8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries

Bank Reconciliation

Purpose of Bank Reconciliation

A bank reconciliation compares a company's internal cash records (the "books") with the bank statement to find and resolve any differences between the two. Every company's cash ledger and its bank statement will show different balances at any given time, and the reconciliation process explains why they differ and brings both to the same correct number.

This matters for several reasons:

• Detecting errors and fraud. The reconciliation can reveal missing deposits, unauthorized withdrawals, or simple recording mistakes on either side.
• Identifying unrecorded transactions. Banks often process fees, interest, and returned checks that the company hasn't recorded yet. Without reconciliation, those items stay off the books.
• Resolving timing differences. Checks the company has written may not have cleared the bank yet, and deposits may still be in transit. These aren't errors; they just reflect the lag between when the company records a transaction and when the bank processes it.
• Maintaining internal control over cash. Regular reconciliation is a key internal control that strengthens the reliability of financial statements and supports sound cash management.

Preparing the Reconciliation Statement

A bank reconciliation has two sides: you adjust the bank statement balance and the book (company) balance until they match. The number they converge on is the company's true (corrected) cash balance.

Adjusting the bank balance:

1. Start with the ending balance on the bank statement.
2. Add deposits in transit. These are amounts the company has received and recorded (like customer payments or cash sales) but that haven't been credited by the bank yet.
3. Subtract outstanding checks. These are checks the company has written and recorded but that haven't cleared the bank yet (supplier payments, payroll checks, etc.).
4. Correct any bank errors. If the bank posted a transaction to the wrong account or recorded an incorrect amount, adjust here.
5. The result is the corrected bank balance.

Adjusting the book balance:

1. Start with the ending cash balance per the company's books.

2. Add any items the bank recorded that increase cash but the company hasn't recorded yet, such as interest earned on the account or electronic funds transfers received.

3. Subtract items that decrease cash but haven't been recorded on the books:

   • Bank service charges (monthly fees, check printing fees, overdraft charges)
   • NSF (non-sufficient funds) checks, which are checks the company deposited from a customer that bounced because the customer's account lacked sufficient funds
   • Automatic payments (loan payments, utilities) processed by the bank but not yet recorded by the company

4. Correct any book errors. For example, if the company recorded a check for $450$ but the correct amount was $540$, adjust the difference here.

5. The result is the corrected book balance.

After completing both sides, the corrected bank balance and the corrected book balance must be equal. If they aren't, a discrepancy still exists and you need to find it before moving on.

Journal Entries for Reconciliation Adjustments

Only the book-side adjustments require journal entries, because those are the items the company hasn't recorded yet. Bank-side adjustments (deposits in transit, outstanding checks) are already in the company's records and will clear the bank on their own.

NSF checks:

When a deposited check bounces, the company needs to reverse the cash it thought it received.

• Debit: Accounts Receivable (restores the amount the customer still owes)
• Credit: Cash (reduces the cash balance)

Bank service charges:

• Debit: Bank Service Charges Expense (records the cost)
• Credit: Cash (reduces the cash balance)

Interest earned:

• Debit: Cash (increases the cash balance)
• Credit: Interest Revenue (records the income)

Correcting book errors:

The entry depends on the nature of the error. For example, if a $890$ check to a supplier was mistakenly recorded as $980$, the company overstated the payment by $90$:

• Debit: Cash $90$
• Credit: Accounts Payable $90$

Always verify that total debits equal total credits in any correcting entry.

Unrecorded automatic payments or EFTs:

If the bank processed a payment the company hadn't recorded (say, a $200$ utility bill paid automatically):

• Debit: Utilities Expense $200$
• Credit: Cash $200$

Impact on Financial Reporting

• The corrected cash balance from the reconciliation is the figure reported on the balance sheet.
• Reconciliation adjustments feed into the income statement as well (service charge expenses, interest revenue).
• Completing the reconciliation before preparing financial statements ensures those statements reflect the company's actual cash position, which supports reliable decision-making by managers, investors, and creditors.