If you are looking for ways to safeguard your company's assets, ensure your financial statements are accurate and get the exact position of your business at any point in time, then you should be making balance sheet reconciliations. Conducted monthly, a balance sheet reconciliation provides a cost-effective way to improve the internal control processes of your business and reduce risk.
What Is a Balance Sheet?
Before you can think about reconciliations, you need to understand what a balance sheet is, and that's a statement of a company's assets, liabilities and capital at a specific point in time. It's one of the key documents in a company's accounting suite.
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Managers, lenders and investors rely on the balance sheet to assess the financial situation of a company, which means it's crucially important to remove any mistakes. If the balance sheet is not correct, it could result in management making decisions about the business based on incorrect or outdated information, which may result in a financial loss to the company.
What Are Balance Sheet Reconciliations?
One way to ensure the accuracy of the balance sheet is to conduct a balance sheet reconciliation at the end of every month or quarter. A reconciliation is the process of comparing all the line items that appear on the balance sheet against the transactions that make up those balances. The purpose is to make sure that you've accounted for every transaction in your business and recorded them in the proper place.
What Goes Into a Balance Sheet?
When you look at a balance sheet, you'll see that it's broken down into three top-line sections followed by a number of line items or classifications as follows:
- Assets including cash, inventory, accounts receivable, prepaid expenses and fixed assets.
- Liabilities such as amounts owed to suppliers and creditors, payroll and taxes.
- Shareholder's equity which represents the shareholders' investment in the business plus the net income made since the business began. If the company sold off all its assets at book value and paid off its debts, shareholders' equity would be the amount of cash that's left. It is calculated using the following formula: shareholders' equity = total assets − total liabilities.
It should be fairly obvious that businesses must classify their transactions into the right section or the balance sheet will not be accurate. Yet misallocating or miscoding transactions is a common accounting error, especially for small businesses that rely on bookkeeping software to manage their finances. When you reconcile the balance sheet, you try to spot these errors and fix them before someone relies on the discrepancy for decision-making.
Why Reconcile the Balance Sheet?
Quite simply, a company needs to maintain an accurate balance sheet to properly reflect the efficiency (or inefficiency) of its performance. Imagine the scenario where you've issued a check by debiting your cash account, but the recipient doesn't present the check for several months. For this period, your cash-in-the-bank entry will be greater than it should be, so it looks like you have more cash available than you actually do.
Extrapolate this example over hundreds of similar transactions that take place each month, and you can see how your cash estimates can go horribly wrong if you don't reconcile the accounts on a regular basis. Taking the time to reconcile the balance sheet can:
- Ensure the accuracy of the cash position, by checking that the cash figure on the books tallies with the closing balance in the company's bank accounts. Neither you nor outside advisers such as banks and loan providers will be able to see how creditworthy the business is if the cash position is out of whack.
- Make it easier to spot errors, duplicated items and fraud that would potentially be hidden for months if you didn't reconcile the balance sheet. Reconciliation essentially is a double check on the company's financial position, which reduces the risk of fraud.
- Monitor the company's activities, for example, how many sales and purchases it is making and the consumption of raw materials.
- Ensure the accuracy of all heads in the balance sheet, by ensuring that debits and credits are set off by a corresponding credit or debit in another account. This is essential in a double-entry bookkeeping system.
Balance Sheet Reconciliation Tutorial
There isn't a standardized process for reconciling balance sheets as every ledger must be reviewed and checked for classification accuracy, and every ledger needs a different approach. For instance, reconciling inventory means checking the inventory line items against stock control sheets. For cash, you'd look at the company's bank statements.
Cash, accounts receivable, inventory, accounts payable, payroll liabilities and debt are just some of the ledgers you'd look at when reconciling the balance sheet. The following is a balance sheet reconciliation checklist to guide your processes.
The bank balance should match the cash position in the balance sheet, with the difference of uncleared checks and deposits that are on their way to the bank. Uncleared checks more than a few weeks old need investigation to find out why the check hasn't been presented.
Reconciling accounts payable
This important account shows the amount of money that your customers owe on invoices that you've sent out. Reconciling this account shows you which invoices are past due and whether any accounts need to be written off as bad debts or escalated for chasing and collections.
To reconcile inventory, you might look at the company's stock sheets or you might do a physical inventory count. Either way, inventory on hand must match the number on the balance sheet. Discrepancies could be the result of theft or fraud, or they could be the result of a well-intentioned re-make done to please a customer. Either way, it needs to be investigated.
Reconciling fixed assets
Reconciling this account tells you whether the business still has the computers, vehicles, machinery and so on that it thinks it does. If you can't locate the assets listed on the balance sheet, there may be issues with theft or poor reporting – and you may be overpaying taxes.
Reconciling accounts payable
Accounts payable represents the amounts the company owes to its suppliers for products and services that you've ordered. Reconciling this account is essential to make sure that you're paying vendors on time and are not jeopardizing your vendor relationships through frequent late payments. This account changes quickly, so you may wish to perform a weekly reconciliation.
Payroll liabilities can get fairly complicated, especially when the business pays some employees hourly and pays others a salary. The balance sheet reconciliation process for this account is to make sure that payroll expenses (including overtime, bonuses and commissions) are recorded for the correct period.
If notes payable, debts and loans are not recorded properly, then the company's financial position, as stated on the balance sheet, will be incorrect. Reconciling these transactions requires matching the loan documents to the line item shown on the balance sheet.