Financial statement reconciliations primarily focus on balance sheet accounts, specifically assets and liabilities. This article, part two of a series, examines account reconciliation of the assets experts identify as the most important to reconcile: cash, accounts receivable, inventory, and prepaid assets. Part three delves into liability accounts.
Financial Statement Reconciliation: Focus on Cash
All SME owners can benefit from close management of cash flows and cash balances necessary to meet short- and long-term obligations. Even profitable businesses can become insolvent and fail if cash flow is badly synchronized with operational needs. Cash reconciliations are generally regarded as the most crucial of account reconciliations, due to the catch-all nature of cash accounts. By reconciling cash accounts to bank statements, all day-to-day transactions paid by debit card, check or electronic fund transfer are confirmed. Ultimately, proper cash reconciliation helps SME owners and managers prevent overspending, or overdrawing bank accounts.
Experts recommend cash reconciliations be done at the subsidiary account level – each account reconciled separately against its external bank statement – rather than in aggregate.2 A tedious process of matching every cash debit in the general ledger to each deposit on the bank statement, as well as every cash credit to each withdrawal, usually uncovers variances. Typical variances include deposits in transit, outstanding checks, and unrecorded bank fees or penalties.3 Using bank statements that cover a different time period than the general ledger period and unreconciled beginning balances in the general ledger cash account are two common pitfalls when reconciling cash.
Another variance is theft. According to The 2017 Hiscox Embezzlement Study, approximately 70 percent of check fraud occurs in businesses with fewer than 100 employees.4 Reconciliations can uncover employees who create inaccurate journal entries or commit payroll fraud to pay themselves more money. As such, some experts recommend weekly reconciliations rather than monthly. Most accounting software packages can facilitate daily cash reconciliations.
Financial Statement Reconciliation: Focus on Accounts Receivable
Management of accounts receivable (AR) – amounts owed to a business when goods or services are sold to customers on credit – is important because of the link between AR collection and cash flow. The objective of AR reconciliation is to ensure that the amounts owed are real, properly valued, and properly aged, both in the aggregate and by each AR component. For that reason, the general ledger account reconciliation process for AR has two steps:
- The first step verifies that the total AR balance on the balance sheet equals the aggregate of all customer balances, usually recorded in a subsidiary sales ledger, customer aging, or invoice book.
- The second step is a deep dive into customer-level detail. Using bank statements and merchant processing statements, payments received are matched to cash applied to customer balances. Common mistakes, like transposed numbers on a check or invoice entry, checks recorded as received but never deposited, or partial payments that were applied to the incorrect invoice or customer account, can be identified and corrected. That helps avoid collection issues and strained relationships with customers.
Experts recommend that AR reconciliation be done at least monthly during month-end closing procedures, so adjustments are included in the correct period.
Reconciling AR can help businesses qualify for loans, either directly – using AR as collateral for short-term financing or AR factoring – or indirectly, because positive cash flow from AR is viewed favorably by lenders.
Financial Statement Reconciliation: Focus on Inventory
Account reconciliation for inventory focuses on ensuring that the quantity and value of an SME’s tangible stock is equal to the amount reflected in the general ledger. This is primarily accomplished by periodically counting actual physical stock of raw material and finished products (on retail shelves and in the warehouse) and comparing the results to the general ledger account balances.
Commonly, variances arise from using different units of measure (e.g., each item versus boxes that contain a dozen items), misclassification of stock, or item number transpositions, and can be resolved by recounting the physical stock.5 Sometimes, ownership issues cause variances by mistakenly including sold product still sitting in a warehouse or, conversely, excluding purchased supplies not yet unloaded. When variances cannot be explained, a general ledger adjustment is required to bring “book inventory” in line with actual inventory on hand.
Because inventory represents a major investment of working capital for SMEs, improving tracking and accuracy can potentially yield big operational benefits, reducing inventory variances that can raise the cost of goods sold and lower profitability. Inventory shrinkage, (when the number of products in stock are less than those recorded on the general ledger), can be caused by clerical errors, damaged stock, or theft.6 Shrinkage cost retailers of all sizes about 1.33 percent of sales in 2017, on average, according to a study by the National Retail Federation.7
How often inventory is reconciled depends on the nature of the SME’s business and its inventory. Because it is normally a substantial and disruptive undertaking, some SMEs opt for “cycle counting,” where only a small portion of inventory is counted and reconciled at a time.8 But take care: the risk of shrinkage, stock outs, and obsolescence rises proportionally with the length of time between reconciliations.
Reconciling inventory is necessary in order to qualify for asset-based loans where inventory serves as collateral. It is also expected under Generally Accepted Accounting Principles (GAAP) and IRS tax regulations.
Financial Statement Reconciliation: Focus on Prepaid Assets
Prepaid expenses – future expenses that have been paid in advance but not yet used – are reported on a company's balance sheet as an asset. As a prepaid asset is used, it is amortized based on its own unique schedule. This amortization is reflected as an expense, so errors – in either the value of the asset or the amortization – have a direct impact on an SME’s income statement and profitability.
Account reconciliation for prepaid assets begins with examination of third-party documents, usually invoices or contracts, to establish the initial value of the asset, followed by corroborating the disbursement from a bank or credit line. Finally, after verifying the terms of the transaction in supporting documentation, the amortization schedule and resulting expense can be tied into the general ledger (as a non-cash expense, as amortization cannot be tracked to a disbursement account).
Because of the one-off nature of prepaid assets, their amortization schedules tend to be handled manually via spreadsheet, making them vulnerable to clerical error. For this reason, and because an SME’s financial statements can be manipulated via the amortization schedule, account reconciliation is an effective way an SME owner can ensure proper matching of revenue and expense is being followed.9
Reconciling prepaid asset accounts on a monthly basis is the standard for most businesses, but can be adjusted based on the average length of the underlying amortization schedules.
