Balancing the Books: Understanding the Main Purpose of Bank Reconciliation in Accounting

When students first begin studying accounting, they are introduced to a variety of concepts and techniques designed to help businesses maintain accurate financial records. One of the fundamental skills every budding accountant must learn is how to reconcile a company’s bank statements with its own records. This process, known as bank reconciliation, is crucial for ensuring that financial records are accurate and up-to-date.

In this tutorial, we will explore the main purpose of bank reconciliation, why it’s necessary for accurate accounting, and how it works step by step. Using examples, journal entries, and financial statements, we’ll help you understand how to perform a bank reconciliation and why it matters in the broader context of business finances.

What is Bank Reconciliation?

Bank reconciliation is the process of comparing a company’s cash records (usually found in the cash book or general ledger) with its bank statement. The goal is to ensure that the balance shown in the company’s accounting records matches the balance reported by the bank. A mismatch between these two figures often occurs due to timing differences, errors, or transactions that haven’t yet been recorded.

A bank reconciliation can identify discrepancies, such as:

• Outstanding Checks: Payments that the company has made but that have not yet cleared the bank.
• Deposits in Transit: Money that has been deposited into the bank but has not yet been recorded on the bank’s statement.
• Bank Fees or Charges: Charges the bank may impose, which the company has not yet recorded.
• Errors: Mistakes in either the company’s or the bank’s records.

Bank reconciliation ensures that both the company’s and the bank’s records reflect the same financial reality, contributing to better cash management and preventing fraud.

Why is Bank Reconciliation Important?

The primary purpose of bank reconciliation is to ensure the accuracy of financial records. Here’s why it’s essential:

1. Accuracy in Financial Reporting: Businesses need accurate financial statements for decision-making. If the records do not match the bank statement, it can lead to incorrect cash balances, affecting other financial reports such as the balance sheet and income statement.
2. Preventing Fraud: A regular bank reconciliation helps detect unauthorized transactions, accounting errors, or even fraudulent activity. Any discrepancies can be investigated before they escalate into bigger issues.
3. Better Cash Management: By reconciling bank records regularly, a company can better track its cash flow. This allows for more effective budgeting and financial planning, preventing situations where the company believes it has more cash than it actually does.
4. Compliance: In many countries, businesses are required to perform bank reconciliations as part of maintaining compliance with financial reporting standards or regulations. Regular reconciliations ensure the company meets legal requirements.
5. Error Detection: Bank reconciliations help in spotting errors, such as double entries, missing transactions, or mathematical mistakes. Without this process, these errors can go unnoticed and compound over time.

How to Perform a Bank Reconciliation

Now that we understand why bank reconciliation is important, let’s walk through the process of performing one. We’ll use a practical example to illustrate the steps involved.

Example: A Simple Bank Reconciliation

Suppose that on March 31, a company, XYZ Ltd., needs to reconcile its bank records for the month. Here’s the information they have:

• The cash book (company’s records) shows a balance of $15,000.
• The bank statement (from the bank) shows a balance of $13,800.

At first glance, there is a difference of $1,200 between the two balances. To reconcile this, we must adjust for the following:

1. Outstanding Checks: XYZ Ltd. issued checks during March that haven’t cleared the bank yet. The outstanding checks total $700.
2. Deposits in Transit: XYZ Ltd. deposited $500 on March 30, but the deposit hasn’t appeared on the bank statement yet.
3. Bank Charges: The bank charged XYZ Ltd. a fee of $50 for account maintenance, but XYZ Ltd. hasn’t recorded it yet.
4. Error in Company’s Record: XYZ Ltd. mistakenly recorded a check payment of $300 twice.

Let’s go through each adjustment step by step.

Step-by-Step Bank Reconciliation Process

Step 1: Start with the Bank Statement Balance

We begin with the bank’s balance of $13,800.

Step 2: Add Deposits in Transit

Deposits in transit are deposits that the company has made but the bank hasn’t yet processed. We add the deposit of $500 to the bank’s balance.

Bank Balance After Adjusting for Deposits in Transit: 13,800+500=14,300

Step 3: Subtract Outstanding Checks

Next, we subtract the outstanding checks. These are checks that the company has written but haven’t cleared the bank yet. The total of outstanding checks is $700.

Bank Balance After Subtracting Outstanding Checks: 14,300−700=13,600

Step 4: Adjust for Bank Charges

The bank charged XYZ Ltd. a $50 fee, which needs to be subtracted from the balance, but has not been recorded in the cash book.

Adjusted Bank Balance After Charges: 13,600−50=13,550

Step 5: Compare with Company’s Cash Book

Now, we turn to the company’s cash book. The balance in the cash book is $15,000, but we need to adjust for the error in the company’s records and the double entry for a check payment.

Step 6: Correcting the Company’s Record

We will subtract the error of $300 for the double payment of a check. The company’s cash book will be adjusted as follows:

Company’s Cash Book Balance After Correcting the Error: 15,000−300=14,700

Step 7: Adjust for Bank Charges

Remember that the bank charged a fee of $50, which the company needs to record in the cash book. We will subtract $50 from the company’s cash book.

Adjusted Cash Book Balance After Charges: 14,700−50=14,650

Now that both the bank and the company’s cash book have been adjusted, we can compare the final balances.

Final Reconciliation Summary

• Adjusted Bank Balance: $13,550
• Adjusted Cash Book Balance: $14,650

Clearly, there is still a discrepancy of $1,100. This is because the company has not yet accounted for the deposit in transit of $500, which the bank has not processed yet. Once we add this deposit to the company’s cash book:

Adjusted Cash Book Balance After Adding Deposit in Transit: 14,650+500=15,150

Now, both the bank and the cash book balances match. The reconciliation is complete, and the accounts are in agreement.

Bank Reconciliation Journal Entries

To properly record the adjustments in the company’s general ledger, XYZ Ltd. must make the following journal entries:

1. To Record Bank Charges:
   • Debit Bank Charges $50
   • Credit Cash $50
2. To Correct the Double-Entry Error:
   • Debit Cash $300
   • Credit Accounts Payable $300

Bank Reconciliation Practice Questions

Now that we’ve walked through a comprehensive bank reconciliation, it’s time to practice. Below are a few practice questions to help you solidify your understanding.

Practice Question 1: Bank Reconciliation

XYZ Ltd. has the following information for the month of April:

• Cash Book Balance: $8,000
• Bank Statement Balance: $7,500
• Outstanding Checks: $1,200
• Deposits in Transit: $400
• Bank Fees: $20

Perform a bank reconciliation.

Answer:

1. Start with the bank’s balance of $7,500.
2. Add deposits in transit of $400 to the bank’s balance. 7,500+400=7,900
3. Subtract outstanding checks of $1,200 from the bank’s balance. 7,900−1,200=6,700
4. The bank fees of $20 need to be recorded in the cash book.
   • Debit Bank Charges $20
   • Credit Cash $20
5. Adjust the cash book balance by subtracting $20. 8,000−20=7,980
6. The bank and cash book balances now match at $7,980.

Practice Question 2: Bank Reconciliation

ABC Corp. has the following information for the month of May:

• Cash Book Balance: $12,500
• Bank Statement Balance: $13,200
• Outstanding Checks: $1,500
• Deposits in Transit: $800
• Bank Service Charges: $30
• Error in Cash Book: ABC Corp. recorded a check payment of $200 twice.

Perform a bank reconciliation for ABC Corp.

Answer:

1. Start with the bank’s balance of $13,200.
2. Add deposits in transit of $800 to the bank’s balance: 13,200+800=14,000
3. Subtract outstanding checks of $1,500 from the bank’s balance: 14,000−1,500=12,500
4. Subtract bank service charges of $30 (which the company has not yet recorded) from the cash book:
   • Debit Bank Charges $30
   • Credit Cash $30
5. Correct the error in the cash book: ABC Corp. mistakenly recorded a check payment of $200 twice. To correct this, add back $200 to the cash book: 12,500+200=12,700
6. Adjust the cash book balance by subtracting the bank charges: 12,700−30=12,670
7. Final reconciliation: The adjusted cash book balance is $12,670, and the adjusted bank balance is also $12,670, so the reconciliation is complete.

Practice Question 3: Bank Reconciliation

LMN Enterprises has the following information for the month of June:

• Cash Book Balance: $10,000
• Bank Statement Balance: $9,750
• Outstanding Checks: $650
• Deposits in Transit: $200
• Bank Error: The bank mistakenly deposited $150 into LMN’s account.
• Bank Charges: $10

Perform a bank reconciliation for LMN Enterprises.

Answer:

1. Start with the bank’s balance of $9,750.
2. Add deposits in transit of $200 to the bank’s balance: 9,750+200=9,950
3. Subtract outstanding checks of $650 from the bank’s balance: 9,950−650=9,300
4. Correct the bank error: The bank mistakenly deposited $150 into LMN’s account, so subtract $150 from the bank’s balance: 9,300−150=9,150
5. Subtract the bank charges of $10 from the cash book:
   • Debit Bank Charges $10
   • Credit Cash $10
6. Adjust the cash book balance by subtracting the bank charges: 10,000−10=9,990
7. Final reconciliation: The adjusted cash book balance is $9,990, and the adjusted bank balance is also $9,990, so the reconciliation is complete.

These practice questions are designed to help reinforce your understanding of the bank reconciliation process. By working through these scenarios, you’ll develop a deeper understanding of how adjustments are made and how to handle common discrepancies in bank records.

Conclusion

Bank reconciliation is an essential process in accounting that ensures a company’s financial records are accurate and reliable. It serves as a crucial control mechanism to identify discrepancies, prevent fraud, and improve cash management. By mastering the reconciliation process, accounting students can better understand how to maintain accurate financial records and ensure that business transactions are correctly recorded. Regular practice with different examples and adjustments will build your skills, making you proficient in this foundational aspect of accounting.