Chapter Six: Cash and Highly-Liquid Investments

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Cash Register pictureWhat exactly is cash? This may seem like a foolish question until one considers the possibilities. Cash includes coins and currency. But what about items like undeposited checks, certificates of deposit, and similar items? Generalizing, cash includes those items that are acceptable to a bank for deposit and are free from restrictions (i.e., available for use in satisfying current debts). Cash typically includes coins, currency, funds on deposit with a bank, checks, and money orders.

Link to Excel ExerciseItems like postdated checks, certificates of deposit, IOUs, stamps, and travel advances are not classified as cash. These would customarily be classified in accounts such as receivables, short-term investments, supplies, or prepaid expenses.  The existence of compensating balances (amounts that must be left on deposit and not withdrawn) should be disclosed and, if significant, reported separately from cash.

Separate treatment is also given to "sinking funds" (monies that must be set aside to satisfy debts) and restricted foreign currency holdings (that cannot easily be transferred or converted into another currency). These unique categories of funds may be reported in the long-term investments category. Some companies will report "cash and cash equivalents":

Cash Equivalent Balance Sheet Disclosure

Cash equivalents arise when companies place their cash in very short-term financial instruments that are deemed to be highly secure and will convert back into cash within 90 days (e.g., short-term government-issued treasury bills). These financial instruments are usually very marketable in the event the company has an immediate need for cash.


Cash Management

It is very important to ensure that sufficient cash is available to meet obligations and that idle cash is appropriately invested. One function of the company "treasurer" is to examine the cash flows of the business, and pinpoint anticipated periods of excess or deficit cash flows. A detailed cash budget is often maintained and updated on a regular basis. The cash budget is a major component of a cash planning system and represents the overall plan that depicts cash inflows and outflows for a stated period of time. A future chapter provides an in-depth look at cash budgeting.

Link to Excel ExerciseAlthough cash shortages may seem to be a sign of weakness or mismangement, this is not always the case. Successful companies may need cash for new business locations, added inventory levels, growing receivables, and so forth. Careful cash planning must occur to sustain growth.


As a business looks to improve cash management or add to the available cash supply, a number of options are available. Some of these solutions are "external" and some are "internal" in nature.

External solutions include:

Issuing additional shares of stock -- This solution allows a company to obtain cash without a fixed obligation to repay. Unfortunately, the existing shareholders do incur a detriment, because the added share count dilutes the ownership proportions. In essence, existing shareholders are selling off part of the business.

Borrowing additional funds -- This solution brings no shareholder dilution, but borrowed funds must be repaid along with interest. Thus, the business cost and risk is increased. Many companies will pay a fee to establish a standing line of credit that enables them to borrow as needed.

Internal solutions include:

Accelerate cash collections -- If customers pay more quickly, a significant source of cash is found. Simple tools include electronic payment, credit cards, and cash discounts for prompt payment.

Postponement of cash outflows -- Companies may delay payment as long as possible. Paying via check sent through the mail allows use of the "float" to preserve cash on hand. However, one needs to know that it is illegal to issue a check when there are insufficient funds in the bank to cover that item.

Cash control -- Internal control for cash is based on the same general control features introduced in the previous chapter; access to cash should be limited to a few authorized personnel, incompatible duties should be separated, and accountability features (like prenumbered checks, etc.) should be developed.

  • Control of receipts from cash sales should begin at the point of sale and continue through to deposit at the bank. Specifically, point-of-sale terminals should be used, actual cash on hand at the end of the day should be compared to register reports, and daily bank deposits should be made.
  • Control of receipts by mail begins with the person opening the mail. They should prepare a listing of checks received and forward the list to the accounting department. The checks are forwarded to a cashier who prepares a daily bank deposit. The accounting department enters the information from the listing of checks into the accounting records and compares the listing to a copy of the deposit slip prepared by the cashier.
  • Controls over cash disbursements include procedures that allow only authorized payments and maintenance of proper separation of duties. Control features include making disbursements by check, performance of periodic bank reconciliations, proper utilization of petty cash systems, and verification of supporting documentation before disbursing funds.

Proper bank reconciliation and petty cash systems are discussed in following sections.


Bank Reconciliation

One of the most common cash control procedures is the bank reconciliation. In business, every bank statement should be promptly reconciled by a person not otherwise involved in the cash receipts and disbursements functions. The reconciliation is needed to identify errors, irregularities, and adjustments for the Cash account. Having an independent person prepare the reconciliation helps establish separation of duties and deters fraud by requiring collusion for unauthorized actions.

Link to Excel ExerciseThere are many different formats for the reconciliation process, but they all accomplish the same objective. The reconciliation compares the amount of cash shown on the monthly bank statement (the document received from a bank which summarizes deposits and other credits, and checks and other debits) with the amount of cash reported in the general ledger. These two balances will frequently differ as shown in the following illustration:

Bank Reconciliation illustration

Differences are caused by items reflected on company records but not yet recorded by the bank. Examples include deposits in transit (a receipt entered on company records but not processed by the bank) and outstanding checks (checks written which have not cleared the bank). Other differences relate to items noted on the bank statement but not recorded by the company. Examples include non-sufficient funds (NSF) checks ("hot" checks previously deposited but which have been returned for nonpayment), bank service charges, notes receivable (like an account receivable, but more "formalized") collected by the bank on behalf of a company, and interest earnings.

The following format is typical of one used in the reconciliation process. Note that the balance per the bank statement is reconciled to the "correct" amount of cash; likewise, the balance per company records is reconciled to the "correct" amount. These amounts must agree. Once the correct adjusted cash balance is satisfactorily calculated, journal entries must be prepared for all items identified in the reconciliation of the ending balance per company records to the correct cash balance. These entries serve to record the transactions and events which impact cash but have not been previously journalized (e.g., NSF checks, bank service charges, interest income, and so on).

Bank Reconciliation Process


The following pages include a detailed illustration of the bank reconciliation process. Begin by carefully reviewing the bank statement for The Tackle Shop found below. Then look at the company's check register spreadsheet that follows. Information found on that spreadsheet would correlate precisely to activity in the company's Cash account within the general ledger.

The following additional information must also be considered:

  • Check #5454 was written in June but did not clear the bank until July 2. There were no other outstanding checks, and no deposits in transit at the end of June.
  • The EFT (electronic funds transfer) on July 11 relates to the monthly utility bill; the Tackle Shop has authorized the utility to draft its account directly each month.
  • The Tackle Shop is optimistic that they will recover the full amount, including the service charge, on the NSF check that was given to them during the month.
  • The bank collected a $5,000 note for The Tackle Shop, plus 9% interest ($5,450).
  • The Tackle Shop's credit card clearing company remitted funds on July 25; the Tackle Shop received an email notification of this posting and simultaneously journalized this cash receipt in the accounting records.
  • The Tackle Shop made the deposit of $3,565.93 late in the day on July 31, 20X3.
  • The ending cash balance, per the company general ledger, was $47,535.30.

Be aware that conducting a successful bank reconciliation requires careful attention to every detail. After examining the bank statement, check register, and additional information, proceed to verify each component within (1) the balance per bank statement to the correct cash balance and (2) the balance per company records to the correct cash balance.

Bank Statement

Bank Statement Example

check register

The Tackle Shop Cash Register

Below is the July reconciliation of the balance per bank statement to the correct cash balance.

Ending Balance per Bank Statement illustration

The reconciliation of the balance per company records to the correct cash balance is presented below. This reconciliation will trigger various adjustments to the Cash account in the company ledger.

Ending Balance Per Company Records illustration

The identified items necessitated increasing cash by $4,968.21 ($52,503.51 correct balance, less the balance per company records of $47,535.30). Note that the $462.06 debit to Accounts Receivable indicates that The Tackle Shop is going to attempt to collect on the NSF check and related charge. The interest income of $569.34 reflects that posted by the bank ($119.34) plus the $450 on the collected note.

Bank Reconciliation Journal Entries

This reconciliation example demonstrates the importance of the process, without which accounting records would soon become unreliable.


Many businesses prepare a reconciliation just like that illustrated. However, this approach leaves one gaping hole in the control process. What if the bank statement included a $5,000 check to an employee near the beginning of the month, and a $5,000 deposit by that employee near the end of the month (and these amounts were not recorded on the company records)? In other words, the employee took out an unauthorized "loan" for a while. The reconciliation would not reveal this unauthorized activity because the ending balances are correct and in agreement. To overcome this deficiency, some companies will reconcile not only the beginning and ending balances, but also the total checks per the bank statement to the total disbursements per the company records, and the total deposits per the bank statement to the total receipts on the company accounts. If a problem exists, the totals on the bank statement will exceed the totals per the company records for both receipts and disbursements. This added reconciliation technique is termed a proof of cash. It is highly recommended where the volume of transactions and amount of money involved is very large.

Also illegal is "kiting" which occurs when one opens numerous bank accounts at various locations and then proceeds to write checks on one account and deposit them to another. In turn, checks are written on that account, and deposited to yet another bank. And, over and over and over. Each of the bank accounts may appear to have money; but, it is illusionary because there are numerous checks "floating" about that will hit and reduce the accounts. Somewhere in the process the perpetrator makes a cash withdrawal and then vanishes. That is why one will often see bank notices that deposited funds cannot be withdrawn for several days. Such restrictions are intended to make sure that a deposit clears the bank on which it is drawn before releasing those funds. Kiting is complex and illegal. Enhanced electronic clearing procedures adopted by banks have made kiting far more difficult to accomplish.


Petty Cash

Video LecturePetty cash, also known as imprest cash, is a fund established for making small payments that are impractical to pay by check. Examples include postage due, reimbursement to employees for small purchases of office supplies, and numerous similar items. The establishment of a petty cash system begins by making out a check to cash, cashing it, and placing the cash in a petty cash box:

Petty Cash illustration

Link to Excel ExerciseA petty cash custodian should be designated to safeguard and make payments from this fund. At the time the fund is established, the following journal entry is needed. This journal entry, in essence, subdivides the petty cash portion of available funds into a separate account.

Petty Cash Journal entries

Policies should be established regarding appropriate expenditures that can be paid from petty cash. When a disbursement is made from the fund, a receipt should be placed in the petty cash box. The receipt should set forth the amount and nature of expenditure. The receipts are known as petty cash vouchers. At any point in time, the receipts plus the remaining cash should equal the balance of the petty cash fund (i.e., the amount of cash originally placed in the fund).


As expenditures occur, cash in the box will be depleted. Eventually the fund will require replenishment. A check for cash is prepared in an amount to bring the fund back up to the original level. The check is cashed and the proceeds are placed in the petty cash box. At the same time, receipts are removed from the petty cash box and formally recorded as expenses.

Replenishment of Petty Cash illustration

The journal entry for this action involves debits to appropriate expense accounts as represented by the receipts, and a credit to Cash for the amount of the replenishment. Notice that the Petty Cash account is not impacted -- it was originally established as a base amount, and its balance has not been changed by virtue of this activity.

Replenishment of Petty Cash Journal entries

cash short and over

Occasional errors may cause the petty cash fund to be out of balance. The sum of the cash and receipts will differ from the correct Petty Cash balance. This might be the result of simple mistakes, such as math errors in making change, or perhaps someone failed to provide a receipt for an appropriate expenditure. Whatever the cause, the available cash must be brought back to the appropriate level.

The journal entry to record full replenishment may require an additional debit (for shortages) or credit (for overages) to Cash Short (Over). In the following entry, $635 is placed back into the fund, even though receipts amount to only $615. The difference is debited to Cash Short (Over):

Cash Short Journal entries

The Cash Short (Over) account is an income statement type account. It is also applicable to situations other than petty cash. For example, a retailer will compare daily cash sales to the actual cash found in the cash register drawers. If a surplus or shortage is discovered, the difference will be recorded in Cash Short (Over); a debit balance indicates a shortage (expense), while a credit represents an overage (revenue).


As a company grows, it may find a need to increase the base size of its petty cash fund. The entry to increase the fund would be identical to the first entry illustrated; that is, the amount added to the base amount of the fund would be debited to Petty Cash and credited to Cash. Otherwise, take note that the only entry to the Petty Cash account occurred when the fund was established.


Trading Securities

Video LectureA business may invest cash in stocks of other corporations. Or, a company may buy other types of corporate or government securities. Accounting rules for such investments can depend on the "intent" of the investment. If these investments were acquired for long-term purposes, or perhaps to establish some form of control over another entity, the investments are classified as noncurrent assets.

Link to Excel ExerciseThe accounting rules for those types of investments are covered in subsequent chapters. But, when the investments are acquired with the simple intent of generating profits by reselling the investment in the very near future, such investments are classified as current assets (following cash on the balance sheet). These investments are appropriately known as trading securities.

Trading securities are initially recorded at cost (including brokerage fees). However, the value of these items may fluctuate. Subsequent to initial acquisition, trading securities are to be reported at their fair value. The fluctuation in value is reported in the income statement. This approach is often called "mark-to-market" or fair value accounting. Fair value is defined as the price that would be received from the sale of an asset in an orderly transaction between market participants.


Assume that Webster Company's management was seeing a pickup in their business activity and believed that a similar uptick was occurring for its competitors as well. One of its competitors, Merriam Corporation, was a public company, and its stock was trading at $10 per share. Webster had excess cash earning very low rates of interest and decided to invest in Merriam with the intent of selling the investment in the very near future for a quick profit. The following entry was needed on March 3, 20X6, the day Webster bought stock of Merriam:

Purchase of Stock Journal entry

Next, assume that financial statements were being prepared on March 31. Despite Webster's plans for a quick profit, the stock declined to $9 per share by March 31. Webster still believes in the future of this investment and is holding all 5,000 shares. But, accounting rules require that the investment "be written down" to current value, with a corresponding charge against income. The charge against income is recorded in an account called Unrealized Loss on Investments:

Unrealized Loss on Investments Journal entry

Notice that the loss is characterized as"unrealized." This term is used to describe an event that is being recorded ("recognized") in the financial statements, even though the final cash consequence has not yet been determined. Hence, the term "unrealized."

During April, the stock of Merriam bounced up $3 per share to $12. At the end of April, another entry is needed if financial statements are again being prepared:

Unrealized Gain on Investments Journal entry

Notice that the three journal entries now have the trading securities valued at $60,000 ($50,000 - $5,000 + $15,000). This is equal to their market value ($12 X 5,000 = $60,000). The income statement for March includes a loss of $5,000, but April shows a gain of $15,000. Cumulatively, the income statements show a total gain of $10,000 ($5,000 loss + $15,000 gain). This cumulative gain corresponds to the total increase in value of the original $50,000 investment.

Trading Securities illustration

The preceding illustration assumed a single investment. However, the treatment would be the same even if the trading securities consisted of a portfolio of many investments. That is, each and every investment would be adjusted to fair value.


The fair value approach is in stark contrast to the historical cost approach. The rationale is that the market value for trading securities is readily determinable, and the periodic fluctuations have a definite economic impact that should be reported. Given the intent to dispose of the investments in the near future, the belief is that the changes in value likely have a corresponding effect on the ultimate cash flows of the company. As a result, the accounting rules recognize those changes as they happen.


As an alternative to directly adjusting the Trading Securities account, some companies may maintain a separate Valuation Adjustment account that is added to or subtracted from the Trading Securities account. The results are the same; the reason for using the alternative approach is to provide additional information that may be needed for more complex accounting and tax purposes. One such purpose is to determine the "taxable gain or loss" on sale. Tax rules generally require comparing the sales price to the original cost (tax rules sometimes differ from accounting rules, and the fair value approach used for accounting is normally not acceptable for tax purposes). There are also more involved accounting rules relating to measurement of the "realized" gains and losses when the securities are, in fact, sold. Those rules are ordinarily the subject of more advanced courses.


Since trading securities are turned over rather quickly, the amount of interest and dividends received on those investments is probably not very significant. However, any dividends or interest received on trading securities is reported as income and included in the income statement:

Dividends Journal entry

The presence or absence of dividends or interest on trading securities does not change the basic fair value approach for the Trading Securities account.


Beyond the rather straight-forward investments in trading securities are an endless array of more exotic investment options. Among these are commodity futures, interest rate swap agreements, options related agreements, and so on. These investments are generally referred to as derivatives, because their value is based upon or derived from something else (e.g., a cotton futures contract takes its value from cotton, etc.). The underlying accounting approach follows that for trading securities. That is, such instruments are initially measured at fair value, and changes in fair value are recorded in income as they happen.