What Is Bank Reconciliation?

Bank reconciliation is the process of comparing your company’s internal cash records (the cash book or accounting ledger) with the bank’s official statement to make sure they match. If they don’t match — and they often don’t — you identify and explain every difference.

Think of it as a monthly health check for your cash account. It catches errors, detects fraud, and ensures your records are accurate before you prepare financial statements.

Why Your Cash Book and Bank Statement Usually Differ

It’s completely normal for these two records to show different balances at any given point in time. The most common reasons:

Timing Differences

• Outstanding checks (unpresented checks) — Checks you’ve written and recorded in your books, but the recipient hasn’t deposited yet. Your bank doesn’t know about them.
• Deposits in transit — Cash or checks you’ve deposited (and recorded), but the bank hasn’t processed yet — typically the last deposit of the month.

Bank-Initiated Items (Not Yet in Your Books)

• Bank charges and fees — Monthly service fees, wire transfer charges, overdraft fees the bank deducts automatically
• Direct credits — Interest earned on your account, direct deposits from customers that you haven’t yet recorded
• Returned (bounced) checks — A customer’s check that was deposited but bounced; the bank reverses the deposit
• Direct debits — Automatic payments (insurance premiums, loan installments) the bank processes without a manual check

Errors

• Your errors — Transposition errors ($459 recorded as $495), entering the wrong amount, posting to the wrong account
• Bank errors — Rare, but banks do occasionally credit or debit the wrong account

Step-by-Step: How to Prepare a Bank Reconciliation

You’ll work with two starting points: the closing balance per bank statement and the closing balance per your cash book. You adjust both to arrive at the same “adjusted balance.”

Step 1 — Adjust the Bank Statement Balance

1. Start with the closing balance on the bank statement
2. Add deposits in transit (recorded in your books, not yet on bank statement)
3. Deduct outstanding checks (issued by you, not yet cleared at the bank)
4. Result = Adjusted Bank Balance

Step 2 — Adjust the Cash Book Balance

1. Start with the closing balance in your cash book
2. Add any bank credits not yet in your books (interest earned, direct deposits)
3. Deduct any bank charges not yet in your books (service fees, bounced check fees)
4. Correct any errors in your cash book
5. Result = Adjusted Cash Book Balance

Step 3 — Verify They Match

The Adjusted Bank Balance must equal the Adjusted Cash Book Balance. If they don’t match, keep investigating until you find the remaining difference.

Worked Example

Journal Entries After Reconciliation

Any adjustments made to the cash book side need to be recorded as journal entries in your accounting system:

Note: Items on the bank statement side (deposits in transit, outstanding checks) are already in your books — they just haven’t hit the bank yet. No journal entries are needed for those.

How Often Should You Reconcile?

• Monthly is the minimum standard for most businesses
• Weekly for high-volume businesses or those with fraud risk
• Daily for businesses processing large cash volumes (retail, restaurants)

Key Takeaways

• Bank reconciliation compares your cash book balance to the bank statement balance and explains the differences
• Differences arise from timing (outstanding checks, deposits in transit) or items not yet recorded (bank charges, direct credits)
• Both the bank side and cash book side are adjusted to reach the same final “adjusted balance”
• Only cash book adjustments require journal entries — timing differences do not
• Regular reconciliation is a critical internal control that deters fraud and catches errors

Disclaimer. This lesson is educational. The worked example uses representative numbers and does not constitute personalized financial, tax, legal, or investment advice. Trading and investing involve risk including loss of principal. US tax rates change annually — verify against the current IRS publications and your specific state’s tax code. See our Financial Disclaimer for the full statement.

Accounts Receivable and Bad Debts: Managing What Customers Owe You

Accounts receivable (AR) represents money owed by customers who have received goods or services but haven’t yet paid. Managing AR effectively is critical — outstanding receivables are only valuable if they’re actually collected.

Recording a Credit Sale

Sold goods worth $50,000 on 30-day credit terms:
Dr. Accounts Receivable $50,000
Cr. Sales Revenue $50,000

When customer pays $50,000:
Dr. Cash $50,000
Cr. Accounts Receivable $50,000

The Aging Schedule

An AR aging schedule categorizes outstanding invoices by how long they have been outstanding:

Allowance for Doubtful Debts (Bad Debt Provision)

Under the matching principle, bad debt expense should be recorded in the same period as the related revenue — even before any specific customer is confirmed as defaulting. The allowance method creates an estimate based on historical experience:

Dr. Bad Debt Expense $8,450
Cr. Allowance for Doubtful Debts $8,450
(A contra-asset account that reduces AR on the balance sheet to its net realizable value)

Writing Off a Specific Bad Debt

When a specific debtor’s account is confirmed uncollectible (say $5,000):
Dr. Allowance for Doubtful Debts $5,000
Cr. Accounts Receivable $5,000
(This does NOT affect the income statement — the expense was already recorded when the provision was created.)

Lesson Summary

• AR is money owed by customers; manage it via an aging schedule.
• The allowance method estimates bad debt expense in the same period as the sale (matching principle).
• Writing off a debt uses the allowance — it does not create a new expense at the time of write-off.

The Credit Sales Cycle: From Invoice to Collection

Allowance Method: Three Estimation Approaches

Aging Schedule Example: Horizon Events

Disclaimer. This lesson is educational. The worked example uses representative numbers and does not constitute personalized financial, tax, legal, or investment advice. Trading and investing involve risk including loss of principal. US tax rates change annually — verify against the current IRS publications and your specific state’s tax code. See our Financial Disclaimer for the full statement.

Accounts Payable: Managing What Your Business Owes Suppliers

Accounts payable (AP) represents money your business owes to suppliers for goods and services received on credit. Efficient AP management preserves cash flow while maintaining strong supplier relationships.

Recording a Credit Purchase

Purchased raw materials worth $30,000 on credit:
Dr. Purchases / Inventory $30,000
Cr. Accounts Payable $30,000

When you pay the supplier:
Dr. Accounts Payable $30,000
Cr. Cash $30,000

Payment Terms and Early-Payment Discounts

Suppliers often offer discounts for early payment. The notation 2/10, net 30 means: take a 2% discount if you pay within 10 days; otherwise the full amount is due in 30 days.

Invoice: $100,000 with terms 2/10, net 30.
If paid within 10 days: Pay $98,000; record $2,000 as Purchase Discount.
Annual cost of NOT taking the discount: approximately 36.7%.
Unless your business earns more than 36.7% elsewhere, always take early-payment discounts.

AP Aging and Controls

Just as AR has an aging schedule, so does AP. Reviewing it ensures:

• No invoices are paid twice (duplicate payment risk)
• All invoices are paid before late fees accrue
• Credit terms are being honoured correctly
• Disputed invoices are flagged and resolved

The AP Process (Purchase-to-Pay Cycle)

1. Purchase Order (PO) raised by the buying department
2. Goods/services received; Goods Received Note (GRN) issued
3. Supplier invoice received and matched against PO and GRN (three-way match)
4. Invoice approved and posted to AP ledger
5. Payment processed on or before due date

The three-way match (PO + GRN + Invoice) is a critical internal control that prevents payment for goods never ordered or received.

AP vs. Accrued Liabilities

AP is for invoices received. Accrued liabilities are for costs incurred but not yet invoiced (e.g., electricity used in March but the bill arrives in April). Both appear under current liabilities on the balance sheet but arise differently.

Lesson Summary

• AP records amounts owed to suppliers; cleared when payment is made.
• Early-payment discounts (e.g., 2/10 net 30) are almost always worth taking.
• Three-way match (PO + GRN + Invoice) prevents fraudulent or erroneous payments.

The Procure-to-Pay Cycle

Accounts payable (AP) represents money you owe to suppliers for goods or services received but not yet paid for. Managing AP well means taking advantage of payment terms, protecting supplier relationships, and optimising cash flow.

AP Metrics That Matter

Worked Example: DPO Analysis

Company A has AP of $45,000 and COGS of $540,000:

DPO = ($45,000 ÷ $540,000) × 365 = 30.4 days

This means Company A pays suppliers every 30 days on average — in line with standard net-30 terms. Retailers like Walmart routinely achieve DPOs of 60–90 days, effectively using supplier financing to fund operations.

Disclaimer. This lesson is educational. The worked example uses representative numbers and does not constitute personalized financial, tax, legal, or investment advice. Trading and investing involve risk including loss of principal. US tax rates change annually — verify against the current IRS publications and your specific state’s tax code. See our Financial Disclaimer for the full statement.

Inventory and Cost of Goods Sold: Valuing What You Sell

For businesses that sell physical products, inventory is often the largest asset on the balance sheet. The method used to value inventory directly affects reported profit — making this one of the most consequential accounting choices a business makes.

What Counts as Inventory Cost?

Inventory cost includes all costs necessary to bring the goods to their present condition and location: purchase price, import duties, freight charges, and handling costs. Trade discounts are deducted; general selling expenses are not included.

Inventory Valuation Methods

1. FIFO (First-In, First-Out)

Assumes the oldest inventory is sold first. In a period of rising prices, FIFO produces a lower COGS (older, cheaper costs are expensed first) and a higher closing inventory value. This results in higher reported profit but higher tax.

2. LIFO (Last-In, First-Out)

Assumes the newest inventory is sold first. In rising prices, LIFO produces higher COGS (recent, dearer costs expensed first) and lower reported profit — reducing tax. Note: LIFO is not permitted under IFRS, only under US GAAP.

3. Weighted Average Cost

Calculates a new average cost after each purchase. All units (whether sold or remaining) carry the same average cost. Produces results between FIFO and LIFO. Commonly used in the US under US GAAP (ASC 330).

Numerical Example

Purchases: 100 units @ $100 = $10,000; then 100 units @ $120 = $12,000. Sold 150 units.

FIFO COGS: 100 × $100 + 50 × $120 = $16,000. Closing inventory: 50 × $120 = $6,000.
LIFO COGS: 100 × $120 + 50 × $100 = $17,000. Closing inventory: 50 × $100 = $5,000.
Avg Cost: ($22,000 ÷ 200) = $110/unit. COGS: 150 × $110 = $16,500. Closing: 50 × $110 = $5,500.

Perpetual vs. Periodic Inventory Systems

Under the perpetual system, inventory records are updated after every purchase and sale (standard in modern businesses with POS systems). Under the periodic system, inventory is physically counted at period end and COGS is calculated as: Opening Inventory + Purchases − Closing Inventory.

Lower of Cost or Net Realizable Value (LCNRV)

Under US GAAP (ASC 330), inventory must be measured at the lower of cost or net realizable value (NRV). If market prices drop below cost, the inventory is written down to NRV — applying the conservatism principle.

Lesson Summary

• FIFO, LIFO (US GAAP only), and weighted average are the main inventory valuation methods.
• The choice of method affects COGS, profit, tax, and balance sheet inventory value.
• Inventory must be recorded at the lower of cost or net realizable value.

Inventory Costing Methods — Side-by-Side Comparison

When prices change over time, the inventory method chosen has a direct impact on COGS, gross profit, and taxes. Consider a retailer who purchased 300 units at varying costs and sold 200 units:

Key takeaway: In a period of rising prices, LIFO gives the highest COGS, lowest profit, and lowest tax bill. FIFO gives the most realistic ending inventory value. The US (GAAP) allows all three; IFRS prohibits LIFO.

Journal Entries for Inventory Transactions

Disclaimer. This lesson is educational. The worked example uses representative numbers and does not constitute personalized financial, tax, legal, or investment advice. Trading and investing involve risk including loss of principal. US tax rates change annually — verify against the current IRS publications and your specific state’s tax code. See our Financial Disclaimer for the full statement.

Depreciation: Spreading the Cost of Long-Lived Assets

When a business buys equipment, a vehicle, or a building, it would distort the income statement to expense the full cost in the year of purchase. Instead, depreciation systematically allocates the asset’s cost over its useful life — matching the expense to the periods the asset generates revenue.

Key Terms

• Cost — The original purchase price plus any costs to bring the asset into use (installation, delivery).
• Useful Life — Estimated period the asset will generate economic benefits (3 years for a laptop; 30 years for a building).
• Residual (Salvage) Value — Estimated amount recoverable at end of useful life.
• Depreciable Amount = Cost − Residual Value.
• Carrying (Book) Value = Cost − Accumulated Depreciation.

Depreciation Methods

1. Straight-Line Method (SLM)

Equal depreciation charge every year. Simple and widely used.

Annual Depreciation = (Cost − Residual Value) ÷ Useful Life

Machine cost: $500,000 | Residual value: $50,000 | Life: 5 years
Annual depreciation = ($500,000 − $50,000) ÷ 5 = $90,000/year

2. Declining Balance / Written Down Value (WDV) Method

Applies a fixed percentage to the carrying value each year. Produces higher depreciation in early years and lower in later years — mirrors how many assets actually lose value (vehicles, computers).

Machine cost: $500,000 | Rate: 40% (WDV)
Year 1: $500,000 × 40% = $200,000. Closing book value: $300,000.
Year 2: $300,000 × 40% = $120,000. Closing book value: $180,000.

3. Units of Production Method

Depreciation is based on actual usage rather than time. Ideal for machinery where wear-and-tear depends on output.

Per-Unit Depreciation = Depreciable Amount ÷ Total Expected Units

Journal Entry for Depreciation

Dr. Depreciation Expense $90,000
Cr. Accumulated Depreciation $90,000
Accumulated Depreciation is a contra-asset — it offsets the asset’s cost on the balance sheet.

Disposal of an Asset

When an asset is sold or scrapped, remove both the cost and accumulated depreciation from the books and record any gain or loss on disposal.

Machine (cost $500,000 accumulated depreciation $400,000) sold for $120,000:
Dr. Cash $120,000
Dr. Accumulated Depreciation $400,000
Cr. Machine (Asset) $500,000
Cr. Gain on Disposal $20,000

Lesson Summary

• Depreciation matches long-lived asset costs to the periods they benefit (matching principle).
• Three main methods: straight-line (equal charges), declining balance (front-loaded), units of production (usage-based).
• Accumulated depreciation reduces the asset’s carrying value on the balance sheet.

Three Depreciation Methods Compared

All three methods allocate the same total depreciable cost ($45,000 = $50,000 − $5,000 salvage) over the asset’s life. They just do it differently each year.

*DDB switches to SL in final year(s) to avoid going below salvage value.

Depreciation Impact on Financial Statements

Disposal of Depreciable Assets

Example: A truck cost $80,000, has $60,000 accumulated depreciation (book value $20,000), and is sold for $25,000.

The $5,000 gain appears on the income statement as other income.

Disclaimer. This lesson is educational. The worked example uses representative numbers and does not constitute personalized financial, tax, legal, or investment advice. Trading and investing involve risk including loss of principal. US tax rates change annually — verify against the current IRS publications and your specific state’s tax code. See our Financial Disclaimer for the full statement.

Payroll Accounting: Recording Employee Compensation

Payroll is often a company’s largest expense. Recording it correctly matters not just for accuracy but because payroll has legal, tax, and regulatory implications — errors attract penalties from tax authorities and erode employee trust.

Components of Gross Pay

• Base Wages / Salary — hourly wages or fixed salary for the period.
• Overtime — under the FLSA, non-exempt employees earn 1.5× their regular rate for hours worked beyond 40 in a workweek.
• Bonuses & Commissions — variable, performance-based pay (treated as supplemental wages for withholding).
• Taxable Fringe Benefits — personal use of a company vehicle, certain gift cards, etc.

Statutory Withholdings (U.S.)

• Federal Income Tax — withheld per the employee’s Form W-4 using IRS Publication 15-T.
• Social Security Tax — 6.2% of wages up to the 2026 wage base of $184,500.
• Medicare Tax — 1.45% of all wages (no cap), plus an Additional Medicare Tax of 0.9% on wages over $200,000.
• State & Local Income Tax — varies by state (nine states have no wage income tax).
• Pre-tax Deductions — 401(k) elective deferrals and Section 125 (cafeteria-plan) health premiums reduce taxable wages.

The Payroll Journal Entry

Employee gross salary: $50,000
Less: Federal income tax $6,000 | Social Security $3,100 | Medicare $725 | 401(k) $2,000
Net Pay: $38,175

Journal Entry:
Dr. Salaries Expense $50,000
Cr. Federal Income Tax Payable $6,000
Cr. Social Security Tax Payable $3,100
Cr. Medicare Tax Payable $725
Cr. 401(k) Contributions Payable $2,000
Cr. Cash / Bank $38,175

Employer Payroll Taxes

Beyond gross wages, the employer owes its own payroll taxes: a matching 6.2% Social Security and 1.45% Medicare (FICA match), plus federal (FUTA) and state (SUTA) unemployment tax.

Employer FICA match on the $50,000 above:
Dr. Payroll Tax Expense $3,825
Cr. Social Security Tax Payable $3,100
Cr. Medicare Tax Payable $725
FUTA (0.6% net on the first $7,000) and SUTA are added on top.

Remitting & Reporting

• Withheld income tax and FICA are deposited through EFTPS (semiweekly or monthly, based on payroll size) and reported on Form 941 quarterly.
• FUTA is reported annually on Form 940.
• W-2s go to employees and the SSA by January 31.
• Income tax and FICA withheld from employees are “trust fund taxes” — failing to remit them can trigger a 100% personal Trust Fund Recovery Penalty.

Lesson Summary

• Net pay = gross pay − federal/state income tax withholding − FICA (6.2% SS + 1.45% Medicare) − pre-tax deductions.
• The employer owes matching FICA plus FUTA and SUTA on top of gross wages.
• Deposits run through EFTPS; payroll is reported on Forms 941, 940, and W-2.

The Complete Payroll Process

Payroll accounting has two distinct stages: (1) recording the payroll expense (what employees earned and what was deducted), and (2) recording the employer’s payroll taxes (FICA match, FUTA, SUTA).

Stage 1: Employee Payroll Journal Entry

Scenario: Biweekly payroll for 3 employees: Gross wages $15,000

Stage 2: Employer Payroll Tax Entry

Total employer cost: $15,000 gross wages + $1,147.50 employer taxes = $16,147.50 per pay period.

Payroll Compliance Deadlines

Disclaimer. This lesson is educational. The worked example uses representative numbers and does not constitute personalized financial, tax, legal, or investment advice. Trading and investing involve risk including loss of principal. US tax rates change annually — verify against the current IRS publications and your specific state’s tax code. See our Financial Disclaimer for the full statement.