Reconciliation

What is Reconciliation?

Reconciliation is the process in accounting that ensures accuracy by cross-checking records between two parties to align figures with the terms and conditions of a transaction.

In simple terms, reconciling a company’s internal records ensures accuracy and consistency by checking the relevant statements (external or internal) related to the transaction and comparing them against the company's internal records. 

This allows the company to maintain the consistency and completeness of its journal entries. “But why does a company need to do that? Are you implying that the company has fraudulent activities going on for the discrepancies that occurred?”  

No, that's not the case. The primary purpose of reconciling is to ensure accuracy and consistency by fact-checking using external sources. Every human is prone to errors and omissions, whether in a company, bank, government, or any other context. 

But that being said, reconciling accounts is an excellent measure to check for any malicious activities. Reconciling an account can pinpoint its weak areas and identify the person responsible for explaining the situation and circumstances of the discrepancies. 

One can expect a certain level of discrepancies, as any reasonable level of discrepancies is mostly due to natural human error. Still, if the level of discrepancies is of day and night difference, it can be due to fraudulent activities. 

Let's explore what reconciling your accounts has to offer for your business so that your records remain accurate and consistent to avoid any problems that threaten your business’s reputation and existence. So, let’s dig in.

Understanding The Reconciliation

Reconciliation is an accounting measure used to ensure the accuracy and consistency of the books of accounts by cross-checking the facts and figures of the company’s statement against the statement of external sources.

No standard procedures exist to govern reconciling efforts exclusively since experienced professionals perform the reconciling tasks; however, accounting standards such as GAAP and IFRS issue guidelines on how to reconcile the accounts properly. 

Both accounting standards require operating companies to adopt a double-entry bookkeeping system, developed by Luca Pacioli in 1494, which identifies and categorizes the movements of the affected accounts into debit and credit balances from the general ledger. 

Any transaction taking place will affect both sides of the account, ensuring that transactions are accurate and complete by showing a dissected view of the accounts. This allows the identification of possible weaknesses. Therefore, the balances should be cut out to zero.  

The reconciling efforts shouldn’t be limited to businesses but can be incorporated into personal life. Finance is everywhere, whether it is corporate or personal finance. Knowing how to manage finance is trivial as it can drive a person or a business to financial downfall.

Types Of Reconciliation 

Different standards are available for everything crafted to meet the requirements. Reconciling is no different, as its types are suited to different entities to meet their circumstances. Broadly, there are two reconciling types: 

Business Reconciliation 

Businesses are the ones that experience the full extent of reconciliation by accounting professionals, as the company is accountable to many users, both external and internal, such as shareholders and stakeholders, which requires the company to report accurate figures. 

Therefore, companies must be reconciled to ensure accurate figures are recorded and maintain consistencies, and if any discrepancies are found, make adjustments for them, as there are consequences for inaccuracy and inconsistency, especially during the audit.   

Typically, reconciling measures for a month prior occurs once a month after the previous month’s end. The reconciling efforts ensure the accuracy and consistency of the financial statements to the general ledger and between each financial statement.

Companies typically must reconcile their accounts using accounting standards relevant to the location, such as GAAP for operating in the US. In contrast, companies based in the rest of the world follow IFRS.

Suppose you are the Chef Accountant of Vel Co. You decided to reconcile the internal records of Vel Co. with the bank using their statements to ensure accuracy in the company’s bookkeeping. Any discrepancies you find are further discussed on whether to record them.

Personal Reconciliation 

Generally, people don't usually account for their finances, leading to a bad habit of spending and financial troubles. Being accountable to your finances is a great habit to build and can lead to financial freedom and prosperity. 

However, financial freedom and prosperity don't come from just recording expenses but should be strategically planned. “But what is the connection between financial freedom and strategy?” we hear you say. Well, it is quite simple actually: It's the quality data. 

Ensuring one's finances are accurate and reliable can help make better decisions and execute plans. And how to ensure its accuracy? Reconcile the accounts. 

Reconciling a record is an essential habit to practice, as human beings are naturally prone to errors and omissions; it's better to use external sources to fact-check the accuracy and consistency of the personal record. 

Suppose you are in the market for the latest iPhone. You are looking for a 256 GB storage option as you are heavy on storage consumption and prefer a comfortable size that fits your pocket. You researched and decided on the iPhone 15. But on the Apple website, it costs $899. 

You look at your budget; you can't afford it now, as you are left with $500 at the month's end. So you decided to save up $300 every month based on this month end’s remaining money for the next three months to afford the purchase.

Types Of Account Reconciliations 

Aside from the above-stated nature of reconciling, we will be driving some types of reconciliation related to the businesses. Some of the common types of reconciling practices performed by businesses are explained below. 

Bank Reconciliation 

The prime reconciliation for every organization. Banks provide detailed statements of the account, which provide insights into each transaction a particular account has dealt with. Using this, the company can reconcile with their records. 

Vendor Reconciliation 

Reconciling with vendor statements would be the next type in the list as it is another frequent type businesses use. Companies can approach their vendor/seller for their statement, which the company can reconcile against their records for the accuracy of the purchases. 

Customer Reconciliation 

From the name itself, one can decipher that the companies make requests to their customers for their record of statements, using which the company can reconcile its records to see the accuracy. Typically, this measure takes place when the client is a retailer.   

Intercompany Reconciliations

This type of reconciling practice is usually seen performed by the holding companies. The parent company would unify all the subsidiary companies into one group of companies and conduct intercompany transactions such as intercompany sales, loans, etc. 

Such parent company would reconcile statements of subsidiary company between or within to ensure accuracy, completeness, and consistency in the recording processes of the intercompany transactions for the entire group of companies.  

Internal Reconciliation 

Companies would often reconcile accounts with their internal statements, especially departments, from the start of the financial cycle to the end to ensure consistency and accuracy in the company's internal records. 

Reconciliation Methods 

Reconciliation should be structured, as these procedures are performed regularly on all accounts related to the company, with the intent of keeping the integrity of the company's financial records. 

Now, there are two methods by which accounts or statements can be reconciled depending upon the circumstances and the type of procedures required.

Documentation Review 

Under the documentation review, the reconciling team procures physical evidence of the occurred transaction, such as receipts, to ensure that the event has occurred and to avoid any discrepancies in the account or any accounts connected to the account. 

To give a practical instance, during the documentation review, an auditor procures the inventory record and investigates on site of the company’s inventory management by comparing the amount in the record to the physical inventory (sheet-to-floor) or vice-versa (floor-to-sheet)

Analytical Review 

Under the analytical review, the reconciling team assesses the historic level of activity to estimate the appropriate amount that should have been recorded in the internal records and compares it with supporting statements to identify any irregular levels of discrepancies. 

For instance, during the analytical review, an auditor can re-evaluate the KPIs presented by the management to ensure that the figures presented are accurate. Accuracy is ensured when the auditor reaches the same conclusion as the management.

Reconciliation Processes

Every procedure has a preset process, with which there will be a proper execution of the plan and reap the benefits of the plan. Reconciling is no different, as it is the set of processes undertaken to ensure the accuracy and completeness of the records. 

Below are the five common processes every business undertakes when reconciling their accounts.

1. Compare internal records to an external statement for any discrepancies.  
2. Identify recorded particulars in the internal record and not in the external record (and vice-versa), as there can be situations where the recorded item in the company’s record may not reflect in the external record at the time, especially the issuance of cheques. 
3. Confirm cash receipts and deposits are recorded in both internal and external statements.
4. Be alert for external errors. An External statement, such as bank statements, are also run by human beings and are prone to errors in the bank statements. Therefore, notify the external authorities to reflect the required changes.  
5. Balance both internal and external records.

What Causes Discrepancies When Reconciling Accounts?

Discrepancies are acceptable up to a limit due to the human tendency to cause errors. But human error is not the sole factor contributing to discrepancies; let's explore some known factors.

Slow Timing 

A timing difference is one factor leading to discrepancies in an account. Generally, when recording a payment made in the books of account, it will not reflect in the bank account instantly, as was the case when the economy ran off paper-based transactions. 

Now, the world has embraced digital transactions, so the time to reflect the bank account should be a few minutes to hours, depending on the nature of the transaction. 

Omissions/Forgetfulness 

Humans are prone to forget. It's a fact one way or another, especially when a human ages. Unlike computers, a human is bound to miss a detail or two during the recording processes; even though the human brain is more capable than a machine, it is still bound to missing details. 

Typos/Mistakes 

As mentioned above regarding human omissions, it is relevant to assume that humans are bound to make typing mistakes and errors during the recording processes, which may be critical for the company.

So, to avoid reaching the critical stage, reconciling accounts can help spot and adjust remedies to the weak points before the adverse consequences take shape. 

Fraudulent Activities

Fraudulent activities are a temptation for human beings, especially when they possess large quantities of wealth and power. Reconciling accounts allows companies to spot malicious activities as the fraud-affected accounts probably have a discrepancy. 

When such discrepancies are discovered, it is usually night and day difference; the management responsible for the account should be questioned for an explanation regarding the cause of discrepancies in the account.

Abundant Tools 

As the business grows, the accounts it deals with increase in both size and complexity along with new accounts it has to deal with. As the accounts grow, it becomes difficult for the companies to manage every one of them, which can lead to errors.

Therefore, many tech companies attempt to address this issue by providing various solutions. However, the abundance of options can lead to decision fatigue. As the market is filled with options, the companies need help to choose the right solution. 

Only some solutions solve the company's issue at hand. Therefore, becoming a waste of investment in both terms of money and time (training the employees) for a solution that only partially solves the problem.

Practical Application Of Reconciliation 

As mentioned earlier, reconciling is a fact-checking procedure commonly employed by a company's accounts department. Let's now understand it from a business perspective using a simple scenario.

Amila and her two friends started a digital marketing agency named DigitalExpansion in Dubai. The start-up is a small-scale venture, due to which she and her co-founders were able to provide the initial funds from their own pockets.

DigitalExpansion’s employees are three industry-experienced professionals, including Amila and two other co-founders. Therefore, she purchased three individual Mac Studio in cash for the three employees to start the work, costing around AED 27,000, i.e., USD 7,351.

Leveraging the newly acquired Mac Studios, DigitalExpansion successfully closed a deal for AED 6,000, equivalent to USD 1,634, and received the full payment via bank after delivering the product to the client, prompting the need to update the records.

During the acquisition of the Mac Studio and the subsequent earnings, according to double-entry bookkeeping, a simple journal entry for the two events (equipment acquisition and payment) general ledger should be as follows:

DigitalExpansion 

General Ledger A/c

Since buying a Mac Studio is an investment (Asset) to the business, the asset increases, debiting a dedicated equipment account. When purchasing the Mac Studio with cash (Asset), the asset decreases as cash goes out of the business; therefore, credit the account.

Since the transaction is in credit, the accounts receivable account is debited as it is an asset (income) a company expects to receive in the future from the client. The sales account is credited as the sale is closed and increases the investor’s equity.  

Regarding the client's payment, the client paid the amount using a credit card. The DigitalExpansion receives the amount in its bank account (Asset), therefore debiting the bank account as cash enters the business.

The accounts receivable is an asset that expects a customer to receive an amount. Since the client paid the amount, the accounts receivable (asset) is reduced, therefore crediting the account.

DigitalExpansion can enquire a statement from the bank, using which DigitalExpansion confirms that AED 6,000 income in the bank statement matches with the internal records of the DigitalExpansion as shown below.

Liv Banking 

DigitalExpansion Bank Statement

Notice how in the internal record, the same transaction is debited but in bank statement it is credited? Well, it is because, when a company’s cash in the bank increases, it is an asset for the company, but for the bank, it is a liability as it is not the bank’s money, therefore, credited.

Researched and authored by Muhammed Ishfaque Ishaque | LinkedIn

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