Account reconciliation is the process of comparing the balance of your financial statement amounts to the detailed statements and ledgers supporting those amounts. The reconciliation process is really only relevant to balance sheet line items, and more specifically they are only relevant to assets and liabilities.
The reconciliation process should be done for all assets and liabilities – not just Cash. It is through this process that you find errors in process and procedure, and ensure that the balance sheet disclosures are supported by underlying detail. It is an exercise that is tedious at times but is absolutely critical to ensuring the integrity of your financial statements. So not only does it add value to the integrity of your balance sheet, but it also bolsters your ability to rely on all of your financial statements.
Here’s how. You know that:
Assets – Liabilities = Ending Owner’s Equity.
You also know that:
Ending Owner’s Equity = Beginning Owner’s Equity + Net Income (Loss) + Owner Contributions – Owner Draws.
If you have all Assets and Liabilities reconciled and have rolled forward the Ending Owner’s Equity, then it must follow that your Net Income is also correct. Now the Income Statement may have classification errors, but the bottom line has been supported through the reconciliation process.
Reconciliations can take different forms. You are probably most familiar with the Cash reconciliation where the balance on the bank statement is reconciled to the general ledger cash account. In this case, many of the reconciling items are timing differences – checks and deposits recorded in the Company’s books but not having cleared the bank account; bank fees charged to the bank account but not having been recorded in the Company’s ledgers. If the differences are not appropriate (differences like those described above) then more research is needed to determine whether there was a banking error or irregularity.
Notice the cash reconciliation uses a document prepared by a third party (the bank statement) in order to substantiate the activity recorded by the Company. Most reconciliations do not work this way.
Most reconciliations compare the subsidiary ledgers generated by one area within the Company to its general ledger account balance. For example, the Accounts Receivable aging trial balance is compared with the Accounts Receivable general ledger balance; the Fixed Asset subsidiary ledger is compared to the Fixed Asset general ledger balance; or the Accounts Payable detail aging report is compared to its general ledger control account.
Some balance sheet accounts are used to ensure that transactions are complete. These accounts are called suspense accounts or clearing accounts. They are used when 2 different areas of the Company are involved in the same transaction. For example, the warehouse may receive shipments of inventory but the accounting department records the invoice as a payable. Offsetting entries are recorded in the same suspense or clearing account so that the balances clear. So in the reconciliation process it is important to verify that the suspense and clearing accounts are functioning as designed. In other words, clearing accounts should clear.
The importance of a good reconciliation process cannot be overstated. Accurate and timely reconciliation can be a foundational process that the integrity of the financial statements can be proven.