What is reconciliation in accounting?

What is reconciliation?

Reconciliation is an accounting process which SMB owners and their accountants need to perform to ensure that the correct balances are recorded within their accounts.

The task requires comparing two pieces of data - typically one created internally and the second by a third party such as a bank, supplier or customer - and ensuring that they match up to give the same value on a specific date.

Completing reconciliations gives SMB owners the confidence that the values recorded in their accounts are accurate, and allows them to record their cash position and accurately forecast their cash flow.

Historically, reconciliation accounting was a relatively manual process, with the reconciliations themselves taking place in an Excel spreadsheet or on physical pieces of paper. However, cloud accounting software has made this a much more efficient process by the adoption of automation features, ensuring that matching transactions is hassle-free.

Types of reconciliation

Bank reconciliation

These are the most common type of reconciliation and require businesses to reconcile their cash position by comparing the value of recorded bank transactions in their accounting software to those on their monthly bank statements.

Vendor reconciliation

Vendor reconciliations compare the balance owed on supplier provided statements to transactions within the payable ledger and its overall balance.

Supplier statements are not provided automatically so may need to be requested periodically in order to reconcile these accounts.

Customer reconciliation

Customer reconciliations are performed by businesses which offer credit terms to their customers.

This process checks whether there are any discrepancies with associated transactions by comparing details of the accounts receivable ledger, which records all related invoices and payment individually, with the receivables control account in the general ledger. The receivables control account is a summary of receivables transactions as opposed to the recognition of them individually.

Intercompany reconciliation

Intercompany reconciliations are undertaken by companies which are part of a wider group. Performing intercompany reconciliations allow for the parent company to produce accurate consolidated accounts.

The procedure compares the booked value of what is owed/owned by one company with the balance of its counterpart. These are often cash transactions (i.e. one company lending funds to another) but another common example is one company declaring to dividends to another in the group.

The reconciliation has been successful if the same balance appears in the accounts of both companies, with it being a debtor in one company's books and a creditor in the other’s. This, in essence, ensures that the consolidated accounts eliminate any artificial profit/loss from intercompany transactions.

Business specific reconciliation

These are unique and relate to the specifics of individual businesses. For example, companies which sell goods will need to conduct a stock take to ensure that the inventory value in the balance sheet accurately reflects the value of goods held in storage. This requires an individual having to physically count the number of goods held.

Alternatively, businesses with a field sales team will have to reconcile the value of employee expenses payable with the individual balances of submitted expense reports. There is more likely to be difference when reconciling if part of the expenses process is performed manually.

One of the more onerous types of business specific reconciliations is the requirement for companies operating within the financial services sector to have to produce frequent reconciliations of accounts with client held funds.

Why you should reconcile your accounts

Accurate annual accounts must be maintained by all businesses

Reconciling your accounts is not optional due to the necessity for all companies to file annual statements, summarising a year’s worth of transactions accurately. Companies which are audited will have the validity of their financial statements put under greater scrutiny due to the audit process, testing whether they are accurate and free from material misstatement.

Balance sheet reconciliations and tests are some of the key tasks performed during annual audits.

Maintain good relationships with suppliers

Reconciling vendor accounts will result in them being paid on time. This is critical to ensure that day to day operations are maintained.

Failure to pay suppliers is bad for business as being behind on payments can result in a loss of service or goods from key external stakeholders. These deteriorating supplier relationships can result in business output being affected due to demand from customers no longer being able to be met.

Avoid late payments and penalties from banks

Financial institutions are less likely to be forgiving for missed payments or approved overdraft values being exceeded.

Reconciling your bank regularly will minimise the likelihood of receiving avoidable fines and penalties.

When is reconciliation done?

The frequency of reconciliations depends on the nature of the business and the types of reconciliation.

SMBs which produce monthly management accounts will need to reconcile their bank, receivables (customer reconciliations) and payables (supplier reconciliations) at a minimum of once per month for the correct information to be presented in their accounts.

Whilst small and less complex businesses may not have an internal need to carry out reconciliations regularly, it is best practice for them to reconcile their bank at least once per month. Any differences found will be easier to understand if they took place over a short time frame.

High growth businesses which burn large amounts of cash or those with little cash left in the bank should perform bank reconciliations weekly. These requirements may be put on them by their investors and shareholders.

In some cases, cash strapped businesses may reconcile their cash daily.

Companies which are part of a group tend to perform intercompany reconciliations at month-end. These values tend to be reported separately within annual accounts, so their accuracy is important for both internal and external purposes.

How to reconcile accounts

1. Check that the opening balances agree

Access the internal source of data being reviewed (i.e. the bank ledger account on your accounting software) and compare it against the external document it is being compared against (i.e. bank statement). Confirm that the opening balance on the former agrees to the closing balance on the latter.

2. Record the difference of the closing balances

Make a note of the closing balance (i.e. month-end) on the external document and compare its value to the closing balance of the corresponding account in your accounting software. The difference represents the value needed to fully reconcile this account.

3. Mark off all new activity from the external document

Update the internal data source being reconciled to record all new transactions (i.e. payments, issue of new invoices, bank charges and interest received) from the external document.

If you use cloud accounting software, this can be made relatively easy by using the reconciliation function. For example, if you are conducting cash reconciliations this process will involve simply matching activity from the bank feed to the transactions on your bank ledger, and then posting any new reconciling transactions.

4. Review the closing balance and, if necessary, produce a reconciliation report

Once all legitimate missing or duplicate transactions have been posted or removed, the closing balance on the account being reconciled should agree to the closing balance of the external document it is being reconciled against.

However, in reality, there are often still discrepancies due to timing issues related to transactions (i.e. cash in transit) or errors from external providers (i.e. omitted transactions).

In these instances, a reconciliation report needs to be produced, which quantifies and explains the reasons for the closing balance between the two data sources. Producing this report makes it easier to perform the next reconciliation, as these differences explain why there is a discrepancy between the opening balances of the two different documents.

Failure to produce a reconciliation report when there are differences means that the correct values are not included in the corresponding account. This results in the main accounts themselves being inaccurate. Depending on the significance of these differences, this could cause problems related to cash flow and could result in fines or penalties for unpaid bills.

Not producing a reconciliation report when one is needed will also make it more time consuming to produce future reconciliations, due to it being harder to unpick the differences.

Whilst there is no prerequisite for most businesses to reconcile regularly, doing so is a good habit as it will mean that business and financial information is up to date. Additionally, reconciling regularly will make it easy to spot and explain any reconciling transactions or errors.