What is a three-way bank reconciliation and how is it performed?

What makes a reconciliation three-way?

An ordinary bank reconciliation compares two records: the bank statement and your books. If they agree after timing items, you know the cash figure in your books is right. It tells you nothing about what that cash is made of.

A three-way reconciliation adds a third record that breaks the same balance into parts, usually one ledger per person whose money is in the account, and requires all three to agree. The Colorado Division of Real Estate explains it to brokers as a third component compared against the reconciled bank statement and the journal total: the total of the liability ledgers. In its words, "A and B represent two-way reconciliation and A, B and C represent the 3 way reconciliation."

The difference is the question each one answers. Two-way: is the cash figure in my books right? Three-way: is the cash figure right, and is every dollar of it assigned to someone?

Which three records are you comparing?

North Carolina's rule for lawyer trust accounts names the three balances precisely, and the structure carries over to any account where a detailed record sits beneath the balance:

1. Your ledger balance. The rule's first balance is "The balance that appears in the general ledger as of the reporting date". In a small business this is the register or the general ledger account for the bank account.
2. The detailed record, totalled. The second is the total of the individual ledgers, "determined by listing and totaling the positive balances in the individual client ledgers and the administrative ledger maintained for servicing the account, as of the reporting date". Outside trust accounting, the same role is played by a subsidiary ledger.
3. The bank balance, adjusted. The third is the adjusted bank balance, "determined by adding outstanding deposits and other credits to the ending balance in the monthly bank statement and subtracting outstanding checks and other deductions from the balance in the monthly statement."

To find your own three, ask what record explains who or what the balance belongs to. For a law firm it is the client ledgers. For a property manager it is the owner and tenant ledgers. For a closing agent it is the file-by-file trial balance. For receivables or customer deposits it is the subsidiary ledger by customer.

Where does the third record come from, and why does that matter?

The bank statement comes from outside the business, and the general ledger comes from inside it. The third record usually does not come from the bank. It comes from one of two places, and the answer changes what agreement proves.

Kept by the business, beneath its own ledger. Client ledgers, owner ledgers and customer subledgers are usually posted by the same people, and often from the same entries, as the general ledger. Agreement shows the two internal records were posted consistently and that the total is backed by cash at the bank. It does not independently confirm that each person's balance is what they would say it is.

Kept by someone outside the business. Sometimes the detail comes from another party: a client's own schedule of deposits held, a management company's owner statements, or a system run by a different firm. Agreement with an outside record is stronger evidence, because a posting error on your side is unlikely to be mirrored there. It also brings a new problem: you depend on that party to give you a record cut off at your date.

When the third record lives in a separate system from the books, export both as at the same date and time before you compare. A posting made in one system after the other was run will show up as a difference that is not real.

When is a three-way tie-out expected rather than optional?

It is expected mainly where a business holds money that belongs to other people in a pooled account. Each rule below binds only the people it names in its own state. If you are in another state or hold a different kind of account, the authority that licenses or regulates you sets your standard, and you should read its rule rather than assume one of these applies.

• Lawyer trust accounts, North Carolina. For general trust accounts, "a reconciliation report shall be prepared at least quarterly", and "Each reconciliation report shall show all of the following balances and verify that they are identical:" followed by the three balances listed above. Separately, "Each month, the balance of the trust account as shown on the lawyer's records shall be reconciled with the current bank statement balance for the trust account."
• Real estate brokers, Washington. Washington's trust-account rule (WAC 308-124E-105) states: "The designated broker shall be responsible for preparation of a monthly trial balance of the client's ledger, reconciling the ledger with both the trust account bank statement and the trust account check register or bank control account." The checkbook balance, the bank reconciliation and the client ledgers "must be in agreement at all times."
• Closing agents, Iowa. "A closing agent shall perform a three-way reconciliation of bank balance, book balance, and trust account trial balance for each bank trust account at least once each calendar month."

In each case the third record exists because the account holds money for many people at once. The bank sees one balance, and only the individual ledgers show how much of it belongs to each person.

If your business holds no one else's money, a three-way tie-out of a control account against its subsidiary ledger is good practice, not a rule. AccountingTools states the standard: "The ending balance in a control account should match the ending total for the related subsidiary ledger." The required contents of a regulated trust reconciliation report, and the professional rules behind it, are covered in the guide on preparing a trust account reconciliation statement.

How do you bring all three records to the same position?

Alignment comes before comparison. Three records compared at slightly different moments will disagree, and the difference will look real.

1. Pick one cut-off. Use the bank statement's closing date. North Carolina's rule measures both internal balances "as of the reporting date".
2. Close off both internal records at that date. Post everything that belongs in the period to the register and to the individual ledgers. Print or export both as at the cut-off, not as at today.
3. Adjust the bank balance to the same point. Add deposits recorded in your books but not yet on the statement. Subtract checks and other payments recorded but not yet cleared. This is the adjusted bank balance.
4. Total the detailed record. List every individual ledger and its balance at the cut-off, including any administrative or unassigned ledger.

If the third record is produced on a different cycle, such as an owner statement run on the 25th, do not use it as-is against a month-end bank statement. Ask for a run at your cut-off or roll it forward yourself with the transactions in between.

How do you perform the comparison?

With all three at the same date, compare them in pairs. A practical order, because the bank-to-book pair carries the most timing items, is:

1. Adjusted bank balance against the ledger balance. This is the ordinary tie-out, which is covered in its own guide. Clear it first, because it is the pair with the most timing items.
2. Ledger balance against the total of the individual ledgers. This is the control-to-detail check.
3. Confirm the third pair. If the first two pairs agree, the adjusted bank balance and the detail total must also agree. Write all three figures side by side so a reviewer sees it.
4. Scan the individual ledgers. Look for any ledger below zero, and resolve it before you sign off (see the section on matching totals below).

The reconciliation is complete only when all three balances are identical at the same date and no individual ledger is negative. Stopping once bank and books agree gives you the ordinary reconciliation under a different name. Differences carried forward "to investigate" mean it is not complete.

How does a worked example look?

A property manager holds rent and deposits for four clients in one account. Month end is June 30.

Step 1: adjust the bank balance.

Step 2: total the individual ledgers.

Step 3: set the three side by side. The register shows 47,000.00. Adjusted bank is 47,000.00 and the ledger total is 47,000.00. All three agree, no ledger is negative, and June is complete.

July, with a difference. At July 31 the adjusted bank balance is 51,300.00, the register shows 51,300.00, and the individual ledgers total 50,900.00. Bank and register agree, so cash is not the problem. The 400.00 gap sits between the register and the detail. The search is now confined to July postings that reached the register but not an individual ledger, or were posted to a ledger for the wrong amount. Here a 400.00 pet deposit was entered in the register and never posted to Owner B's ledger. Posting it brings the ledger total to 51,300.00 and all three agree.

How do you tell which record is wrong?

The pattern of agreement tells you where to look.

• Bank differs; register and ledger total agree. The internal records are consistent with each other, so something happened at the bank that neither records: an unrecorded fee, interest, a returned deposit, or a wrong item on the outstanding list. Work the bank-to-book pair.
• Ledger total differs; bank and register agree. Cash is right, but its assignment is wrong. AccountingTools names the classic cause: "If the balance does not match, it is possible that a journal entry was made to the control account that was not also made in the subsidiary ledger." Also look for a posting to the wrong person's ledger for a different amount, or a missing ledger.
• Register differs; bank and ledger total agree. An entry reached the individual ledgers but not the register, or the register has an arithmetic or duplication error.
• No two agree. Before hunting for errors, recheck alignment, because records cut off at different dates can pull all three apart. If the dates are right, clear the bank-to-register pair first and then return to the other one.

Why is a matching total not enough?

Agreement in total can hide a shortfall on an individual ledger. Suppose that in a later month all three agree at 47,000.00 as in June, Owner D's ledger holds 6,500.00, and you pay a 6,800.00 repair bill for Owner D from the trust account. D's ledger goes to (300.00). Bank, register and the net ledger total all fall by the same 6,800.00, so all three still agree, at 40,200.00. Yet 300.00 of other owners' money paid D's bill.

North Carolina's rule totals only "the positive balances". Listed that way, the ledgers total 40,500.00, which does not match the 40,200.00 in the bank and register. The mismatch exposes a shortfall that a netted total conceals. Whatever rule you work under, treat any negative individual balance as a finding to resolve, never as an offset against other balances.

What does a finished three-way reconciliation prove?

A two-way tie-out proves that the cash in your books matches the cash at the bank at a date. A completed three-way reconciliation adds two things: every dollar in the account is assigned to a named person or item, and the assignments add back to the cash that is actually there. With no negative ledgers, no one's money is funding someone else's balance.

It does not prove that each individual ledger is correct for that person. A receipt posted to the wrong client leaves all three totals agreeing. That is caught only by reviewing activity on the ledgers or by confirming balances with the people concerned. Where the detail comes from an outside party, agreement also confirms that your records and theirs match.

Who prepares it, who reviews it, and how often?

Where the tie-out is required, it is a recurring control with a named owner and a review.

• Cadence. As above: monthly in Washington and Iowa, quarterly in North Carolina with a monthly bank tie-out.
• Review. North Carolina: "The lawyer shall review, sign, date, and retain a copy of the reconciliations of the general trust account for a period of six years". In Iowa, a member of management "shall review and approve the reconciliation at least once each calendar month."
• Preparer. Iowa's rule adds: "It is recommended that trust account reconciliations be prepared by a person other than a person who records receipts or makes deposits to the trust account."

Where no rule applies, a sensible standard is to reconcile at each month-end, to follow Iowa's recommendation that reconciliations be prepared "by a person other than a person who records receipts or makes deposits to the trust account", and to keep the dated reconciliation with its listing of individual balances.

What changes when you keep the books for a client?

If you are a bookkeeper preparing a three-way reconciliation for a client, responsibility stays with the client's licensed person. Under the rules above, that is the lawyer in North Carolina, the designated broker in Washington, and, for an Iowa closing agent, a member of its management team, who must review and approve the reconciliation. Iowa's rule also states that "A closing agent may use an outside accountant to perform reconciliations." You can prepare the work, but the review and sign-off belong to them.

Check who keeps each record. If you post the register but the client or their software keeps the individual ledgers, get the ledger listing directly from that system, as at your cut-off, and note who supplied it. You can conclude that the three records agree at that date. You cannot vouch for postings you did not make or for a ledger you did not maintain. Put that limit in writing on the reconciliation, and send any negative ledger or unexplained difference to the responsible person rather than adjusting it away.