What is bank reconciliation & how is it made?

What is bank reconciliation & how is it made?

What is bank reconciliation?

A bank reconciliation is a process performed by a company to ensure that its records (check register, general ledger accountbalance sheet, etc.) are correct. This is done by comparing the company's recorded amounts with the amounts shown on the bank statement. Any differences must be justified. When there are no unexplained differences, accountants state that the bank statement has been reconciled.

The bank reconciliation is an important part of a company's internal controls over its assets. To be effective, it should be done by someone other than an authorized check signer and/or record keeper.

Example:
Let's assume that a new company opens its first checking account on June 4 with a deposit of Rs.10,000. During the month of June the company wrote five checks with a total of Rs.5,000. It also made a Rs.2,000 deposit in the bank's night depository after banking hours on June 30. As a result, the company's Cash account (in its general ledger and referred to as the "books") as of June 30 shows a positive, debit balance of Rs.7,000.

The bank statement shows a June 30 balance of Rs.5,975. Note that this balance is different from the company's general ledger's Cash account balance of Rs.7,000. Generally, neither balance is the correct amount of cash that should be reported on the company's balance sheet.

To reconcile the company's balance and the bank's balance requires comparing the details. To illustrate, let's assume that:

  • The bank statement shows a bank service charge of Rs.25, but the company's general ledger does not
  • The Rs.2,000 deposit made by the company on June 30 is not shown on the bank statement
  • One of the company's five checks written in June having an amount of Rs.1,000 does not appear on the bank statement

We prefer to perform the bank reconciliation by adjusting both the company's cash balance and the bank statement balance to be the correct amount of the company's checking account balance, as shown here:

  • The company's Cash account balance of Rs.7,000 needs to be decreased by Rs.25 for the bank service charge. As a result, the adjusted balance per the company's books is Rs.6,975. This is the amount that the company can report on its balance sheet if it agrees to the adjusted balance per the bank.
  • The bank statement balance of Rs.5,975 needs to be increased for the Rs.2,000 deposit and to be decreased by the Rs.1,000 check. After these adjustments, the adjusted balance per the bank is Rs.6,975 (Rs.5,975 + Rs.2,000 - Rs.1,000).

Since both the company's books and the bank statement have an adjusted balance of Rs.6,975 the bank statement has been reconciled.


Can you explain credit memo and debit memo in bank reconciliation?

A bank Credit Memo is an item on a company's bank account statement that increases a company's checking account balance.
Example:

A few examples of a bank credit memo appearing in a company's bank account include:

  • The bank adding interest that was earned for having money on deposit
  • The bank having collected a note for the company
  • A refund of a previous bank charge

Since the amount of the bank's credit memo has already been added to the bank's balance, the bank reconciliation will not reconcile unless the amount is also included in the company's general ledger Cash account. To record the bank credit memo the company will debit Cash and credit another account. For example, if the bank statement shows a credit memo of Rs.20 for interest earned, the company will debit Cash for Rs.20, and credit Interest Income for Rs.20. (The company's Cash account needs to be debited because its asset has increased.)


A bank Debit Memo is an item on a company's bank account statement that reduces the company's checking account balance.
Example:

Some examples of bank debit memos include:

  • Bank service charge for maintaining the checking account
  • A subtraction for a customer's check that did not clear the customer's bank account
  • A bank fee for handling a check that was returned for insufficient funds
  • A monthly loan payment

Since the amount of a bank debit memo has already been subtracted from the bank account, the amount must also be subtracted from the company's general ledger Cash account. For example, if the bank statement shows a debit memo of Rs.25 for a service charge, it means that the company's general ledger Cash account will need an entry that credits Cash for Rs.25, and debits Bank Fee Expense or Miscellaneous Expense for Rs.25. (The company's Cash account needs to be credited because the company's asset account has decreased.)


What are some reasons that cause the balance on the bank statement differ from the cash balance on the books?

Some of the reasons for a difference between the balance on the bank statement and the balance on the books include:

  • Outstanding checks
  • Deposits in transit
  • Bank service charges and check printing charges
  • Errors on the company's books
  • Electronic charges and deposits that appear on the bank statement but are not yet recorded in the company's records.

How to document the differences

Any items that are already recorded in the company's general ledger accounts, but have not yet appeared on the bank statement (outstanding checks, deposits in transit), will be noted as an adjustment to the balance per bank statement. Outstanding checks are a deduction to the balance per bank; deposits in transit are an addition to the balance per bank.

If an item is on the bank statement but has not yet been entered on the books, the items are noted as an adjustment to the balance per books. Bank service charges, check printing charges, and other electronic deductions that are not yet recorded in the company's accounts will become deductions from the cash balance per the books. Electronic deposits not yet recorded by the company will become additions to the cash balance per books.


In a bank reconciliation, what happens to the outstanding checks of the previous month?

Outstanding checks are checks written by a company, but the checks have not cleared the bank account.
Example:

In a bank reconciliation the outstanding checks are a deduction from the bank balance (or balance per the bank statement).

If an outstanding check from the previous month did not clear the bank account in the current month, the check will remain on the list of outstanding checks. As a result, the bank reconciliation for the current month will again show the outstanding check amount as a subtraction from the bank statement balance.

If an outstanding check of the previous month clears the bank, it means the bank paid the check and the check will appear as a deduction on the statement. Hence, the check is removed from the list of outstanding checks.


Why does a company prepare a bank reconciliation?

There are several reasons for a company to prepare a bank reconciliation:

  • To safeguard the company's cash. Performing a bank reconciliation results in improved internal control over the company's cash if the reconciliation is done by someone other than the person handling and/or recording receipts and payments. Having this additional person prepare the bank reconciliation reduces the odds of an improper use of the company's cash.
  • To improve the confidence that the amount of cash that is reported on the company's balance sheet is accurate. The additions and deductions on the bank statement are compared (or reconciled) with the items that are entered in the company's general ledger Cash account. Some differences, such as outstanding checks and deposits in transit, are noted as simply timing differences.
  • Since most companies use the double-entry system of accounting, any omission or error in the company's general ledger Cash account also means that at least one other general ledger account will have a corresponding omission or error. For example, if a company had wired money from its bank account for emergency computer maintenance services and had not recorded the credit to its Cash account, it is also omitting the debit to the account Computer Maintenance Expense. The bank reconciliation could prevent this omission from occurring.

What is bank balance and book balance?

The term Bank Balance is commonly used when reconciling the bank statement. It is also known as the balance per bank or balance per bank statement. Typically it is the ending balance on the bank statement for each month.
Example:

When a company receives its checking account statement from its bank showing June's activity, the ending balance on June 30 is the bank balance. (Generally, this bank balance will not agree with the amount in the company's records since some checks written by the company will not have cleared the bank by June 30. Similarly, some money received by the company on June 30 may not have been deposited in time for the amount to appear on the June bank statement.)

The term Book Balance, which is also used in the bank reconciliation is the amount shown in the company's general ledger for the bank account. Book balance is also referred to as the balance per books
Example:

The balance on June 30 in the company's general ledger account
 entitled Checking Account is the book balance that pertains to the bank account being reconciled. (For an individual, the book balance is likely to be the balance appearing in the person's check register.) It is common for the book balance to not agree with the balance on the bank statement as of the same day. This is the case when there are bank fees or electronic transfers on the bank statement that have not yet been recorded in the company's general ledger accounts. For example, the bank statement may reveal that a bank service charge was withdrawn from the account on the last day of the month.

Is an entry made for outstanding checks when preparing a bank reconciliation?

No entry is made to a company's general ledger for outstanding checks when preparing a bank reconciliation. The reason is outstanding checks are an adjustment to the bank balance. Outstanding checks are not an adjustment to the company's Cash account in its general ledger.

However, if a company voids one of its outstanding checks, the company will need to make an entry to its general ledger. The entry will debit Cash in order to increase the account balance. The credit portion of the entry will likely be to the account that was originally debited when the check was issued.


How do you treat voided checks on the bank reconciliation?

If a voided check was written in a previous month, remove the voided check from the list of outstanding checks and write a journal entry to debit Cash and credit the account(s) that was debited when the check was originally recorded. This entry restores the cash into the checking account and eliminates the debit entered at the time the check was recorded. If the check was written in the current month, you can simply write the journal entry I just described.

Some software will allow a person to go into a previous period's activity (as well as the current period's activity) and remove the voided check or to change the amount to zero. This too will increase the cash balance and will remove the debit from the account originally debited when the check was recorded.


How many days after a month ends should the bank reconciliation be done?

The bank reconciliation should be done within a few days after the month ends. The reasons include (1) making certain that the company's Cash account has the correct balance, and (2) making sure that the financial statements for the month include all of the company's transactions. At the latest, the bank reconciliation should be done prior to closing the books for the month.

The bank reconciliation might reveal that some revenues and/or receipts were electronically deposited into the bank account but were not yet recorded in the accounting records. Likewise, there might be some expenses and/or payments that were deducted electronically from the bank account, but were not yet entered into the company's accounts. Further, the bank reconciliation might reveal some errors in the transactions already recorded in the company's general ledger.

To save time and to improve internal control, have the bank reconciliation be performed by someone other than the person writing the checks and/or recording amounts in the general ledger.


What adjustment is needed when a check that was written in a previous month appears on the current month's bank statement?

A check written in any previous month but not appearing on previous bank statements, should have been included in last month's list of outstanding checks. Now that the check appears on the current month's bank statement, the check should not be included in the current month's list of outstanding checks. No other action is needed.

The general ledger account has always been correct, because the amount of the check reduced the general ledger account balance at the time the check was written and recorded.

The problem was the previous bank statements. The bank statement balances were too high since the check had not yet cleared the bank checking account. That's why we subtract the amount of the outstanding checks from the bank statement balance. Now that the bank statement balance has been reduced by the check clearing the bank account, there is no longer a need to further subtract the amount of the check as outstanding.


Should receipts be recorded using the date the money was received or the date the money was deposited in the bank accounts?

Cash receipts should be recorded with the date the money was received. For example, a church collects money during each of its services on Sunday, June 4.

On Monday, June 5, the money is counted and is deposited into the church's bank account. The transaction to record the cash and the revenues (remember double entry) should be dated Sunday, June 4, since that is the day of the transaction—the day the church received the money.

The day the money is deposited into the bank account is not the proper date of the transaction. The accounting records should report that the money was received on Sunday, June 4.


How does one prepare a company's first bank statement reconciliation?

To prepare a bank reconciliation for a company that never prepared one previously, I would first make a list of outstanding checks. For example, if your recent bank statement is dated August 31, I would look at the bank statements from June through August and make a list of the check numbers that had been written after June 1, but had not appeared on any of the bank statements from June through August. Next to each check number write the dollar amount of each check. Subtract the total of the outstanding checks as of August 31 from the bank statement balance as of August 31. The resulting amount is the adjusted balance per bank. 

Next, look at the general ledger account that is associated with the bank statement. Let's assume it is the Cash account. Be certain that the Cash account shows items that appear on the recent bank statements. For example, Have the bank service charges been entered in the Cash account? Have the electronic transfers been entered? If not, you will need to make those entries. You may have to go back to earlier bank statements and enter those amounts as well.

Eventually, you need to get the August 31 balance in the Cash account to be equal to the adjusted balance per bank. If the difference is not a significant amount, you can debit or credit the Cash account for the amount necessary for it to agree to the adjusted balance per bank. I would put the same amount into an income statement account such as Difference per Bank Reconciliation Keep a copy of your documentation and begin a file entitled Bank Reconciliations.

When the September 30 bank statement arrives, prepare another bank reconciliation. Using a copy of the August 31 listing of outstanding checks, cross off the checks that cleared on the September bank statement. Prepare a September 30 listing of outstanding checks beginning with the checks not crossed off on the August 31 copy, and then add the checks written in September that did not clear on the September bank statement. The total of the outstanding checks as of September 30 should be deducted from the bank statement balance of September 30 to arrive at the adjusted balance per bank as of September 30. Be sure to enter into the Cash account the September bank service charge and other items appearing on the bank statement that have not yet been entered in the Cash account. This adjusted balance in the Cash account as of September 30 should be the same as the adjusted balance per bank as of September 30. If there is a difference, you must identify it and make any necessary adjustments.




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