Reconciliation

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What is 'Reconciliation'

Reconciliation is an accounting process that uses two sets of records to ensure figures are correct and in agreement. It confirms whether the money leaving an account matches the amount that's been spent, ensuring the two are balanced at the end of the recording period. The purpose of reconciliation is to provide consistency and accuracy in financial accounts.

Reconciliation is particularly useful for explaining the difference between competing financial records or account balances. Some differences may be acceptable due to the timing of payments and deposits; unexplained or mysterious discrepancies may be signs of theft or cooking the books.

BREAKING DOWN 'Reconciliation'

There is no standard method of accounting reconciliation, but generally accepted accounting principles (GAAP) consider double-entry accounting and account conversion to be the main procedures. Businesses and individuals may reconcile their records daily, monthly or annually using either of these methods.

Difference Between Double-Entry Reconciliation and Account Conversion

In double-entry accounting, commonly used by companies, every financial transaction is posted in two columns of a balance sheet.

For example, if a business takes out a long-term loan for $10,000, the accountant credits the long-term debt or notes payable column with that amount and debits the cash column with the same amount. When these amounts are added together, the account reconciles or balances at zero. Similarly, imagine that a business incurs an invoice for carpet-cleaning services. It credits the amount of the invoice in its accounts payable column, and it debits a column devoted to administrative expenses for the same amount. When the company pays the bill, it debits accounts payable and credits the expenses column. Again, the two columns should agree, balancing out at zero.

Under the account conversion method, records such as receipts or canceled checks are simply compared with the entries in a ledger.

Reconciliation in Personal Accounting

At the end of every month, many individuals reconcile their checkbooks and credit card accounts by comparing their canceled checks, debit card receipts and credit card receipts with their bank and credit card statements. This type of account reconciliation makes it possible to determine whether money is being fraudulently withdrawn. It also ensures that financial institutions have not made any errors with individuals' accounts, and it gives consumers an overall picture of their spending.

When an account is reconciled, the statement's transactions and ending balance should match the account holder's records. For a checking account, it is also important to know how any pending deposits or outstanding checks affect the statement balance.

Reconciliation in Business Accounting

Account reconciliation is also important for businesses. Companies must reconcile their accounts to prevent balance sheet errors, check for fraud and avoid penalty from auditors: Accurate bookkeeping reduces legal risks as much as financial risks. Mistakes can have serious ramifications for publicly traded companies. For example, an auditor who reviews the company’s financial statements in accordance with federal regulations such as the Sarbanes-Oxley Act of 2002 (which mandates reconciliation of reported accounts) could find a material error, which the company would have to publicly disclose as a failure of controls, a material misstatement and/or a material weakness.

Some reconciliations are necessary to ensure all cash inlays and outlays match up between the income statement and the cash flow statement. Other reconciliations turn non-GAAP measures, such as earnings before interest, taxes, depreciation and amortization (EBITDA), into their GAAP-approved counterparts.

It is popular for companies to show profitability through EBITDA rather than the GAAP-friendly net income from continuing operations. The Financial Accounting Standards Board (FASB), and SEC consider EBITDA to be a poor substitute for net income as a measure of performance, however, and EBITDA cannot appear on the financial statements of publicly listed companies. So businesses need to perform a reconciliation of EBITDA figures into accounts that are allowable under GAAP. While most investors consider EBITDA to equal operating income, which is a GAAP measurement, the SEC warns this is incorrect. The correct reconciliation of EBITDA equals net income from continuing operations before interest, income tax expense, and depreciation and amortization, excluding some other income.

The Business Accounting Reconciliation Process

Before beginning the account reconciliation process, the company must have a working log for the process itself. This work log should contain account numbers, names and purposes of accounts. It should also reflect the reconciliation period (start date to end date) and document how all balances were substantiated.

After a business completes a financial transaction, the dollar values are recorded in the general ledger. Over time, adjusting journal entries are often made when details change. The volume of these journal entries can be substantial and leave room for accounting errors, so businesses typically use accounting software  to reconcile accounts.

The company accountants perform reconciliation by double-checking the ledger entries. Sometimes this takes the form of reviewing invoices or bills of sale. Sometimes it is necessary to pull bank statements or ask for records from business partners.

Next, accountants create a list of all unusual transactions or entries that lack supporting documentation. This is where investigative accounting skills are most important, since instances of fraud or embezzlement are most likely to be detected during the reconciliation phase.

Most companies establish internal record retention guidelines for reconciling accounts. If some accounts cannot be confidently reconciled through documentation or analytic review, an allowance for doubtful accounts should be created.

GAAP vs IFRS

The Securities and Exchange Commission (SEC) requires that domestic issuers of securities prepare their financial statements in accordance with GAAP. Domestic companies that do not issue securities fall outside of the SEC's jurisdiction, but are nonetheless encouraged to follow GAAP guidelines for tax purposes.

The majority of the securities trading world, however, does not operate on GAAP. Instead, it uses the International Financial Reporting Standards (IFRS). Convergences between GAAP and IFRS are the subject of much debate; the Obama Administration explicitly voiced its support for a total conversion to international standards. In the past, foreign issuers were required to reconcile to GAAP standards before offering securities to American investors.

History of Reconciliation

The word "reconciliation" comes from the Latin word "reconcilare," which means "to bring together again."

Italy was the birthplace of modern double-entry accounting. Anecdotal accounts suggest that Genoan and Florentine bookkeepers created dual entries because the Catholic church did not like negative numbers. The earliest known existence of records that include matching debits and credits were accounts of the Republic of Genoa in 1340, though it is likely that the practice predated those works by some time.

One of the first books to be published on the subject (and in fact, one of the first books to be published, period) was "Everything About Arithmetic, Geometry and Proportion" by Luca Bartolomoes Pacioli in 1494. In it, Pacioli – a Franciscan friar – described how accounts could be reconciled through carefully balanced dual entries. Modern financial accounts still rely on those same concepts.

Accounting reconciliation was not considered essential in the United States until the Sarbanes-Oxley Act in 2002.