2. Bank Reconciliations: What and Why

I want to talk about bank reconciliations. And I want to talk about it because it's gonna be on your test, but I also want to talk about it because this is one of my favorite topics in financial accounting. And I know by now you probably all think I'm insane for liking this stuff, but here's why I like bank reconciliations particularly. Bank reconciliations are, in their most basic form, a puzzle, and I like puzzles. I've told you before that accounting is not hard. You just have to understand the words, and it comes logically after that. So I wanna take a second to talk about the word reconciliation because most of your teachers and the book itself typically launch straight into the discussion of how do you do a bank reconciliation with little to no time put into the discussion of what the heck is a bank reconciliation?

Why would anyone ever want to do one of these? Why are they important? And if you understand the why behind bank reconciliations, the what and the how becomes legitimately a piece of cake. So let's talk about the word reconciliation. And hopefully by now you know from time to time I like to use Google to help us out. Some things never change. So the word reconciliation. The first definition is the restoration of friendly relations, "reconciliation with your uncle." Reuniting, reunion, bringing together. Mm, okay. That's pretty good. Second definition is the act of making one view or belief compatible with another. "Reconciliation between art and technology." Act of making financial accounts consistent.

This one's probably closest to what we're dealing with. Harmonization. "Reconciliation process should be consistent with the business strategy." That doesn't mean anything to me. So if we're trying to figure out what the word reconciliation means, let's pull out some common definitions. Bringing together, compatible, consistent, and harmonization. Those words right there all kind of mean the same thing, right? The way that I think of reconciliation is you've got, um, two or more competing viewpoints. So let's say you've got two or more competing stories, two or more competing viewpoints, stories, views, ideas, whatever. And the process of reconciliation is making all of these competing stories, viewpoints, ideas, all of these consistent with one truth.

So you're trying to harmonize or make compatible or bring together two or more different sides of the same story and distill it into what is the actual story? What is the truth? There is one event that happened, and there are multiple angles from which we observed it, but what is the event? What is the truth? So you could have two descriptions of an event, but there was only one event. Two people can see something, but that something was still one thing. I bet you never thought so much of accounting was actually English. Now that we know what the word reconciliation means, what is it that we're trying to figure out?

What is the truth we're looking for? And what are the two or more stories or viewpoints that we're trying to bring together to find that truth? In financial accounting, a bank reconciliation is trying to get to this nugget of truth. How much cash do we have?

This is the truth we're after. The truth is, how much cash do we have? And the reason I call this the truth is because there's one answer. There's only one answer to the question, how much cash do we have? We don't have $1,000 and also at the same time have $1,500. That's a logical impossibility. You either have $1,000 or you have $1,500, but you can't have both.

And so the truth is, how much cash do we have? There is one single answer. Now what are the two or more competing viewpoints to answer how much cash? So if the answer is cash, what are the viewpoints? Well, the two viewpoints are, what do our books say that we have? We're the company. We keep track of all of our stuff. What do our books say that we have? The other one that's completely separate is, what does the bank say that we have? The bank may say that we have a different amount than our books say that we have, but at the end of the day, we have one amount of cash.

And that is what a bank reconciliation does. It reconciles what our books say we have for cash and what our bank says we have for cash because we know that we only have one cash amount. We either have $1,000 or we have $1,500. We think on our books we've got $1,000. The bank thinks on theirs we've got $1,500. So a bank reconciliation process is reconciling the $1,000 to the $1,500 and coming up with whatever our true cash amount is, and it may be different than either of those. Now there's a reason I drew a line between the books and the bank.

Should really be a wall. So between the books and the bank, the books is our company. Our company keeps books. Books say we have $1,000. The bank is obviously the bank. The bank keeps its records. It says we have $1,500. Now, the reason there's this wall here is because our company and the bank are two separate and discrete entities. We are not the bank. The bank is not us. So we're operated as two distinct entities. I mean, just think about your life. You are a person. Bank of America is a bank. Those two are not the same thing. There's this giant wall in between them, and that may be obvious and sound ridiculous, but it's important because we have knowledge on our side of certain events that happened.

They may have knowledge on their side of certain events that happened. That knowledge doesn't get shared immediately. The bank may know that certain things have happened, but because the bank and the company have different brains, the bank may know about it before it finally gets through over to the company. The company may know about certain things that haven't reached the bank yet.

All a bank reconciliation does is solve the problem of incomplete knowledge. And I'll show you in the next videos how this actually plays out and why knowing this makes everything else easy. But let's talk about why a bank reconciliation solves the problem of incomplete knowledge.

So in this very simple example, I'm gonna give you two events where there was incomplete knowledge. So on the book side, we thought we had $1,000. On the bank side, they think we have $1,500. The real amount that we actually have is $1,300. How can that be? That can be because the bank doesn't have full knowledge and the company doesn't have full knowledge. Let's say, for example, that the bank tells the company, "Hey, we collected $300 for you."

The company didn't know that until the bank told it. So the company would say, "Awesome. Thank you for letting us know. We will add $300 to our books because you collected $300 for us. We didn't know that until you told us. While I have you on the phone, why don't I tell you, 'Hey, we wrote $200 in checks. They haven't hit the bank yet.'" The bank says, "Great. Thank you for letting us know. We were unaware that you had written $200 of checks."

Now, after adjusting for those things, you'll see that the truth is $1,300. On the company side, you had to adjust for the lack of knowledge that the bank collected $300 for you. On the bank side, they had to adjust for the lack of knowledge that you had already written $200 in checks, they just hadn't been cashed yet. They didn't know that. So now you're at $1,300 on both sides, and this is your true cash amount. Now that you're armed with this knowledge right here, I give you permission to memorize nothing. You don't have to memorize what an NSF check is.

You don't have to memorize where deposits in transit go. You don't have to memorize anything. If you know that a bank reconciliation solves the problem of incomplete knowledge, you can figure everything else out. And in the next video, I'll show you exactly how to do that.