Organizations spend a lot of time and money implementing internal controls to ensure financial reporting is reliable, operations are effective and efficient, the company complies with applicable laws and regulations, and its assets are safeguarded against theft and unauthorized use. Yet companies often overlook one of the most important internal controls: Account reconciliation.
In the simplest terms, account reconciliations involve comparing two sets of related financial records to ensure they agree. When done regularly – and with the help of automation – reconciliation ensures a smooth financial close.
Companies typically perform account reconciliation after the close of a financial period by reviewing each account in the general ledger, comparing the account balance with outside sources, and investigating any discrepancies.
Four Basic Methods for Account Reconciliation
There's more than one way to reconcile an account. Here, we cover the various reconciliation methods, as well as the advantages and disadvantages of each.
Method #1: Reconcile a bank, credit card, or loan statement.
For bank accounts, credit cards, and loans, the company reconciles the balance in the general ledger to a statement provided by the financial institution or lender.
The reconciliation process should always begin by ensuring that the previous reconciliation still ties out. If the company changed or added new transactions to a prior period, the accountant needs to review those transactions and update the prior reconciliation.
Next, the accountant goes through each transaction on the statement and matches it to transactions in the company's accounting software.
For a loan or rarely used bank or credit card account, this process may be fairly simple. Accounts with hundreds of transactions, however, can be more complex. In these instances, the balance in the company's general ledger is rarely the same as the balance shown on the statement either because of transactions recorded in the general ledger that haven't yet cleared or payments and deposits not yet received by the financial institution.
In some cases, the accountant may discover errors that require disputing transactions with the credit card processor or bank.
Once the accountant records any bank fees or credit card interest and resolves errors and timing differences, the accounting software's balance should match the statement balance.
Method #2: Reconcile account activity.
Many accounts on the balance sheet don't come with handy monthly statements. For these types of accounts, the accountant may need to reconcile the general ledger balance with another form of documentation – usually a spreadsheet calculation.
One common example is prepaid expenses. Typically, an accountant will prepare a prepaid expenses amortization spreadsheet, which includes the beginning and ending dates of the amortization period and the amount being capitalized.
For example, say the company prepays $12,000 to cover six months of rent on Jan. 1. Each month for six months, the company moves $2,000 from prepaid to rent expense, leaving a balance of $10,000 as of Jan. 31, $8,000 as of Feb. 28, and so on.
At the end of each period, the accountant compares the general ledger balance to the prepaid rent amortization spreadsheet to ensure the amortization journal entry has been posted as scheduled. If the account balance doesn't match, the accountant needs to determine why and possibly adjust the account balance.
Other accounts that typically reconcile account activity include unearned revenues and accrued liabilities.
Method #3: Reconcile subsidiary ledger activity
Some balance sheet accounts are tracked in separate subsidiary ledgers or schedules.
One common example is accounts receivable. To reconcile accounts receivable, the accountant compares the balance in the general ledger to the AR aging report – a detailed listing of unpaid customer billings.
Again, the accountant's starting point should always be the previous reconciliation. Starting with the last accounting period where the aging was in balance ensures that the accountant doesn't waste time searching for discrepancies that stem from a prior period. Once the prior period is in balance, the accountant can move on to the current period.
During the reconciliation, the accountant may find differences between the general ledger and the AR aging report because of journal entries made to the general ledger that bypassed the subsidiary ledger, or
billings or receipts accidentally posted to an account other than AR.
If the accountant identifies any errors, it's best to reverse incorrect entries and repost them correctly rather than simply posting the difference only. This makes any necessary entry adjustments easier to follow.
Other accounts that typically reconcile with a subsidiary ledger include accounts payable, inventory, and fixed assets.
Method #4: Reconcile with a roll-forward
Equity accounts, such as common stock, preferred stock, additional paid-in capital, retained earnings, and treasury stock are typically reconciled with a roll-forward. For this reconciliation method, start with the ending balance from the prior period, then add all debits and credits to arrive at the ending balance.
The key is to ensure that each debit and credit is valid, correct, and appropriate. A roll-forward reconciliation shouldn't simply be a replication of the general ledgers.
In most cases, changes to these accounts stem from net profit or loss closed out to retained earnings and dividend payments to shareholders. Calculations and documentation should support these and other transactions impacting equity accounts to ensure that senior management and external auditors can quickly find the sources and explanations for every change to the equity account balances.
Companies often take account reconciliations for granted, but they're an essential internal control for ensuring accuracy and efficiency of its financial close process and the financial statements themselves. Getting in the habit of reconciling regularly – and taking advantage of automation tools to streamline the process – makes it easy to spot errors and ensures your company's financial information is accurate and up-to-date.
Guest post courtesy of Richard Anderson