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The Importance of Financial Statement Reconciliation for SME Liabilities

By Kristina Russo

Having established the importance of reconciling financial statements as one of the most effective controls a small or midsize enterprise (SME) can use in part one of this series, part two explained reconciliation of key asset accounts. This third and final installment delves into the liability accounts experts identify as most important to reconcile: accounts payable, accrued expenses, payroll, and debt.

Financial Statement Reconciliation: Focus on Accounts Payable

 

Management of accounts payable (AP)—amounts owed by a business when goods or services are purchased on credit—is important because this account typically makes up the largest portion of an SME’s current liabilities. The objective of AP reconciliation is to ensure that the amounts owed are real, properly valued, and properly aged, both in the aggregate and by each AP component. For that reason, the general ledger account reconciliation process for AP has two steps:

 

  • The first step verifies that the total AP balance on the balance sheet equals the aggregate of all vendor balances, usually recorded in a subsidiary AP ledger, purchase order ledger, vendor aging, or check book.
  • The second step is a deep dive into vendor-level detail. Using vendor statements, invoices are verified to the AP activity. Then, payment details from bank statements and credit card statements are matched to payments made on vendor statements, and as applied to vendor balances in the AP ledger.

Common mistakes in reconciling AP statements include clerical errors in invoice numbers or amounts, payments to the wrong vendor, duplicate invoices, duplicate payments, and checks sent to the vendor but never cashed.1 Often, variances arise due to timing inconsistencies between when a payment was received by a vendor and the vendor statement cutoff date. Conversely, an invoice that has yet to be received may be included on the vendor’s statement but is not in the AP ledger (see accrued expense discussion).

 

Experts recommend performing AP reconciliation whenever AP checks are run, typically weekly, but at a minimum during month-end closing procedures so adjustments are included in the correct period.2 Timely reconciliation is especially important to avoid overdraft situations if any payments are automatically deducted from cash accounts.

 

Reconciling AP can yield operational benefits such as positive supplier relationships, which are helpful when negotiating things like credit terms, pricing, and returns.3 It also helps to avoid disruption of future supply due to late payments. Further, the process can help maximize cash flow by avoiding overpayment and ensuring discounts are applied, reducing costs.

 

AP reconciliations are an especially useful tool to detect payment fraud, which affects upwards of 74 percent of all companies, according to the Association for Financial Professionals’ 2017 Payments Fraud and Control Survey.4 Further, a separate survey, from the Association of Certified Fraud Examiners (ACFE), found that small businesses with fewer than 100 employees suffered twice as much fraud from all sources than their larger counterparts. Forty-two percent of that fraud was attributed to lack of internal controls such as reconciliation of financial statements.5

 

Financial Statement Reconciliation: Focus on Accrued Expenses

 

Accrued expenses—amounts owed for goods or services that have been used but an invoice has yet to be received—is another area for reconciliation, often considered an extension of AP.6 Like AP, the objectives of reconciling accrued expenses are to ensure that the amounts owed are real, properly valued, and comprehensive. Documents typically used to verify the general ledger balance include external vendor statements, shipping documents, contracts, and invoices received the following month.

 

Properly reconciling accrued expenses helps ensure that profits are correctly stated and reduces cash flow surprises, in addition to all the same benefits that come from AP reconciliation.

 

Financial Statement Reconciliation: Focus on Payroll

 

Account reconciliation for payroll focuses on confirming that an SME’s general ledger accounts properly reflect the amounts paid to employees, as well as withholdings and employer liabilities. This process is essential in ensuring that payroll expense, often one of the largest SME costs, and net income are correctly stated, and to aid in tax filing.7 Financial statement reconciliation of payroll is primarily accomplished by comparing wages, salaries and deductions from payroll registers to the general ledger account balances. Deductions include mandatory federal and state tax deductions, as well as voluntary employee deductions for insurance or retirement plan contributions.8

 

In addition to reconciling payroll at the general ledger level, reconciling earnings at the employee level is also important.9 Double-checking overtime, hourly, and salaried wages for correctness, and comparing individual checks to payroll registers, helps confirm the payroll accounts are accurate.

 

Experts recommend reconciling payroll each pay period and again at the end of the year.10 The year-end financial statement reconciliation also includes review of IRS tax form W-2, Wage and Tax Statements.

 

In smaller businesses, where staffing does not allow for ideal segregation of duties, payroll reconciliation is a key internal control to protect against common errors and fraud such as duplicate payments or ghost employees.11 According to the ACFE study, the incidence of payroll fraud in companies with fewer than 100 employees is almost triple that of larger companies.12

 

Financial Statement Reconciliation: Focus on Loans and Debt

 

Reconciliation of debt—amounts owed to all creditors, such as banks, individuals and other lenders—is done to ensure that an SME’s financial position is properly understood and stated. In addition to assisting better decision making, debt reconciliations can also uncover unexpected expenses like bank charges or penalties.

 

The first step in reconciling loans, notes payable, or lines of credit is to match the external source documents, such as loan agreements, mortgages, or contracts, to the general ledger. It is also a best practice to include a note or supporting schedule that summarizes the amount of principal owed, the term and end date, the interest rate, and any other details relating to each loan.13 The next step is to verify funds borrowed, and repayments made, by corroborating them with cash account bank statements.

 

While debt reconciliation is usually straightforward, variances commonly arise when debt service payments are misclassified as expense rather than debt reduction.14

 

Financial statement reconciliation for debt is typically done monthly, unless there is a high volume of transactions, such as with a revolving line of credit, where more frequent reconciliation may be beneficial.

 

The
Takeaway:

All SME owners benefit from a firm grasp of their business’ financial health. Reconciliation of financial statements, especially for key liabilities, are an effective control to ensure accuracy for better-informed decision-making and for mitigating fraud.

Kristina Russo

The Author

Kristina Russo

Kristina Russo is a CPA and MBA with over 20 years of business experience in firms of all sizes and across several industries, including media and publishing, entertainment, retail and manufacturing.

Sources

1. “Why Reconcile Vendor Statements?” Henry Curtis via Linkedin; https://www.linkedin.com/pulse/why-reconcile-vendor-statements-henry-curtis
2. “Importance of Monthly Balance Sheet Reconciliations for SMBs,” Greg Sonzogni, COO at TGG Accounting, via Linkedin; https://www.linkedin.com/pulse/importance-monthly-balance-sheet-reconciliation-smbs-greg-sonzogni
3. “Why Reconcile Vendor Statements?” Henry Curtis via Linkedin; https://www.linkedin.com/pulse/why-reconcile-vendor-statements-henry-curtis
4. 2017 Payments Fraud and Control Survey, Association for Financial Professionals; https://www.afponline.org/docs/default-source/default-document-library/pub/2017paymentsfraud-final-ion.pdf?sfvrsn=2
5. Report to the Nations-2018 Global Study on Occupational Fraud and Abuse, Association of Certified Fraud Examiners; https://s3-us-west-2.amazonaws.com/acfepublic/2018-report-to-the-nations.pdf
6. “Steps in an Account Reconciliation for Accrued Expenses,” Accounteer; https://www.accounteer.com/blog/steps-in-an-account-reconciliation-for-accrued-expenses
7. “What is Payroll Reconciliation?” Chron; https://smallbusiness.chron.com/payroll-reconciliation-24640.html
8. “How to Reconcile Payroll,” Chron; https://smallbusiness.chron.com/reconcile-payroll-46213.html
9. “What is Payroll Reconciliation?” Chron; https://smallbusiness.chron.com/payroll-reconciliation-24640.html
10. “What is Payroll Reconciliation?” azcentral; https://yourbusiness.azcentral.com/payroll-reconciliation-8404.html
11. “Auditing Payroll – The Why and How Guide” CPA Hall Talk; https://cpahalltalk.com/auditing-payroll/
12. Report to the Nations-2018 Global Study on Occupational Fraud and Abuse, Association of Certified Fraud Examiners; https://s3-us-west-2.amazonaws.com/acfepublic/2018-report-to-the-nations.pdf
13. “Importance of Monthly Balance Sheet Reconciliations for SMBs,” Greg Sonzogni, COO at TGG Accounting, via Linkedin; https://www.linkedin.com/pulse/importance-monthly-balance-sheet-reconciliation-smbs-greg-sonzogni
14. “Auditing Debt – The Why and How Guide” CPA Hall Talk; https://cpahalltalk.com/auditing-debt/