Bank Reconciliations – Fundamentals

The bank reconciliation is a daily accounting function for every small business. In order to fully appreciate its value, the small business owner needs to understand the fundamentals of how bank reconciliations are performed.  In addition, there are some higher level types of transactions that affect the cash position. These more difficult types of transactions are explained in another article in this section of the website. The focus of this article is to introduce the reader to the fundamentals of why you need to reconcile the cash accounts and how to perform a basic reconciliation. 

Every business owner or individual in charge of the finances needs to understand the concept of the cash position, how to perform simple bank reconciliations, and the importance of selecting the correct frequency in which to reconcile the cash accounts. The following sections explain each of these fundamentals of the bank reconciliation: 

Know Your Cash Position 

Back in the days when I was an accountant I had many clients and each morning I would go online to check the status of several client cash accounts. Mostly I was interested in making sure nothing unusual occurred. To me, I wanted to be prepared if I got a phone call from a client requesting an unexpected cash disbursement or didn’t understand a particular transaction. In addition, I needed to stay on top of the client’s cash in’s and out’s in order to maintain my understanding of their business operation.  

For any small business owner, you need to know your cash position. How much do I have right now? What disbursements (checks) are pending? How much cash do I need to deposit to meet my needs over the next few days, week and the month? All of this information changes every day with each check you write, each sale you make and the expenses you incur. To fully understand this, you have to reconcile your cash accounts frequently. 

In addition, it is comforting to know where you stand with cash so if there is an unexpected need, you know how much is really available. If there are inadequate funds, then you will have to make other arrangements to meet this unforeseen situation.  

How to Perform a Simple Bank Reconciliation

When reconciling you have two known amounts at the start. First is the cash ledger balance. This is the dollar amount your books of record indicate you have available in the cash account. The second known number is the bank account balance. The traditional source is the bank statement, but in modern times, the small business owner goes online and can see the exact amount available in the bank account at that very moment. 

Often, these two numbers are quite different from each other.  Why?  Well, let’s start out with the most common item and that is an outstanding check. An outstanding check is one that has been recorded to the books and issued (usually via mail) to the vendor or supplier. They haven’t cashed it yet. The easiest step in the reconciling process is to take the bank balance and subtract any outstanding checks. Often, when you subtract the outstanding checks from the bank balance it ends up matching your ledger balance.  

There are many more basic elements and the following subsections describe these basic types of transactions to reconcile between the two known amounts. Once I explain these different elements, I’ll walk you through a simple spreadsheet that you may use for each day to perform a basic reconciliation. Finally, I illustrate a typical example and use the spreadsheet as my working example. 

From the Bank Account Balance:

• Outstanding Checks – as exemplified above, this is the most common item missing from the bank balance. If you look at the detail activity report the bank provides, it will identify those checks that have been cashed. Since checks never cash in numerical order, it is best to use your ledger activity report as the basis to begin checking off those that have been recorded by the bank. As you proceed through the list of checks, you’ll discover several that are missing from the bank’s activity report. You simply make up a list of these outstanding check numbers and the corresponding amounts and subtract this dollar value from your bank’s balance.  

Invariably, there is always a vendor or employee that doesn’t need or want their respective money right away. I’ve seen folks hold checks for three and four months. As you do your bank reconciliation, look at your prior reconciliation for the list and bring forward any of those checks the bank has not cashed yet. Then go through the process of inserting the newer checks into the list of unrecorded checks to finish off your list of outstanding checks.

• Outstanding Electronic Withdrawals – in addition to outstanding checks there are other forms of withdrawals that the bank may not have recorded yet. A good example is an electronic payment to a government authority such as the IRS or your state government for taxes. Most government institutions take about a day sometimes two days to receive the funds from your bank account. I see this mostly with 941 payments that are posted to the ledger on your books but the IRS hasn’t presented for payment from the bank.  

You can easily spot these by reviewing the transaction cash account ledger against the bank activity ledger and ensuring that each electronic withdrawal shows up in the bank’s activity report. 

• Outstanding Deposits – similar to the outstanding checks, the bank may not have recorded your most recent deposit. How does this happen? Well, the most common reason is associated with the way deposits are processed. Your bookkeeper/accountant records the deposit and prepares the deposit slip for physical deposit to the bank. The physical part is in the night deposit box or was deposited after the posting time (which is typically 2 PM or up to 4 PM for some banks). For the bank, they don’t post the transaction to the activity report until the next banking day. Thus, your ledger shows a deposit, but the physical aspect is not complete yet. 

Some businesses address this by not recording the deposit until the bank deposit slip goes back to the accountant for the recording process. For you, the key is to understand the process and the reasoning associated with why something may not be in the bank account yet.

From the Ledger Account Balance:

• Unrecorded Withdrawals – in the past, the most common form of an unrecorded withdrawal was the monthly bank fee. Each month, the bank automatically removes their fee (usually $10 to $20) and the accountant/bookkeeper hasn’t recorded the entry yet. But in more modern bank accounts, a debit card is used to pay for some item and its automatic, instantly withdrawn. When you are looking at your bank balance on line, it includes these debit card entries. But the bookkeeper hasn’t recorded the entry yet.  Here is a short list of the more common types of withdrawals at the bank but customarily posted into the books after the transaction has occurred:

o   Bank Fees
o   Debit Card Activity
o   Bank Penalty Fees
o   Owner’s Hand Check for Cash (presented at the bank without informing the accountant)
o   Monthly Bank Loan Payments or Automatic Loan Payments
o   Overdraft Fees

• Unrecorded Deposits – you don’t see this one too often. Unless your cash deposits process is the physical deposit first before recording to the cash account ledger, you will rarely see unrecorded deposits in the bank account.  But they do occur. The most common form is unrecorded bank interest deposits. Others include credit card receipts deposited to the bank account prior to recording in the cash ledger. The key is that this type of transaction adjustment is more uncommon than the items identified above. But they do happen! 

Before we proceed, did you notice the terminology? Any issue dealing with the bank is referred to as ‘Outstanding’ and any issued related to the cash ledger account is call ‘Unrecorded’. This makes sense because the term ‘Outstanding’ is a banking industry term used to refer to something that hasn’t happened yet (in the bank account activity ledger). In our business cash ledger accounts, any transaction we haven’t documented to the books of record means we haven’t recorded the transaction to the cash ledger. This is very common and is usually a result of the bookkeeper or the accountant not having entered the data yet. In effect, it is sitting in the in-box on their desk and they just haven’t entered the data into the accounting software. 

Now that I have explained the terminology, let’s take a look at a simple illustration of how to prepare a bank reconciliation: 

Step 1 – Get the bank balance and the corresponding activity ledger in front of you.
Step 2 – Get a copy of the cash account ledger too.
Step 3 – Start with the bank account balance and subtract any outstanding checks.
Step 4 – Still using the bank balance, subtract any outstanding electronic withdrawals.
Step 5 – Continuing with the bank account, add any outstanding deposits as described above.
Step 6 – Calculate the adjusted bank balance which is the bank balance as reported, subtracting outstanding checks and electronic withdrawals. From this dollar value, add the outstanding deposits. This final value is referred to as the adjusted bank balance.
Step 7 – Now we start with the ledger balance and subtract those withdrawals from the bank account that have yet to be recorded to the books.
Step 8 – We continue by adding unrecorded deposits.
Step 9 – Sum steps 7 and 8 to calculate the adjusted book balance.
Step 10 – The adjusted bank balance should equal the adjusted book balance.  

If you will review this spreadsheet you will see how this 10 step process unfolds. Please download this free fundamental example of a bank reconciliation. It is stored on the website and you should have no problems with your virus protection program. Furthermore, my site uses virus software provided by the host to ensure all information is virus and spam free. Download this spreadsheet: Bank Reconciliation – Fundamentals

You can see the fundamentals tab follows the 10 step process as identified above. This is just an example of how you process a basic bank reconciliation.  

Select the Correct Frequency of Reconciling the Cash Accounts

For every small business one of the primary questions is ‘How often do I need to perform a bank reconciliation?’ The answer is simple: EVERY DAY.  

This seems like a lot of work, but in the small business world, it really only takes 7 to 10 minutes to perform each day. It is straight forward because you follow a pattern and it really helps you to understand your financial situation. With modern technology and software it only takes a couple of minutes to go online and pull your bank activity ledger and your business cash account ledger to start the process. Using simple copy and paste you can copy the prior day’s reconciliation to a new worksheet, rename the tab and update the data fields to get quick results. 

As your company grows and you begin to have adequate funds in your account to last more than a week you can change the frequency to a longer cycle such as every 3 days or even a week. I would not recommend longer periods of time between reconciliations due to the value of knowing and understanding your cash position. In the small business world, understanding your cash position is essential as cash is the life blood of the small business operation.

Summary – Bank Reconciliations

The bank reconciliation is a process of identifying outstanding (missing) information at the bank and recognizing unrecorded data in the cash account transaction ledger. It takes about 10 steps to get the two to reconcile and agree as to the correct balance. If performed daily, the owner can easily keep up to date with his cash status.  It also facilitates the desire to earn more cash in order to have adequate funds available to meet your business needs. Act on Knowledge. 

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