2.1 Cash, Cash Equivalents, Petty Cash, and Bank Reconciliation

Cash, Cash Equivalents, Petty Cash, and Bank Reconciliation

Cash problems are among the most reliable points on the FAR paper: the syllabus lists the nature and composition of cash, the bank reconciliation, and petty cash accounting (FAR topic 3.1). This section sorts which items belong in cash and cash equivalents, walks through the imprest fund, and builds bank reconciliations and a four-column proof of cash with the correcting entries.

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1. Cash and Cash Equivalents (PAS 7 & PAS 1)

Cash Defined

Cash encompasses currency, coins, and negotiable instruments accepted by a bank for immediate deposit at face value, without operational or legal restrictions. Cash is categorized into:

1. Cash on Hand:
   • Undeposited collections: currencies, customer checks (demand checks, cashier's checks, traveler's checks, manager's checks, postal money orders, bank drafts).
   • Working funds: petty cash funds, change funds, payroll funds, dividend funds, purchasing funds, tax funds.
2. Cash in Bank:
   • Demand deposits (checking accounts) and savings accounts unrestricted as to withdrawal.

Items Excluded from Cash

Candidates must scrutinize balance sheet items to eliminate non-cash items:

• Customer Postdated Checks (PDC): Excluded from cash; presented as accounts or notes receivable until the date of the check arrives.
• NSF / DAIF Checks: Checks returned by the bank marked "No Sufficient Funds" or "Drawn Against Insufficient Funds" are eliminated from cash and reclassified as accounts receivable (with potential ECL impairment).
• Entity Postdated Checks: Checks drawn, recorded as disbursements, but postdated or unreleased (not delivered to payees before year-end). These checks are restored to cash by reversing the entry: Dr. Cash, Cr. Accounts Payable.
• Stale Checks: Checks drawn and delivered to payees but remaining uncashed for an unreasonable period (typically six months or more under banking practice). If immaterial, credit Miscellaneous Income; if material or payee is known, restore to cash: Dr. Cash, Cr. Accounts Payable.
• IOUs and Expense Advances: Cash advances to officers, employees, or travel funds are reclassified as receivables or prepaid expenses.
• Postage Stamps: Classified as office supplies or prepaid expenses.
• Legally Restricted Compensating Balances: If compensating balances against short-term borrowings are legally restricted, classify separately as "restricted cash" under current assets. If held against long-term borrowings, classify under non-current assets. If unrestricted or informal, include in cash with note disclosure.
• Bank Overdrafts: Negative balances in bank accounts. Under PAS 1, overdrafts cannot be offset against positive cash balances in other banks and must be reported as current liabilities. Under PAS 7, overdrafts that are repayable on demand and form an integral part of the entity's centralized cash management (e.g., cash concentration accounts with the same bank) are netted against cash and cash equivalents.
• Foreign Currencies: Valued at the closing spot rate at the reporting date. Unrestricted foreign currency is cash; funds subject to foreign exchange restrictions are non-current assets.

Criteria for Cash Equivalents under PAS 7

Under PAS 7, paragraph 6, cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and subject to an insignificant risk of changes in value.

                          Criteria for Cash Equivalents (PAS 7)
                                            │
               ┌────────────────────────────┼────────────────────────────┐
               ▼                            ▼                            ▼
         Short-Term                   Highly Liquid              Insignificant Risk of
     3-Month Rule from             Readily convertible to           Value Changes
    DATE OF ACQUISITION             known cash amounts          (Low price volatility)

The Three-Month Acquisition Rule

An investment qualifies as a cash equivalent only when it has a maturity of three months or less from the date of acquisition by the entity:

• Qualifies: A 90-day Bangko Sentral ng Pilipinas (BSP) treasury bill purchased on November 15, 2026 maturing on February 13, 2027.
• Disqualified: A 5-year treasury bond purchased 4.8 years ago that has 2 months remaining until maturity at the reporting date. It was NOT acquired with a maturity of 3 months or less; it is classified as a short-term financial asset.
• Disqualified: Equity investments (common or preferred shares) because shares have no maturity date and possess significant price risk. Exception: Redeemable preference shares acquired three months or less before their mandatory redemption date qualify.

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2. Petty Cash Fund Accounting (The Imprest System)

The imprest fund system maintains a fixed float balance. The fund is established, replenished, and adjusted as follows:

Cash Shortage and Overage Mechanics

At any point, the sum of currencies, coins, and unreimbursed expense vouchers must equal the imprest fund balance. Discrepancies are handled via the Cash Short or Over account:

• Shortage (Actual Cash is less than Accountability): Debit Cash Short or Over on replenishment. At year-end, if the shortage is recoverable from the custodian, debit Advances to Officers/Employees / Due from Custodian; if normal or unresolvable, close to Miscellaneous Expense.
• Overage (Actual Cash is greater than Accountability): Credit Cash Short or Over on replenishment. At year-end, close to Miscellaneous Income (or Payable to Custodian if an identified person overpaid).

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3. Bank Reconciliation & Proof of Cash

A bank reconciliation harmonizes the unadjusted ledger cash balance with the unadjusted bank statement balance.

Reconciling Items Taxonomy

                                Bank Reconciliation Items
                                            │
                    ┌───────────────────────┴───────────────────────┐
                    ▼                                               ▼
           Book Reconciling Items                          Bank Reconciling Items
        (Require adjusting entries)                    (Do not require book entries)
                    │                                               │
     ┌──────────────┴──────────────┐                 ┌──────────────┴──────────────┐
     ▼                             ▼                 ▼                             ▼
   Additions                     Deductions        Additions                     Deductions
• Credit Memos (CM)           • Debit Memos (DM) • Deposits in Transit (DIT)   • Outstanding Checks (OC)
  (Notes collected, interest)   (Bank charges)   • Bank Undercredits           • Bank Overcharges
• Book Undercharges           • NSF/DAIF Checks
                              • Book Overcredits

Formulations under the Adjusted Balance Method

$\text{Adjusted Book Balance} = \text{Unadjusted Book} + \text{Credit Memos} - \text{Debit Memos} - \text{NSF Checks} \pm \text{Book Errors}$

$\text{Adjusted Bank Balance} = \text{Unadjusted Bank} + \text{Deposits in Transit} - \text{Outstanding Checks} \pm \text{Bank Errors}$

Note on Certified Checks: Checks certified by the bank are immediately charged against the depositor's bank account. Certified checks are NOT outstanding checks, even if the payee has not yet cashed them.

Two-Date Reconciliation (Proof of Cash Mechanics)

A proof of cash provides a four-column reconciliation across two dates (e.g., November 30 to December 31):

Proof of Cash Logic:

• Nov 30 DIT: Deducted from December bank receipts because the bank credited deposits in December that were recorded on books in November.
• Dec 31 DIT: Added to December bank receipts because cash collected in December was not yet recorded by the bank.
• Nov 30 OC: Deducted from December bank disbursements because the bank cleared checks in December that were recorded on books as disbursements in November.
• Dec 31 OC: Added to December bank disbursements because checks issued and recorded as disbursements in December have not yet cleared the bank.

Worked Example: Bank Reconciliation & Correcting Entries

On December 31, 2026, Alpha Trading Company reports an unadjusted cash ledger balance of PHP 2,450,000. The December 31 bank statement reports a balance of PHP 3,362,000. Examination of accounting records reveals:

1. Deposits in transit at December 31: PHP 420,000.
2. Outstanding checks at December 31: PHP 850,000 (excluding a certified check of PHP 60,000).
3. Bank collected a customer promissory note of PHP 500,000 with interest of PHP 25,000, charging a collection fee of PHP 5,000 (Net credit memo: PHP 520,000).
4. Customer NSF check returned by bank: PHP 95,000.
5. Bank service charge for December: PHP 15,000.
6. A customer collection of PHP 180,000 was erroneously recorded in the cash receipts journal as PHP 108,000 (Understatement of cash receipts: PHP 72,000).

                                Alpha Trading Company
                              Bank Reconciliation Schedule
                                   December 31, 2026

Book Reconciliation:
Unadjusted Book Balance .......................................... PHP 2,450,000
Add: Note collected by bank (principal) ........... PHP 500,000
     Interest on note collected ....................     25,000
     Book error (understated customer receipt) .....     72,000          597,000
                                                                  ──────────────
Subtotal ......................................................... PHP 3,047,000
Less: Bank collection fee .......................... PHP   5,000
      Customer NSF check returned ..................     95,000
      Bank service charges .........................     15,000          115,000
                                                                  ──────────────
Adjusted Book Balance ............................................ PHP 2,932,000
                                                                  ══════════════

Bank Reconciliation:
Unadjusted Bank Balance .......................................... PHP 3,362,000
Add: Deposits in Transit .........................................       420,000
                                                                  ──────────────
Subtotal ......................................................... PHP 3,782,000
Less: Outstanding Checks .........................................       850,000
                                                                  ──────────────
Adjusted Bank Balance ............................................ PHP 2,932,000
                                                                  ══════════════

Compound Adjusting Journal Entry on Books: $\text{Debit: Cash in Bank } 482{,}000$ $\text{Debit: Bank Service Charge Expense } 20{,}000 \quad (\text{PHP }15{,}000 + \text{PHP }5{,}000)$ $\text{Debit: Accounts Receivable (NSF Check) } 95{,}000$ $\text{Credit: Notes Receivable } 500{,}000$ $\text{Credit: Interest Income } 25{,}000$ $\text{Credit: Accounts Receivable (Error Correction) } 72{,}000$ $\text{Net Cash Adjustment} = \text{Debit of PHP }482{,}000 \quad (\text{PHP }2{,}450{,}000 + \text{PHP }482{,}000 = \text{PHP }2{,}932{,}000)$