Why the Cost Profit and the Financial Profit Differ
Chapter Seven
Syllabus topic 4, "Practical problems based on Reconciliation of cost and Financial accounts"
Pages 17 to 19 of 82
In one line
The two profits differ because some items enter one set of books only, some are valued differently in each, and overhead is charged to cost at a rate rather than at what was actually spent.
Derive them, do not memorise them
The differences follow from the comparison already made. Cost accounting exists to find the cost of making something; financial accounting exists to report what happened to the business. So:
- anything that happened to the business but not to the product is in the financial accounts only;
- anything that is a cost of the product but not a transaction of the period is in the cost accounts only;
- where both record the same thing but measure it differently, the profits differ by the measurement.
Those three sentences generate the whole list.
Group 1: in the financial accounts only
Incomes credited in financial accounts and not in cost accounts:
- interest received; dividend received; rent received
- profit on the sale of an asset or an investment
- transfer fees received
Expenses debited in financial accounts and not in cost accounts:
- interest paid on loans and debentures
- loss on the sale of an asset or an investment
- donations and charity
- income-tax
- goodwill, preliminary expenses, discount on issue of shares or debentures written off
- penalties and fines
- abnormal losses - loss by fire, abnormal wastage, abnormal idle time
- appropriations of profit - transfer to reserve, dividend paid
The test for this group: ask whether the item is part of the cost of making or selling the product. If not, it is here.
Group 2: in the cost accounts only
Items charged in cost accounts as a matter of cost technique, which the financial accounts do not record as an expense:
- notional rent on premises the firm owns
- notional interest on the proprietor's own capital
- notional salary of a proprietor who works in the business
They are charged so that the cost is comparable with a firm that rents its premises and borrows its capital. They are not transactions, so the financial accounts have nothing to record.
Group 3: valued differently in each
Stock. Financial accounting values stock at the lower of cost and net realisable value; cost accounting values it at cost on the method adopted. Raw material, work-in-progress and finished goods can each differ.
Depreciation. The cost accounts may charge it on a machine-hour or output basis; the financial accounts on a straight-line or written-down-value basis.
Group 4: overhead absorbed at a rate
This is the group most often got wrong, and the one MU's Course Outcome 4 points at.
Cost accounting cannot wait until the year end to know what overhead was. It charges production at a predetermined rate, fixed in advance from an estimate. At the end of the period the amount absorbed by production is compared with the amount actually incurred:
Why the Cost Profit and the Financial Profit Differ
| Meaning | Effect on the cost profit | |
|---|---|---|
| Over-absorbed | Charged to cost more than was incurred | Cost shown too high, so cost profit is too low |
| Under-absorbed | Charged to cost less than was incurred | Cost shown too low, so cost profit is too high |
Reason it out rather than remembering it. If cost accounting charged too much cost, it reported too little profit; to get to the financial profit, add the excess back.
The direction of every adjustment
Starting from the cost profit and working to the financial profit:
| Item | Adjustment |
|---|---|
| Income in financial accounts only | Add |
| Expense in financial accounts only | Less |
| Item charged in cost accounts only, such as notional rent | Add back |
| Overhead over-absorbed | Add |
| Overhead under-absorbed | Less |
| Opening stock valued higher in cost accounts | Add |
| Closing stock valued higher in cost accounts | Less |
The two stock rows are opposite, and that is not arbitrary. A higher opening stock is a higher cost, which lowered the cost profit, so it is added back. A higher closing stock is a lower cost, which raised the cost profit, so it is deducted.
Working the other way round, every sign reverses. Starting from the financial profit, add what was deducted and deduct what was added. MU sets it in both directions.
What it does NOT mean
Neither profit is wrong. Each is right for its purpose. The reconciliation explains the gap; it does not correct an error.
Abnormal loss is not simply omitted. It is excluded from cost and charged in the financial accounts, which is why it appears in the reconciliation.
Over-absorption is not a profit. It is a charging difference, and the reconciliation removes it.
This book does not teach absorption rates. How a rate is set and applied is Module I of Cost Accounting II, in Semester VI. What is needed here is only the direction of the adjustment.
Quick revision
- Group 1: financial accounts only - interest, dividend, donation, income-tax, profit or loss on sale of an asset, abnormal losses, appropriations.
- Group 2: cost accounts only - notional rent, interest on own capital, proprietor's salary.
- Group 3: valued differently - stock and depreciation.
- Group 4: overhead over- or under-absorbed.
- From cost profit to financial profit: add financial income and over-absorption; deduct financial expenses and under-absorption; add a higher opening stock and deduct a higher closing stock, both as valued in the cost accounts.
- Reverse every sign when going the other way.
Test yourself
1. Name the four groups of causes of difference. Items appearing in the financial accounts only; items appearing in the cost accounts only; items valued differently in each; and overhead over- or under-absorbed.
Why the Cost Profit and the Financial Profit Differ
2. Is an abnormal loss by fire added or deducted, starting from the cost profit? Deducted. It is an expense in the financial accounts only, and cost accounting excludes abnormal losses.
3. Overhead was under-absorbed by Rs 40,000. What is the adjustment? Deduct Rs 40,000. Too little cost was charged, so the cost profit is too high by that amount.
4. Closing stock is valued higher in the cost accounts than in the financial accounts. Why is it deducted? Because a higher closing stock reduces the cost charged, which raised the cost profit; deducting the excess brings it back to the financial figure.
5. What is notional rent, and why does it appear? A charge made in the cost accounts for premises the firm owns, so that its cost is comparable with a firm that rents. It is not a transaction, so the financial accounts do not record it and it must be added back.
Answer in one sentence
Why do the cost and financial profits differ? Because purely financial items such as interest, dividend, donations, income-tax, abnormal losses and appropriations are recorded in the financial accounts only; notional charges such as rent on owned premises and interest on the proprietor's capital are made in the cost accounts only; stock and depreciation may be valued differently in each; and overhead is charged to production at a predetermined rate, so that it is over- or under-absorbed against what was actually incurred.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.