Reconciliations – balancing the books, says who?

26.03.12 Chris Errington

Reconciliations are a basic business control. Despite them being commonplace, fundamental errors in their application continue.
When you are reconciling one balance to another, you must make sure that you are using the correct balance. It may sound obvious, but when you are performing a bank reconciliation you need to ensure that you are using the balance provided by the bank to reconcile to.
If you don’t, this can happen:

 

  • An error is made because the bank balance hasn’t actually been provided by the bank

 

 

  1. A good example is the recent (much publicised around January 2012) JP Morgan client money segregation case. JPMSL was correctly segregating client money and holding it with fellow subsidiary bank, JPMCB. JPMSL staff reconciled the JPMSL book balance (of client monies held) with the JPMCB book balance (of client monies held in segregated bank accounts). However, JPMSL staff relied upon an electronic feed of data to confirm the JPMCB balance, which proved fatal because (a) the data feed was in fact not from JPMCB at all, but from JPMSL itself (probably the offset account used to record the transfer of monies to JPMCB), and (b) whilst JPMCB was correctly holding the client monies in segregated accounts during the day, because of a system change, it was in fact transferring them to the bank’s prime nostro account overnight (rather than the correct target of JPMCB’s money market account and segregated accounts therein). Had JPMSL staff, or their auditor, obtained a direct confirmation from JPMCB then they would have immediately identified that the monies were not held in the right segregated money market accounts. They didn’t.
  2. The February 2012 UK Supreme Court judgment in the case of Lehman’s seems to suggest there was a similar problem, where Lehman affiliate client money (some $3bn apparently) was deposited with a Lehman’s bank but then not held by that bank as client money in error. Looks like bank reconciliations were being performed again without direct confirmation of balance from the bank (in this case an affiliate).

 

    1. A fraud has been perpetrated but not spotted because the bank balance hasn’t actually been provided by the bank

 

  1. A good example is the much publicised Barings collapse, where Nick Leeson was providing the auditor PwC with fake bank statements supporting cash purported to be held at a bank for Barings. The book balance reconciled exactly with the bank balance BUT the bank balance wasn’t actually the bank balance at all. PwC appear to have relied on a fraudulent fax sent to them by Nick Leeson himself confirming the bank balance rather than ensuring they obtained a confirmation direct from the bank. A costly error.

It’s expensive and embarrassing when it goes wrong.
Poor risk management in (2) contributed to the 1995 collapse of Barings, in (1) b. to client monies being put at risk in an insolvency and in point (1)a led to a fine for JPMSL of £33m and PwC of £1.2m
www.frc.org.uk/aadb/tribunal/pub2689.html

So before you start any reconciliation process, make certain you know precisely where the balances you are reconciling came from and how much reliance you can place on their source – 3rd party confirmations are everything.

Risk management lesson 1: always seek independent confirmation direct from the bank and settle for nothing less. Also, force your auditors to confirm that they have sought and received 3rd party responses from all banks, covering all accounts. Ensure their audit planning records an absolute requirement for this procedure (applied precisely according to the Auditing Standard) with all exceptions to be reported to the Audit Committee.