CMA Intermediate · Cost Accounting

Reconciliation of Costing and Financial Profit: formula sheet

Full chapter guide

Key formulas

Basic reconciliation idea: Profit as per cost accounts ± items of difference = Profit as per financial accounts; Start from either profit. Reverse every sign if you start from the financial profit.
Effect of an item on profit when starting from cost profit: Add items that raise financial profit; deduct items that lower it; Example: income only in financial books is added; expense only in financial books is deducted.
Effect of overheads under-absorbed or over-absorbed: Starting from cost profit: deduct under-absorbed overheads and add over-absorbed overheads.; Financial books charge actual overheads. Cost books charge absorbed overheads. If absorbed is less than actual (under-absorption), cost profit is higher, so you deduct. If absorbed is more than actual (over-absorption), cost profit is lower, so you add.
Effect of stock valuation difference: Starting from cost profit: if closing stock is higher in cost books, deduct the difference; if lower, add it. For opening stock, if it is higher in cost books, add the difference; if lower, deduct it.; Higher closing stock in the cost books makes cost profit higher, so deduct. Higher opening stock in the cost books makes cost profit lower, so add. Adjust only by the difference between the two stock figures.
Items only in financial accounts: expenses and losses: Examples: interest on loans and bank charges, loss on sale of fixed assets, goodwill written off, preliminary expenses written off, fines and penalties, income-tax paid, donations, dividends paid, transfer to reserves, abnormal losses by fire or theft; These reduce financial profit but are not in cost accounts. Add them back when going from financial profit to cost profit.
Items only in financial accounts: incomes and gains: Examples: interest and dividend received, profit on sale of fixed assets or investments, rent received, transfer fees, share premium income, other non-operating income; These raise financial profit but are not in cost accounts. Deduct them when going from financial profit to cost profit.
Items only in cost accounts: Examples: notional rent on own premises, notional interest on own capital, notional salary of the proprietor; These reduce cost profit but do not appear in financial books. Deduct them when going from financial profit to cost profit.
Overhead absorption difference: Under-absorbed overhead = Actual overhead − Absorbed overhead Over-absorbed overhead = Absorbed overhead − Actual overhead; Financial books record actual overhead. Cost books record absorbed overhead. Under-absorption means cost profit is higher than financial profit on this item. Over-absorption means cost profit is lower.
Difference in stock valuation: Effect on profit = Closing stock difference − Opening stock difference; If cost books value closing stock higher than financial books, cost profit is higher. A higher opening stock lowers profit.
Difference in depreciation: Difference = Depreciation in financial books − Depreciation in cost books; If financial books charge more depreciation, financial profit is lower, so add the difference when moving from financial profit to cost profit. If cost books charge more depreciation, cost profit is lower, so deduct the difference.
Cost profit to financial profit: Financial profit = Cost profit + items that raise financial profit − items that lower financial profit; Use this layout when the question gives cost profit and asks for financial profit.
Items only in financial accounts (income): Add: interest received, dividend received, rent received, profit on sale of assets; These are not in cost accounts, so they increase financial profit.
Items only in financial accounts (expense/loss): Deduct: interest paid, loss on sale of assets, preliminary expenses written off, donations, discount allowed, income tax; These are not charged in cost accounts, so they reduce financial profit.
Notional charges: Add: notional rent, notional interest on capital charged in cost accounts only; Cost accounts charged them but financial accounts did not, so financial profit is higher.
Overhead absorption: Cost to financial: Add over-absorption, Deduct under-absorption. Financial to cost: Deduct over-absorption, Add under-absorption; Financial accounts carry actual overheads. Over-absorption means cost accounts charged more overhead to cost than the actual overhead, so cost profit is understated and is added to reach financial profit. Under-absorption means cost accounts charged less than actual, so cost profit is overstated and is deducted. Going from financial to cost, reverse this.
Stock valuation: Closing stock: financial higher than cost = Add; financial lower = Deduct. Opening stock: financial higher than cost = Deduct; financial lower = Add; Opening and closing stock work in opposite directions. These directions are for cost to financial.
Depreciation difference: Depreciation charged in cost accounts higher than in financial = Add the difference; lower = Deduct the difference; Compare the two depreciation figures and take only the difference. This direction is for cost to financial.
Balancing rule (costing profit given): Financial profit = Costing profit + Credit-side items − Debit-side items (other than financial profit); Costing profit goes on the credit side. Financial profit is the balancing figure on the debit side.
Balancing rule (financial profit given): Costing profit = Financial profit + Debit-side items − Credit-side items (other than costing profit); Put financial profit on the debit side and find costing profit as the balancing figure on the credit side.
Debit side items: Expenses and losses only in financial accounts; under-absorbed overheads; higher closing stock or lower opening stock in costing; excess charge in financial accounts; Each of these makes financial profit lower than costing profit.
Credit side items: Incomes and gains only in financial accounts; over-absorbed overheads; notional charges only in costing; higher closing stock or lower opening stock in financial accounts; Each of these makes financial profit higher than costing profit.
Items left out: Purely financial appropriations are not reconciled; Items such as dividends paid, transfer to reserves and income tax paid out of profit are appropriations, not charges. Include income tax or similar items only if the question treats them as charges in arriving at the financial profit.

Quick revision

Cost profit and financial profit differ because of items in only one set of books or valued differently.
Financial charges and losses, such as interest paid on debentures and losses on sale of assets or investments, reduce financial profit and are absent from cost accounts.
Appropriations, such as income-tax, dividends and transfers to reserves, are not charges against profit. They also appear only in financial accounts.
Purely financial incomes such as interest received and dividends received raise financial profit but are not in cost accounts.
Notional charges, like rent of own premises, appear only in cost accounts.
Under-absorbed overhead: cost profit is higher than financial profit on this item.
Over-absorbed overhead: cost profit is lower than financial profit on this item.
Stock differences are the difference between the two sets of books: if closing stock in financial books is higher than in cost books, financial profit is higher; if opening stock in financial books is higher than in cost books, financial profit is lower.
Starting from cost profit: add items that increase financial profit and deduct items that decrease it.
Starting from financial profit, the direction of each adjustment is reversed.
Abnormal losses and gains charged only in financial accounts are deducted or added accordingly.
The memorandum reconciliation account is a ledger-style check, not part of the double entry.
Finish by checking that the reconciled profit equals the profit shown in the other set of books.

Common mistakes

Treating the difference in profits as an error to be corrected Fix: State that the books serve different purposes. Explain the difference; correct only genuine errors.
Adding an item that should be deducted Fix: Ask each time: does this item raise or lower the profit I am moving to? Then sign it.
Adjusting items that are identical in both books. Fix: Reconcile only items that differ. If both books show the same amount, skip it.
Treating interest received as a cost item. Fix: Interest and dividends received are financial incomes. Deduct them from financial profit to reach cost profit.
Reversing the direction of opening stock. Fix: Opening stock is an expense. A higher opening stock value in the target books lowers profit there, so deduct it. Closing stock is the opposite.
Adding or deducting the full depreciation or stock figure instead of the difference. Fix: When both sets show a value, take only the difference between the two figures.
Putting under-absorbed overhead on the credit side Fix: Costing charged less, so costing profit is higher. Financial profit is lower. So under-absorption goes on the debit side. Over-absorption goes on the credit side.
Ignoring notional items such as notional rent or interest on own capital Fix: They reduce costing profit but not financial profit. Put them on the credit side when starting from costing profit.

Exam tips

Read the question for the starting profit and the direction of the reconciliation, and keep that sign logic throughout.
Always present the answer as a proper statement with a heading, the starting profit, items with short reasons, and the final profit.
In theory questions, give reasons for the need first, then list the main causes of difference as supporting points.
Check that the final figure matches the second profit given in the question; this catches most sign errors.
In the objective section, expect questions on which item appears only in financial books, and on whether under-absorption raises or lowers financial profit.
Write a clear table-style statement with the starting profit, then additions and deductions with short labels.
Name each cause in words, such as 'items only in financial accounts', so you earn marks even if a figure slips.
For theory questions, give at least two examples under each of the three headings.