Cost Accounting · Reconciliation of Costing and Financial Profit

Causes of Difference in Cost and Financial Profit

Updated 10 October 2026 · Fact-checked

Cost profit and financial profit differ because the two sets of books treat some items differently. Causes are items only in financial accounts (interest paid, losses on sale of assets, income such as interest received, and abnormal losses, which are excluded from cost accounts), items only in cost accounts (notional rent), and different stock, depreciation and overhead treatment. Classify each item, then adjust.

Understand Causes of Difference in Cost and Financial Profit

A business often keeps two sets of books: financial accounts and cost accounts. Both start from the same transactions, yet they usually show different profits. The difference is not an error. It arises because the two systems have different purposes.

Financial accounts report the whole business to owners, lenders and the law. So they include every income and expense, whether or not it relates to normal production. Cost accounts measure the cost of making and selling products. So they leave out items that are not part of that cost, and they may add some notional items to get a fairer cost.

Abnormal losses, such as loss by fire or theft, are not part of normal cost. They are excluded from cost accounts and charged to the Costing Profit and Loss Account. So for reconciliation they appear only in the financial books.

There are three broad causes of difference:

Items only in financial accounts: purely financial matters (both expenses and incomes), appropriations of profit and abnormal items.
Items only in cost accounts: notional charges such as rent of own building and interest on own capital.
Differences in treatment: stock valuation, depreciation, and under or over absorption of overheads.

When you see a reconciliation question, your job is to sort each item given into one of these groups and decide whether it moves the profit up or down.

For items that appear in both books but at different amounts, only the difference matters. For example, if financial books charge depreciation of ₹80,000 and cost books charge ₹60,000, the gap is ₹20,000.

Key rules to remember

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.

How to solve Causes of Difference in Cost and Financial Profit questions

Use this method for any question that asks for causes of difference or gives a list of items to reconcile.

1Read each item and ask: is it in the financial books, the cost books, or both?
2If it is in financial books only, check whether it is an expense or loss (reduces financial profit) or an income or gain (raises financial profit).
3If it is in cost books only (notional charges), note that it reduces cost profit only.
4For items in both books at different amounts (stock, depreciation, overheads), compute the difference and decide who is higher.
5Decide the effect on the profit you are moving from. Starting from financial profit, add back items that reduced it only there and deduct items that raised it only there.
6Check the direction of each adjustment once more before writing the statement, then state the final cost profit or financial profit.

Quickest way: Three-question item test

When to use it: Use when you have a long list of items and little time.

Ask: does this item relate to normal production and sales? If not, it is in financial books only.
Ask: is it notional, meaning no cash paid? If yes, it is in cost books only.
Ask: is it in both books at different values? If yes, compute only the difference.
Tick the direction: starting from financial profit, add back expenses and losses found only there, and deduct incomes found only there.
For any item that appears in both books with identical amounts, ignore it.

Common mistakes in Causes of Difference in Cost and Financial Profit

Adjusting items that are identical in both books.
Students see an expense and assume it must be reconciled.
Fix: Reconcile only items that differ. If both books show the same amount, skip it.
Treating interest received as a cost item.
It looks like a normal business income.
Fix: Interest and dividends received are financial incomes. Deduct them from financial profit to reach cost profit.
Getting the sign wrong on under and over absorption.
Students mix up which book carries actual overhead.
Fix: Financial books carry actual overhead and cost books carry absorbed overhead. Under-absorption means cost profit is higher on this item.
Adding notional rent to financial profit.
Students think any extra item should raise profit.
Fix: Notional rent is a charge in cost books only. It lowers cost profit, so deduct it when moving from financial profit to cost profit.
Using the closing stock difference alone.
Students forget that opening stock also differs.
Fix: Take the effect as closing stock difference minus opening stock difference.

Worked examples

Example 1

Profit as per financial accounts is ₹5,00,000. The following are noted. Interest received ₹30,000. Loss on sale of machinery ₹20,000. Notional rent of own building ₹40,000. Dividend received ₹10,000. Donations paid ₹15,000. Find profit as per cost accounts.

Show the solution

Start with financial profit: ₹5,00,000.
Loss on sale of machinery ₹20,000 is only in financial books. Add back: ₹5,20,000.
Donations ₹15,000 are only in financial books. Add back: ₹5,35,000.
Interest received ₹30,000 is only in financial books. Deduct: ₹5,05,000.
Dividend received ₹10,000 is only in financial books. Deduct: ₹4,95,000.
Notional rent ₹40,000 is only in cost books. Deduct: ₹4,55,000.

Answer: Profit as per cost accounts = ₹4,55,000.

Example 2

A firm's financial profit is ₹3,20,000. Actual factory overhead is ₹2,40,000 and absorbed overhead is ₹2,10,000. Depreciation is ₹90,000 in financial books and ₹1,05,000 in cost books. Opening stock is ₹60,000 in financial books and ₹65,000 in cost books. Closing stock is ₹80,000 in financial books and ₹92,000 in cost books. Find the cost profit.

Show the solution

Start with financial profit: ₹3,20,000.
Overhead is under-absorbed by ₹2,40,000 − ₹2,10,000 = ₹30,000. Cost books carry less overhead, so add ₹30,000: ₹3,50,000.
Depreciation in cost books is higher by ₹1,05,000 − ₹90,000 = ₹15,000. Cost books charge more, so cost profit is lower. Deduct ₹15,000: ₹3,35,000.
Opening stock is higher in cost books by ₹5,000, which lowers cost profit. Deduct ₹5,000: ₹3,30,000.
Closing stock is higher in cost books by ₹12,000, which raises cost profit. Add ₹12,000: ₹3,42,000.

Answer: Profit as per cost accounts = ₹3,42,000.

Exam tips

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.
In MCQs, check whether the question starts from financial profit or cost profit before choosing the sign.
Show the working for under or over absorption separately so the marker can see the figure.

Practice questions from Reconciliation of Costing and Financial Profit

Causes of Difference in Cost and Financial Profit in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CMA FoundationCost Accounting vs Financial Accounting

Causes of Difference in Cost and Financial Profit: frequently asked questions

Why do cost profit and financial profit differ?

The two systems serve different purposes. Financial accounts record all items of the whole business, while cost accounts record only items relevant to cost and may add notional charges. Valuation of stock, depreciation and overheads also differ.

Is notional rent included in financial accounts?

No. Notional rent is charged in cost accounts only, because no rent is actually paid on a building the business owns. It lowers cost profit but not financial profit.

How is under-absorbed overhead treated in reconciliation?

Financial books charge actual overhead while cost books charge absorbed overhead. If overhead is under-absorbed, cost books have charged less, so cost profit is higher. Add it when moving from financial profit to cost profit.

How do I decide whether to add or deduct an item?

Start from the profit given. Add back expenses that reduced profit only in that set of books. Deduct incomes that raised profit only in that set. For differing items, work out which book is higher.