logical series of steps:
- Start with a Base Profit: Begin with the profit (or loss) as per either the cost accounts or the financial accounts. This is your starting point.
- Identify Discrepancies: Analyse both Profit & Loss Accounts to list all items that have been treated differently.
- Add Certain Items: Add back expenses that are charged only in cost accounts or incomes credited only in financial accounts. Also, add the over-absorption of overheads. Essentially, you add items that caused the other set of accounts to show a higher profit.
- Subtract Certain Items: Subtract incomes that are included only in cost accounts or expenses charged only in financial accounts. Also, subtract the under-absorption of overheads. Here, you subtract items that caused the other set of accounts to show a lower profit.
- Arrive at the Reconciled Profit: The final figure after all additions and subtractions will be the profit (or loss) as per the other set of books.
6. How is the under- or over-absorption of overheads treated in the Reconciliation Statement?
The treatment of overheads is a key adjustment. If you start with profit as per cost accounts:
- Over-absorption of overheads means too much expense was charged in the cost accounts, reducing the cost profit. To correct this, you must add the over-absorbed amount in the Reconciliation Statement.
- Under-absorption of overheads means not enough expense was charged in the cost accounts, inflating the cost profit. To correct this, you must subtract the under-absorbed amount in the Reconciliation Statement.
The logic is reversed if you start with the profit as per financial accounts.
7. What are the consequences for a business if it fails to reconcile its cost and financial accounts regularly?
Failing to reconcile regularly can have serious consequences for a business. Without reconciliation, management may make decisions based on inaccurate or conflicting profit figures. This can lead to incorrect pricing of products, poor budgeting, and a flawed understanding of operational efficiency. It also undermines the internal control system, as errors or potential fraud may go undetected. Ultimately, it erodes the credibility and reliability of the company's financial reporting, both internally for management and externally for stakeholders.
