Bank reconciliations are a great way to double check your books. It provides accuracy and completeness, allowing management to have a true picture of the business.
What is a Bank Reconciliation?
A bank reconciliation is where a business confirms account balances recorded on their books. The process involves tying your bank account balance on the books to what’s recorded on your company’s bank statement.
This involves a line by line check of entries made during a certain period of time. It’s like double checking your work as a bookkeeper and making sure no transactions were missed.
If your business is involved in many transactions, then this should be done at the end of every month. Lastly, a bank reconciliation should be performed for all company bank accounts and credit cards.
Note: You only need to reconcile bank statements if your small business uses the accrual method of accounting. Otherwise, your books should be based off your bank statement amounts. Later on I will discuss these two methods of accounting.
Purpose of a bank reconciliation
Following are some key reasons why regular bank reconciliations should be done:
- To see an accurate picture of your business. A business transaction can accidentally be forgotten or double counted by your bookkeeper leading to a false picture of a business. If there is nothing to check every entry against this problem can go on being unsolved and even added to in the future. By being able to check every entry, allows for accurate numbers and a true picture of a business.
- Manage cash flows. A bank statement will show every transaction that moved cash in or out of a business. It is important to have an understanding of cash available to the business to help protect against overdrawing money. Too much cash can also be a bad thing and maybe some of it should be invested back into the business.
- Protect against fraud. All withdrawals and cleared checks will be reviewed to allow someone to catch if a check is withdrawn for an amount higher than it was written for. When reconciling the credit card, you can find online fraud charges because they will show up on the statement but will not be recorded in the books. Double check that this is fraud and not just a charge where the receipt was lost and never recorded.
- Detect bookkeeping or bank errors. Bookkeepers are people too and can sometimes make mistakes while entering a transaction. Also, as I just mentioned, sometimes a receipt/invoice can get lost and then never recorded in the books. By performing a bank reconciliation you can catch these errors and fix them whether they are errors in the company’s books or the rare bank error.
How to do a bank reconciliation
- Start by filtering book entries to the period on the bank statement.
- Match dates, names, and amounts for all line items on the bank statement. The statement will include deposits, checks/withdrawals, and electronic bank transfers.
- If any differences are found between bank statement entries and bookkeeping entries you need to find out which is correct. If the entry occurs towards the end of the statement period it might be an outstanding balance. For types of differences read below.
- Once all differences are corrected, match the ending balance in your books with the ending balance on the statement. Go through and match all correct withdrawal and deposit entries to double check nothing extra was included and nothing was omitted.
Two Methods of Accounting
This is the most common accounting method because it gives a better picture of the business during a period.
This method records revenues and expenses when they occur, regardless of when the money is actually transferred.
For example, when a product is delivered to the customer, a revenue is recorded even if payment hasn’t been received. Now the only problem with this method is if that payment is never received.
Cash flows are an issue as businesses can look profitable, but they lack money because payments haven’t been collected.
So, when using the accrual method it is important to manage accounts receivable and accounts payable.
It’s important to understand the accrual method because it causes differences between a company’s books and bank statement balances.
It’s probable that the transactions in your bank account every month don’t match the transactions recorded in your books.
The reason for this is your company uses the accrual method and banks use the cash method.
Books show all revenues and expenses, but the bank statements will only display ones where money was actually transferred.
One circumstance this occurs is with outstanding checks. When a check is written it’s recorded, but the cash doesn’t move until the payee deposits it into their account.
Similarly, this can occur with an outstanding deposit. It will be recorded in the books on the date of deposit. However, it takes a few days for the bank to clear checks and transfer the money into your account.
With things like bank transfers, this eliminates checks and makes the movement of cash simultaneous with expenses and revenues.
Another difference involves credit card clearing where an item is purchased near the end of a bank statement period. The receipt date is within the period, but the card will not be charged until the next statement.
Don’t worry, you have recorded the charge correctly and it will be reconciled with the next periods statement.
All of these activities will cause a difference due to the accrual method but should not be alarming.
The cash accounting method recognizes revenues when cash is received, and expenses when they are paid. Since they are only recognized with the movement of cash, accounts receivable and payable are never recorded.
In contrast to the accrual method, the cash method helps business’ manage their cash flows.
The number in the books will be the exact amount in their bank account.
Most startup business’ use this method as they don’t have a high amount of expendable cash. I think of this method as a wallet, you can only count the amount of money that is actually there.
There is no difference in timing between when something is recorded and money transfers hands. Therefore, there should be no difference between your books and the bank statement balances.
IRS Rules & Regulations
According to the IRS, neither accounting method is required of all taxpaying businesses. However, you must use a system that clearly reflects income and expenses.
The accounting method must also maintain accurate record so that one can file a correct return. Once an accounting method is chosen, it must remain consistent year to year.
If you are an individual running a small business then you probably use the cash method.
This is fine if you are a services business, but all businesses with inventory are required to use the accrual method.
Most inventory is bought on an account and therefore when inventory is recorded a payable must also be.
Outside of having inventory, a business can’t use the cash method if they generate gross annual revenue > $1 million. The limit is $5 million if your business is a partnership or C-corporation.
The last regulation that I want to touch on are the timing rules.
If using the cash basis, the IRS gets very specific on when to record expenses and revenues. This especially applies during the end of a fiscal year.
A business can’t postpone paying expenses until the next tax year just to avoid a net loss. In relation to tax, a business can’t deduct expenses in the current year for a check they haven’t written yet.
Even though both accounting methods are acceptable for a business to use, one must be careful.
There are lots of rules and regulations that should be reviewed before choosing one.
The rules listed are not a comprehensive list and should not be relied upon when choosing which to use. Rather, it was a few rules I felt important to making such a decision.
If you have any further questions or concerns surrounding bank reconciliations or the different accounting methods, please comment below.
I will gladly help your small business out and add any material you find useful.