Today, banking is easier than ever. With a few taps on your phone, you can check your balance, see recent transactions, and get alerts for deposits and payments. Your bank balance might sometimes differ from what you think it should be. It happens because of pending transactions, hidden fees, minor mistakes, and sometimes even fraud.
How do you catch discrepancies? You perform bank reconciliations.
In short, bank reconciliation is comparing a company's internal financial records to the bank statements received from the company's bank. The goal is to make sure that every business transaction recorded in the company's books matches the transactions listed on the bank statement. This process allows the business owner to verify that all recorded cash inflows and outflows are accurate and accounted for.
Bank reconciliations help identify discrepancies before they escalate.
Here are a couple of examples of why bank reconciliations are important:
Situation #1: Forgotten Checks
John runs a small retail business. One day, he gets a check from a customer. It's not for a big amount, so he deposits it into the bank and, like many of us, forgets about it. Life gets busy, and John hasn’t reconciled his bank account for months. Meanwhile, the bank refused the check due to the client’s insufficient funds, but John had no idea. In his mind, the customer had paid, and he just went on as usual. His accounting records showed that the payment was made, and he looked like he was doing well.
Fast forward a couple of months with unreconciled transactions, and his profit appears higher than it actually is because of that missing payment. The worst part is that the customer still hasn't paid, but John doesn’t realize this until it's too late to collect the payment. All of this could have been avoided with timely bank reconciliation
Situation #2: Missed Fees
Sarah owns a small business, and like many people, she doesn’t pay attention to the small fees her bank charges and all the subscriptions she signed up for. Over time, those little deductions add up, but she doesn't notice them eating away at her balance. One day, she writes a check to a key supplier, thinking her account has more than enough funds. However, the balance falls short of what she had in mind, so the check bounces. Now, Sarah is embarrassed, her vendor is upset, and she loses out on future discounts and better credit terms. Her vendor starts questioning whether Sarah is reliable. A simple bank reconciliation could have saved her from all this embarrassment and allowed her to identify unnecessary expenses that are eating into her profit
Situation #3: Unauthorized Charges
David’s business card got compromised and had a couple of unauthorized charges on it. Since he is not in the habit of reconciling his bank accounts, the charges went unnoticed. When David finally discovered the charges, it was too late to do anything since his bank allowed only a certain amount of time to dispute charges.
Situation #4: Inaccurate Financial Statements and Wrong Cash Flow Projections:
Maria owns a small retail business and buys goods for resale. She does not reconcile her statements on time and misses the fact that some of her inventory purchases were never entered in her books. Maria glances at her inaccurate books and sees that she has strong profit for the quarter without knowing that her bank does not have enough cash because the money was spent on unaccounted inventory.
Without a clear picture, Maria's cash flow projection is off, and she moves forward with plans for expansion only to realize that she does not have enough funds to cover necessary day-to-day expenses. Reconciling her accounts on time would have allowed her to adjust her plans and avoid a potentially serious cash shortage.
Common Discrepancies Necessitating Reconciliation
When reconciling clients' bank accounts, our accountants often see the following common issues:
- Uncashed Checks: Sometimes, you issue checks that recipients have not yet cashed. These checks may appear in your accounting records but will not show up in the bank statement until they are processed.
- Pending Deposits: Deposits recorded in your books may not be cleared in the bank, leading to temporary differences between the two balances.
- Unknown Bank Fees: Banks often charge various fees for services, such as account maintenance or wire transfers, which may not be accounted for until the reconciliation process.
- Bank Errors: Occasionally, banks make mistakes, such as recording incorrect transaction amounts or duplicating transactions, creating discrepancies between your and the bank’s records.
Approaches to Bank Reconciliation
In the past, accountants used handwritten ledgers to keep track of bank accounts. Later, they switched to using spreadsheets like Excel. Bookkeepers would carefully note down each transaction and then check if their records matched the information on their bank statements. That was a slow and challenging process, as it involved checking each transaction, finding matches, and fixing any mistakes. It was easy for accountants to make errors, like forgetting a transaction, entering the wrong amounts, or duplicating them. These mistakes would delay balancing the accounts and reporting.
Software Automation
Today, accounting software like QuickBooks Online (QBO) and Xero have revolutionized the reconciliation process. By connecting bank accounts directly, these tools automatically import transactions in real-time or at regular intervals.
- Streamlining Data Entry: No need to manually input transactions; bank feeds do the heavy lifting by syncing bank statements with accounting records.
- Speed and Accuracy: Automatic updates mean discrepancies can be identified and resolved almost instantly, significantly reducing the time spent reconciling accounts.
- Reduced Manual Effort: The labor-intensive process of tracking down transaction errors has been replaced by the software’s built-in tools that suggest categories and flag issues.
- Error Minimization: With bank data flowing straight into accounting software, there are fewer mistakes, but it’s still important to check and categorize transactions for accuracy.
- Real-Time Reconciliation: Unlike waiting for month-end statements, accounting software allows for more frequent reconciliation—weekly, biweekly, or even daily—keeping your accounts accurate and up to date.
To check if your bank account has been reconciled, you can compare ending balance on the bank statement with the ending balance for the same month in your accounting software. If these numbers match, all transactions are likely accounted for. While transactions could still be categorized incorrectly, at least you know that bank reconciliation has been performed for that month.
Why Bank Reconciliations Matter to tax CPAs ?
Beyond catching errors and unauthorized transactions, why do we CPAs think bank reconciliations are essential?
1. Correct Tax Reporting
If you miss an expense on your books, it means that you are also missing a tax deduction on your tax return. Your revenue gets inflated, and you pay more tax just because you missed that expense on your financial statements. On the other hand, if you miss recording a deposit, you under-reported your taxable income, which means you avoided paying taxes on your income, and this could lead to serious consequences with tax authorities.
2. IRS Balance Sheet Requirements
The IRS requires financials for business tax returns, such as forms 1120, 1120S, and 1065, especially if your company’s gross receipts and assets exceed $250,000. The balance sheet on the business tax return (referred to as Schedule L, see an example of it below) shows the ending balances for the year for your cash in bank accounts, other assets, credit cards, accounts payable as so on. The same Schedule L also requests prior year data. The IRS understands how accounting works, and if your bank reconciliations are incorrect, your accounting on Schedule L won't tie and your return will be rejected.
But even with small businesses that that do not meet the $250,000 test, bank reconciliations are still important. In simple terms, the IRS needs to know how much money you took out of your business and how much you have contributed to your business, and one of the easiest ways to figure out an exact number of owner contributions and distributions is to conduct a bank reconciliation.
While bank reconciliation might seem like a chore, it is one of the essential practices for your business. It protects you from costly mistakes and ensures you maintain control over your finances. As we’ve seen, skipping this step can lead to duplicated transactions, inflated profits, overpaid taxes, improperly filed tax returns, and missed business opportunities. When you regularly reconcile your accounts, you can catch small errors before they escalate into significant problems. You also gain the ability to spot unauthorized charges or overlooked fees that could harm your bottom line.
But what if bank reconciliations are a chore you don't have enough patience to tackle? Well, outsource it! Pay someone else to do this unpleasant task. At our CPA firm, we offer bank reconciliations as part of our subscription package. If you are a California business owner who struggles with bank reconciliations and taxes, let us know. Here is a full list of our services.