What is reconciliation in accounting?

What is reconciliation? 

Simply put, an account reconciliation is the process of comparing different financial records against monthly statements produced by external sources. This could include bank statements, credit card statements, or other financial institution provided statements. The purpose of this is to ensure internal financial records align with the evidence provided in the external statements. This is an essential ‘health-check’ for your business’ financial health, and aids in the detection of any discrepancies, errors or fraud within the accounts. 

What are the different types of reconciliation? 

Personal reconciliation 

Reconciliations are not just for business owners. Many individuals can benefit from performing a personal reconciliation on their credit cards and bank accounts. Comparing any written checks, receipts to the movements which have occurred within their bank and credit card statements. Personal reconciliations can highlight fraudulent payments  or any errors on the bank’s behalf (for example - your receipt states ‘100’ but the bank has withdrawn ‘1,000’ from your account). 

Business reconciliation 

The more prevalent type of reconciliation is a business account reconciliation. They’re conducted by firms globally to limit or prevent balance sheet errors and check for fraudulent payments. If a company is audited, an auditor will likely perform a sample based reconciliation of some payments throughout the financial period.  

Most businesses perform reconciliations on a monthly basis, but others may do so as often as daily. The regularity of the reconciliation often depends on the type of business, as well as how prone they may be to errors or fraudulent payments. Monthly reconciliations are most popular as many accounts departments will close-off the books on a monthly basis, and perform the reconciliation as a check for this process and ensures transactions have been appropriately recorded in the correct ledger account. Highlighted errors may lead to some adjustments to journal entries at month end.

There is a generally accepted accounting principle (GAAP) requirement that if the direct method of presenting a cash flow is used, the company is required to reconcile cash flows to the income statement and balance sheet. Conversely, if the indirect method is used, then any cash from the operations section of the cash flow statement is already presented in a manner which should reconcile to the three financial statements.

Read more: Accounting vs Bookkeeping

Why should you reconcile your accounts? 

Understanding the transactions and balances within your accounts can be important for the day-to-day running of the business. It allows you to make sure there are no overdrafts on the accounts, catches any fraudulent behaviour, and recognises overcharged credit card transactions whilst highlighting any negative activity on your accounts. However, that’s not to say that reconciliations are perfect. There can often be timing issues which cause breaks in a reconciliation. For example, your client may have paid a large invoice, but it has taken 24-hours to show up within your bank account. Therefore, your financial accounts show this balance, but the bank balance does not yet recognise it. 

The core benefit of a reconciliation is to keep your accounts free of transaction errors when it comes time to filing your year-end accounts. Being able to catch issues as and when they occur has a significant benefit compared to recognising issues at year-end and having to go through all your annual records to find and resolve the issue.  

Overall, this means that your accountant can easily produce reliable, accurate and high-quality financial statements. An effective reconciliation process can have a lasting impact upon your balance sheet, as it reflects all the money spent, and assets purchased with those funds. Therefore, the accuracy of the balance sheet relies upon a good reconciliation process to make sure that all assets and cash balances are in alignment. 

When should you reconcile your accounts? 

The timing of a reconciliation will depend heavily on the type of business, as well as their susceptibility to errors and fraud. Alternatively, a company like an investment fund, which has many investors may have reconciliation frequency as a part of their investor memorandum. This is because the accuracy of the accounts doesn’t just impact the owner of this company, but also all of the investors, which is riskier than a simple company structure. 

Small to medium sized businesses which produce a monthly set of management accounts will often complete a reconciliation monthly to reconcile their bank balance with payables and receivables. 

However, if the company is really small and has a generally simple structure, regular reconciliation may not be required. It could be a company with very few expenses and primarily just income, like a sole trader web-designer who works from home. Primarily the only bank movements will be income from invoices and a salary for the owner. Therefore, both of these balances will likely be checked upon action anyway. Despite this, even less complex businesses should make it a best practice to reconcile their bank balance at least monthly, as it will make it easier for any issues highlighted to be investigated. 

Bank reconciliation example 

In the below example, we can see a small reconciliation difference between what we expected to see (4,000) and what we actually saw in our bank account (3,750): 

Balance per bank statement: 3750

Deposits in transit: 750

Outstanding Checks: -2000

Active Balance: 5000

Balance per business books: 4000

Invoices Paid: 1000

Expenses: -2000

Cash: 5000

Reconciliation diff: 250

The 250 difference in this simple example clearly relates to the ‘invoices paid’ line within the business books section. As we have recognised this difference, we are able to investigate what has occurred here. The likely reasons are as follows: 

• There are one or more invoices marked as ‘paid’ which have not yet actually been paid (incorrectly marked as paid? OR client stated they had paid, when they haven’t) 

• More likely is that there is a timing difference, where one or more invoices totalling 250 will actually hit the bank account in a day or two