Demystifying the financial close – What is balance sheet reconciliation?

1. Overview: The importance and challenges of the financial close

Accurate financial information is the backbone of good business decision making, never more so given the high levels of economic volatility and shifting strategic priorities. So it is critical for executives to have timely access to reliable financial data. The financial close process is fundamental to that financial visibility; it ensures the accuracy and timeliness of individual company’s numbers so they can be passed over to the group for consolidation and reporting, and comply with regulatory reports – either internal or external.

A well-executed 'fast close' can bring many valuable benefits to the business, from improving organizational performance to propelling accounting executives from financial historians to trusted advisors. Research into the financial close conducted by analyst Hackett Group  found that top performers close their ledgers earlier in the month and complete the process in less time than their peer group, helping them free up resources to conduct analysis and provide financial and other company executives with support for fact-based decision-making.

And yet the financial close has long been a source of frustration and pain for finance departments, with potentially significant ramifications for the organization as a whole.

The challenge of extracting numbers from disparate places remains a major bone of contention for senior finance professionals. Around a quarter of respondents to research into financial reporting conducted last year by FSN said they spent too much time on data collection from multiple data sources. A similar proportion bemoaned the time spent cleaning and manipulating data. The analysis clearly highlighted the desire among respondents to spend more time on financial risk management and analysis and performance measurement activities.

Opportunity costs aside, a slow financial close is more than likely an indicator that your processes are cumbersome. That typically means manual and labor-intensive, relying on use of multiple spreadsheets. The bottom line is that a slow close will increase general and administrative (G&A) expense. It could also be an indication of underlying inefficiencies across other financial processes – such as billing, cashflow and accounts payable.

The last few years has seen a growing focus on the ‘last mile’ of the close – the most externally visible management processes that finance executives perform after the monthly, quarterly or annual close to prepare for financial reporting and disclosure. In contrast, the early stages of the financial close – the ‘first mile’ – which includes the capture of financial data and production of the preliminary trial balance and consolidations, have largely been neglected. And this is the case even though many of the problems that occur in the last mile are due to first mile issues.

2. The 4 key pillars of the financial close process

While the detailed financial close will undoubtedly mean different things to different people, in its broadest sense, it relates to the set of paths or workflows that must be completed in a timely manner to ensure the complete accuracy of financial reporting.

Typically condensed into a 10-day timeframe, the financial close happens every month, quarter and year to varying degrees of complexity. The financial close is the process of taking those individual entities, closing their books and rolling the numbers up to a group level where they can consolidate and produce group financial statements before the information is passed over to a reporting group for disclosure.

There are four main components of the close:

  • Close checklist – a checklist of all the processes that need to be executed along the record-to-report (R2R) journey, typically varying from 300 to 1,200. They need to occur within a tight timeframe and there are lots of dependencies, working across geographies and timeframes – requiring sophisticated project management capabilities to manage that checklist.
  • Journal entry – the process of posting journals and validating them. What you enter must be approved and controlled.
  • Intercompany – intercompany trade can represent a lot of transactions and a huge amount of work for the finance team, but you need to eliminate it from the results. Reconcile and accrue into the next month. The ideal situation is where the reconciliation is zero.
  • Balance sheet reconciliation and certification – it used to be the auditor’s job to ensure the accounts are in order and identify discrepancies, but today it’s an essential part of an organization’s financial checks and balances.

For this article we will focus on balance sheet reconciliation – what it is and its role in the close.

3. What is the role of balance sheet reconciliation in the close?

On one level, balance sheet reconciliation is the comparison of the account's general ledger trial balance with another source, be it internal, such as a sub-ledger, or external, such as a bank statement. But it can also involve substantiating the general ledger account by analyzing line items in the account. This is to make sure you have recorded and accounted for every transaction in your business – and applied the proper classification in the process.

Reconciling your company’s balance sheet is an essential part of the financial close at the end of an accounting period because the accuracy of a company’s balance sheet ensures the accounting department and business decision makers have a clear view of the company’s financial position. At the same time, this information is often used by outside advisors such as bankers and insurers to evaluate the creditworthiness of your business. And having accurate and timely disclosures is vital when looking to attract investors.

It is usually best practice for organizations to adopt a risk-based approach to balance sheet reconciliation whereby their efforts during the financial close are focused on the small proportion of high-risk accounts that represent a material risk and most likely to have the highest impact on the balance sheet.

Low risk accounts are then typically reconciled outside of the financial close because they would not substantially impact the accuracy of the financial numbers.

However, the lack of bandwidth and time pressure means many organizations and their finance teams are actually forced into doing most reconciliations, not just the high-risk accounts, outside of the financial close.

The rationale for moving the reconciliation process inside the financial close is compelling. If things are done correctly upstream, it lessens the need for reconciliation.

4. The key elements of balance sheet reconciliation

Properly reconciling a balance sheet account involves making sure you have recorded and accounted for every transaction in your business and applied the proper classification in the process. Your balance sheet lists Assets and Liabilities as well as Owner’s Equity. Assets are items such as cash, receivables, inventory, prepaid expenses and fixed assets. Liabilities include amounts owed to vendors, customers, employees, debtors and others. Accounts that include liabilities are typically accounts payable, payroll and taxes payable, notes payable, deferred revenue and customer deposits.

The broad framework for balance sheet reconciliation includes:

  • Ensuring every account in your balance sheet is certified/reconciled.
  • Making sure it has proper assignments so they can be put through a workflow. That should include who is responsible for the preparation, the approval or the review; when is it due and the type of balance sheet category it falls into.
  • The ability to apply risk ratings to accounts so you know which ones to focus on. Risk ratings could also drive the frequency of balance sheet reconciliation.
  • Applying auto certification rules.
  • Passing on any accounts that come out at the bottom of the funnel for manual investigation.

5. The common pitfalls and challenges of balance sheet reconciliation

While huge strides have been made in driving inefficiencies out of many financial processes, balance sheet reconciliation is one of the last bastions of reengineering, having seen very little in the way of efficiency gains over the last decade.

A fast close is impressive but could your company be compromising quality for speed? Are your reconciliations roll-forwards of recent activity or a simple listing of what is in your general ledger? How stringent are the review and analysis aspects of the process? Companies that close within a short window often rely more heavily on estimates and accruals, which may not be exact. For this reason, the review stage is critical. Validating the data through balance sheet review and account reconciliations reduces your exposure to risk, fraud and malicious attempts to manipulate numbers.

Businesses have long relied on the accountant’s Swiss Army knife, the Excel spreadsheet, in conjunction with email and workflow systems or collaborative platforms to help with the balance sheet reconciliation process. But this approach is fraught with problems and often fails to solve underlying issues. Reliance on manual processes means that miscoding or misallocations are common errors. A combination of familiarity and blind faith lead people to make assumptions about the integrity and accuracy of the systems they use. Do you know who created the spreadsheet and how it was modeled? Are you confident there are no broken formulas or hidden worksheets?

The very thing that makes spreadsheets so versatile is also their Achilles heel. They’re easy to operate but they also require finance teams to correctly configure and manually populate them, often by sourcing data from a range of different systems, group companies or even third parties. The slightest mistake can (and does) result in errors and this risk increases as the amount of data to be processed grows and the complexity of calculations in spreadsheets increases. Academics estimate that almost nine out of 10 spreadsheets contain errors.

Purpose-built applications go some way to offering businesses visibility and control over their balance sheet reconciliation but offer little in the way of efficiency gains around the manual effort for those preparing the reconciliation. Point solutions prescribe certain ways of addressing processes that may not fit with your business, which can require further manual processes and workarounds to compensate. Evidence shows that either of these approaches still require a substantial amount of work that must be performed manually.

The integrity of your balance sheet is fundamental to the numbers and ensuing trust in the numbers. How do you even know if a reconciliation has been completed? If a substantial reconciliation slips through the net and is subsequently picked up by internal or external auditors, that’s a huge red flag raising question marks over the accuracy of financial statements with the potential to force a correction or restatement. Being forced to report that publicly will do more than leave you with egg on your face – the reputational risk and financial knock-on effect in terms of your stock price or the confidence of investors can be devastating.

6. How can finance teams tackle the challenges of balance sheet reconciliation?

Remove the manual burden

Manual posting is the biggest bottlenecks of the closing process; between 60% and 70% of reconciliation work is performed by the preparers. Therefore, the key to removing the manual burden is auto-certification. Hackett Group analysis suggests the superior efficiency of top performing companies is down to greater use of process and technology-related best practices and automation of many traditionally manual tasks.

Automation cuts out costly, tedious and error-prone processes, freeing up accounting teams to focus on value-added activities. Use automation to match transactions and balances automatically and identify and report any discrepancies to be investigated by accounting staff. This focused approach will save valuable time by minimizing manual intervention but – and just as importantly – play a huge role in preventing errors and eliminating fraud.

 

Use pre-configured reconciliation routines

There’s no point in reinventing the wheel. Pre-configured financial tasks across standard areas including journal entry, balance sheet certification, intercompany and close task and checklist management simplify the process of comparing account balances between external sources and identifying and reporting any discrepancies. This frees up the time and resources of your finance team so they can spend less time on repetitive manual tasks and more time on value-adding analysis and investigation. 

 

Automate review and approval workflows

Many organizations don't have structured account reconciliation workflows. But leaving the process to chance can lead to certifications falling through the gaps. Some form of automated review and approval workflow ensures all steps of the reconciliation process are completed. It also provides a full audit trail that captures every decision, whether robotic or manual, and piece of evidence used for decision-making throughout the entire process.

 

Validate with underlying applications such as ERP or other systems of record

Despite the promise of automation, companies still devote significant resources – human and otherwise – to validating numbers against their ERP and other business systems to optimize the close process. Live integration with ERP systems, bank statements, other source systems and business applications ensure that you always have access to the most accurate data for reconciliation purposes. This improves the accuracy of financial statements and eliminates errors and risks. The solution underpins your balance sheet integrity process with fully auditable automation and builds trust to ensure reconciliations are thorough, accurate and on time.

Keep track with a progress and risk dashboard

Visibility into the reconciliation process is vital to track progress and minimize risk. A dashboard enables finance professionals to easily see the status and current risk of their balance sheet integrity. That includes monitoring reconciling items to understand ageing and potential write-offs, as well as categorizing items to understand the root cause and fix upstream problems.

 

Empower your people

A training plan must be a part of the ongoing activities to make your finance and accounting team a gold standard for your organization. Skimping on this element is a false economy. Make sure you have the right people in the right jobs. Identify talent gaps and look to make those strategic hires.

 

Commit to continuous improvement

Meaningful attempts to increase efficiency demand examination of the entire month-end close process, as focusing solely on the final mile risks missing the causes of bottlenecks, with the likelihood of creating even more issues down the line.

Having full visibility over the full financial close – versus simply closing the books – gives a holistic view that allows you to measure and continuously improve your month-end processes to make the finance and accounting team valued by the entire business and help everyone understand the contribution that the finance and accounting team is making to the overall business goals.

Despite progress in accelerating closing cycle times and submission dates, further opportunities for improving the end-to-end account-to-report process remain. Hackett Group warns that the financial close marks the end of a process that goes on throughout the year and meaningful improvements require it to be addressed in a holistic way. The analyst highlights reconciliations and manual tasks as offering ample room for improvement.

Hackett Group’s research also suggests that the combination of greater use of best practices, a focus on eliminating process bottlenecks, spreading out workloads more evenly over the month, and process improvements using technology solutions, could go a long way to achieving efficiency gains. The research states: “Putting all of these practices in place eliminates the focus on pure speed in the close, emphasizing instead a more efficient, productive and better experience for all stakeholders.”