8.1 Cash and Cash Equivalents

8.1 Cash and Cash Equivalents

Overview and ASC 305 Definitions

Cash is the most liquid asset on a company's balance sheet. Under ASC 305 (Cash and Cash Equivalents), cash consists of currency, coins, and demand deposits (checking and savings accounts). Cash also includes negotiable instruments that are immediately convertible, such as money orders, certified checks, cashier's checks, and bank drafts.

Cash Equivalents are short-term, highly liquid investments that meet two conditions:

1. They are readily convertible to known amounts of cash.
2. They are so near their maturity that they present insignificant risk of changes in value due to interest rate fluctuations.

Under GAAP, the critical threshold for a cash equivalent is a maturity of 90 days (3 months) or less from the date of purchase/acquisition by the reporting entity. The original maturity of the instrument is irrelevant; what matters is the remaining maturity at the time the company acquires it. For example, if a company purchases a 3-year Treasury note that matures in 60 days, it is classified as a cash equivalent. However, if a company purchases a 1-year Certificate of Deposit (CD) and holds it for 9 months, it cannot be classified as a cash equivalent during its remaining 90 days because it was acquired when the maturity was greater than 90 days.

Summary of Cash vs. Non-Cash Classifications

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Bank Reconciliations

Because bank records and book records are maintained independently, their balances rarely match at month-end. A bank reconciliation must be prepared to identify these discrepancies, verify transactions, and establish the correct ending cash balance to be reported on the balance sheet.

Reconciliation involves a two-way adjustment to arrive at the Adjusted Cash Balance.

The Two-Way Reconciliation Framework

1. Balance per Bank Statement:

   • Add: Deposits in transit (DIT). These are deposits recorded in the company's books but not yet credited by the bank.
   • Deduct: Outstanding checks (O/S). These are checks written and recorded in the company's books but not yet cleared/paid by the bank.
   • Add/Deduct: Bank errors. For example, if the bank incorrectly deducted $500 from the company's account instead of another company's account, add it back.

2. Balance per General Ledger (Books):

   • Add: Interest earned. Credit interest paid by the bank on checking/savings accounts.
   • Add: EFT (Electronic Funds Transfer) collections. Direct payments from customers into the bank account not yet recorded on the books.
   • Deduct: Bank service charges. Monthly service fees, check printing fees, and wire fees.
   • Deduct: NSF (Non-Sufficient Funds) checks. Customer checks previously deposited that bounced due to insufficient funds in the customer's account.
   • Add/Deduct: Book errors. For example, if a check written for $980 was recorded in the journal as $890, the books must be reduced by an additional $90 ($980 - $890).

Reconciling Adjustments Summary Table

[!IMPORTANT] GAAP Rule for Adjusting Entries: Journal entries are only recorded for adjustments made to the Book Balance. Reconciling items on the bank side (deposits in transit, outstanding checks) do not require journal entries because they will naturally resolve when the bank processes them in the following month.

Worked Example: Book adjusting entries

Assume a company's bank reconciliation reveals the following book adjustments:

1. Bank interest earned: $45
2. NSF check from customer J. Doe: $320
3. Bank service fee: $15
4. Error: A check written to a supplier for utilities was recorded in the books as $450, but actually cleared the bank for $540. (The books under-recorded the cash disbursement by $90).

Adjusting Journal Entries:

To record interest income:

Debit Cash                                        $45
  Credit Interest Revenue                                 $45

To record the customer's bounced check:

Debit Accounts Receivable - J. Doe               $320
  Credit Cash                                            $320

To record bank service fees:

Debit Miscellaneous Expense / Office Expense       $15
  Credit Cash                                             $15

To correct the cash disbursement recording error:

Debit Utilities Expense                            $90
  Credit Cash                                             $90

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Petty Cash Accounting (Imprest System)

Companies maintain a petty cash fund to pay for small, incidental expenditures (postage, office supplies, taxi fares) where writing a check is impractical. The imprest system is the standard accounting method used.

1. Establishing the Fund

A check is written and cashed to establish the fund.

Debit Petty Cash                                 $300
  Credit Cash                                            $300

At this point, Petty Cash is a separate asset account. No further entries are made to the Petty Cash account unless the company decides to permanently increase or decrease the physical size of the fund.

2. Replenishing the Fund

As payouts are made, the custodian collects receipts. The physical cash remaining plus the sum of the receipts must always equal the established fund size ($300). When the cash runs low, the fund is replenished.

Worked Example: A $300 petty cash fund has $40 cash remaining and receipts for: Office Supplies $160, and Postage $95.

• Total receipts: $160 + $95 = $255
• Cash needed to replenish the fund: $300 - $40 = $260
• Discrepancy: The receipts ($255) are $5 less than the cash required ($260). This represents a cash shortage of $5.

Replenishment Journal Entry:

Debit Office Supplies Expense                    $160
Debit Postage Expense                             $95
Debit Cash Over and Short                           $5
  Credit Cash                                            $260

Note: Cash Over and Short is a temporary account. A debit balance represents an expense (miscellaneous expense), while a credit balance represents revenue (miscellaneous income).

3. Changing the Fund Size

If the company decides to increase the fund from $300 to $450:

Debit Petty Cash                                 $150
  Credit Cash                                            $150

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Restricted Cash and Bank Overdrafts

Restricted Cash

Restricted cash is cash that is not available for general business use because of legal, contractual, or internal covenants. Common reasons include:

1. Debt Service / Sinking Funds: Cash set aside to repay long-term bonds.
2. Compensating Balances: Minimum balances a borrower must maintain in a bank account as a condition of a loan agreement.

• Presentation: Restricted cash cannot be lumped with general cash on the balance sheet. If the restriction is associated with a current liability, it is classified as a Current Asset (but listed separately from unrestricted cash). If associated with a long-term liability or capital expenditure, it is classified as a Non-Current Asset (typically in the 'Other Assets' or 'Investments' section).
• Statement of Cash Flows (ASC 230): Restricted cash must be combined with unrestricted cash and cash equivalents when reconciling the beginning and ending periods on the Statement of Cash Flows. Transfers between restricted and unrestricted cash are not reported as operating, investing, or financing cash flows; they are treated as non-cash reclassifications.

Bank Overdrafts

A bank overdraft occurs when a company writes a check for more than the balance in its bank account.

• GAAP Rule: A bank overdraft must be reported as a Current Liability (typically under Accounts Payable or Accrued Liabilities). It cannot be offset (netted) against positive cash balances in other bank accounts.
• Exceptions: Netting is allowed only if the overdraft account is at the same financial institution as another account with a positive balance, and the bank has a legal right of offset between the accounts.