What is a Bank Reconciliation?

A bank reconciliation is one of the core reports that I discussed in an earlier blog and one of the first reports that businesses prepare on a monthly basis to report their numbers for the month. 

The reason why a bank reconciliation exists is because there are timing differences between when certain cash transfers are initiated and when they are completed. The most common example of these is when you write a check to someone in one month and they don't cash it for another 30 days or so. Under generally accepted accounting principles (GAAP), that check should be recorded as a reduction to cash the day that it was written. This is important because when that check is written as a reduction in cash, but it's not cashed immediately, there's a difference between the balance of the bank account and the balance of the cash account on the company's books. 

A single check shouldn't be hard to find, but the reconciliation also captures checks that you initiate the deposit for that are waiting to clear as well as transfers that have been initiated but not fully cleared by the bank in both directions (to and from the company's bank account). When a company starts doing business with multiple customers it's easy to see why this process can get complicated quickly. 

How Does it Work? 

In any accounting system, the bank reconciliation functions as an interaction between the cash account as it's recorded on the books and a separate process specifically designed to track items that have cleared the bank. In QuickBooks this is represented by a little "Cleared" field that is solely used in the bank reconciliation process.

Every month the staff accountant will go through all the checks written and all the transactions that occurred in the bank account and record them on the books. Once that is complete, they'll go to the bank reconciliation module where they put in the amount that's on the bank statement and are provided a list of all the transactions that have not been marked cleared in the system. then that same staff accountant will go through the monthly bank statement and tag every single item that cleared the bank during the month. 

This process has a built-in check to make sure that everything is properly accounted for: the bank balances. As a part of the bank reconciliation the first item that gets inputted is the opening bank balance for the bank statement. the account will put this number on the reconciliation and then every check from the company will take away from that number and every payment to the company will add back to that number when they are recording the items that cleared the bank statement. If this is done correctly the accountant should always be able to reach the ending balance of the bank statement by putting in all the cleared items. Anything that remains after that is considered a reconciling item and is carried to the next month where it hopefully clears.

Why Does it Matter? 

Now that we've walked through the process of what the bank reconciliation is and how it works, it's important to know why it matters. This report States the company's true cash position at the reconciliation date (which should be done monthly). The company's bank account could show that it has $1,000,000 in it, but if 50 different checks were written for a total of $990,000 and not cashed yet, the company's true cash position only supports $10,000. This concept is crucial to understand because if you're reading this it's likely that your business lives and dies by its cash flow. Businesses need to make decisions about what bills to pay (or what to buy) every day. And if they only use the bank accounts to make that decision and don't consider outstanding checks, they can get into trouble very quickly. 

But I'm Not a Business! 

If you're reading this for the sake of your own personal finances, it's highly unlikely that you will perform a bank reconciliation for yourself. However, these concepts still apply to you from a decision-making process. For myself personally I owe the IRS money every single year, and the way I pay off my taxes is by writing a check when I file my tax returns. Every year when I write this check, I need to keep in mind that the account that I write this check from doesn't have as much money in it as I think it does. Even if the bank says I have $6,000 in my account, I need to remember that I wrote a $2,000 check to the IRS, and therefore actually have $4,000 of funds available in that account. I would be in big trouble if I spent $4,500 and when the IRS went to cash their check there wasn't enough funds in there. Even if I don’t perform a bank reconciliation for myself, I still need to know what funds are outstanding at any given time.

So, whether you're an individual or business, understanding the concept of the bank reconciliation and the timing differences between when banking items are initiated versus when they're processed is essential knowledge to have. For businesses, understanding how the reconciliation works mechanically is also important so the report can get prepared correctly.