A beginner’s guide to bank reconciliation

Bank reconciliation sounds intimidating, but it’s just a fancy name for a pretty simple accounting process. Get it right, and you’re well on your way to being on top of your finances. Get it wrong, and you could end up paying more tax than you should!

But what is bank reconciliation and how can you get it done? In this guide, we’ll answer these questions and provide some practical advice to help you keep your business books accurate and up to date.

What is bank reconciliation?

Bank reconciliation is the process of making sure the information in your business’s records (aka your “books” - these are the accounting records you might keep in software, like FreeAgent, or a spreadsheet) matches the information in your bank account.

This includes the opening bank balance (i.e. what you had in your bank account at the start of the period you’re looking at), the closing bank balance (i.e. what you had in your bank account at the end of the period), and the individual bank transactions (i.e. the money that went in and out of your bank account during that period).

Imagine you buy a train ticket for a business trip on your company debit card. When you see this transaction appear on your bank statement, you will also need to include it in your records. If you don’t do this, your records will show a different figure to your bank account, meaning that the information in your records will no longer be correct.  A missing cost means your profit would be too high and therefore you’d pay too much tax.

Bank reconciliation is best done weekly as it reminds you to keep an eye on your banking -  letting you spot mistakes or inconsistencies early and identify any suspicious activity.

Why is bank reconciliation important?

Getting bank reconciliation wrong can leave you with an inaccurate view of how much money you have in the bank, which could have painful consequences for your small business. Getting reconciliation right keeps your accounts - and your tax returns - accurate.

Reconcile your bank transactions in five easy steps

1. Get your bank statement. Check your banking app or your physical statement, if you receive this by post.

2. Have your records ready. Whether you manage your business through spreadsheets or software like FreeAgent, have your records open in front of you. It’s best practice to do bank reconciliation on a weekly basis, so make sure you’re looking at the same dates in both places when reconciling.

3. Make sure your opening balance matches. Choose a date (for example, 1st of the month) and check that the balance of your bank account on this date matches the balance in your accounting records on the same date. If this number doesn’t match, check that you haven’t missed any transactions from the previous period.

4. Systematically check each transaction on your bank statement. Whether you’ve added your transactions manually or automatically through a bank feed, it’s still wise to double-check that every transaction appears, and no more than once. If you’re using accounting software, this is the best time to explain your transactions - we’ll talk more on this next!

5. Make sure your closing balance matches. Once you’ve reconciled all your transactions and double-checked them, the balance in your accounting records should match your bank statement. If it doesn’t, then head back to step 3.

With your accounting records now matching your bank balance, you’ve successfully reconciled your bank transactions!

How can accounting software make bank reconciliation easier?

If you manually retype your transactions between your bank statement and a spreadsheet or paper ledger, you may miss transactions. This can look like you’re under-reporting your sales. In the worst case, HMRC might see this as a sign that you’re trying to pay less tax than you should, which could trigger an inspection from the taxman.

If you add extra transactions or accidentally double-count transactions like sales, you’ll be liable to pay more tax than you should. It can be costly and time consuming to rectify these types of mistakes.

Accounting software can save you time and reduce errors. 

• Setting up a bank feed will automatically sync your transactions in real time.
• FreeAgent can automatically flag a ‘balance mismatch’ if your bank balance doesn’t match your balance in FreeAgent, letting you know you need to reconcile your transactions to fix the issue.
• Viewing your Bank Reconciliation report in FreeAgent quickly shows you if your closing balance doesn’t match and highlights unexplained transactions.

Accounting software will also help you with the next step to reconciliation: explaining your bank transactions.

Explaining bank transactions

If you’re using accounting software, you may be prompted to “explain” your transactions once they are reconciled. This puts each transaction in the right category so your software knows what the money was for, can calculate VAT, and can populate your business income and expenses in your submissions to HMRC. 

In our earlier example of buying a train ticket, explaining the transaction as a travel expense will let your software handle the VAT rate and attribute it as an allowable expense (though you do of course need to make sure it is allowable for tax).

After you pull your transactions into FreeAgent using a bank feed, any unexplained transactions will show up in red to remind you they need explaining.

When you pick a transaction and select an appropriate category to explain what it is, the record’s colour will change from red to green.

Note: If you’re not sure which transaction type to select, this article can help you choose the right one. If you’re not sure which category to select for a business cost, this article describes the available categories in FreeAgent. 

It’s not only business income and costs you have to explain - if you’re using a business bank account in FreeAgent, you must explain all transactions to and from your bank accounts connected to FreeAgent, including personal transactions. Check this article to make sure you’re explaining personal payments, like drawings, correctly.

For more information on explaining transactions, watch the short video below or read our article.

What about VAT?

What about VAT, indeed? When you’re explaining transactions in FreeAgent, one of the fields will ask you to choose a VAT rate from a dropdown menu. But what should you do if you’re not VAT-registered? 

If you’re below the VAT threshold and not VAT-registered, you can leave the VAT rate as ‘Auto’, or change it to Out of Scope. If you leave it as ‘Auto’, this can reduce the work if you do register for VAT in the future, as FreeAgent will automatically reclaim the VAT on these purchases on your first VAT return. 

Even more tips for explaining bank transactions in record time

In FreeAgent, you can also explain transactions in bulk, making the process even speedier. You can select all the transactions with the same description (for example, monthly internet payments to BT) and explain them in one go.

When you explain transactions in FreeAgent, our AI tool, Guess, will learn how to suggest categories for you to approve or correct in the future (saving you time and effort!). 

For example, once Guess detects you usually categorise your BT Internet payment under the ‘Internet & Telephone’ category, it will automatically categorise future transactions to BT Internet under this category. All you have to do is check the category is right and click accept - which you can also do in bulk! You can find out more about approving explanations from Guess here.

Now you’re ready to go and reconcile your accounting records. Our top tip: it’s easier to reconcile and explain transactions if you do them regularly. If you use FreeAgent, it only needs to take a few minutes. You can do it on the go using your mobile app, using five minutes of downtime to keep your records tidy and accurate!

10th June 2019