Cash and Cash Equivalents 39 Chapter 2 Cash and Cash Equivalents | Learning Objectives | | 1. Define cash and identify the items that are included in the “Cash and Cash Equivalents” line item. 2. Account for petty cash funds and cash shortages/overages. Definition of cash Cash includes money or its equivalent that is readily available for unrestricted use. Money is the standard medium of exchange and the basis of accounting measurements. Other negotiable instruments that can be used to settle obligations and are readily available for unrestricted use may form part of cash. Cash includes cash on hand and in banks. a. Cash on hand - refers to undeposited collections awaiting deposit and other current funds held as of the reporting date. b. Cash in bank — refers to deposits in banks that are available for immediate withdrawal and unrestricted use. Examples of cash: 1. Coins and currencies 2. Demand deposits (checking or current accounts) and savings accounts 3. Bank drafts - guarantees by bank to advance funds on the demand by the party to whom the draft was directed 4. Money orders — similar to bank drafts but are drawn from post offices or other financial institutions. 5. Checks - such as Cashier’s checks, Personal checks, Manager's checks, Traveller’s checks, and Certified checks received from customers or other external parties. 6. Cash funds set aside for use in current operations, such as: a. Petty cash fund Scanned with CamScanner40 > Examples of items not included as cash: 1 2. 3. Revolving fund Payroll fund Change fund Dividend fund Tax fund Travel fund Interest fund other types of imprest bank accounts used in current operations roeaemeaos Revolving fund is a fund similar to the petty cash fund but is | used for a limited or specific purpose set by management (eg, | revolving funds held by sales representatives and revolving funds held by field engineers in a construction firm). Tax fund is a fund set aside to be used in paying taxes. Postdated checks - checks dated at a future date. 10Us or advances to employees Cash funds not available for use in current operations, such as Sinking fund, Plant expansion fund, Depreciation fund, | Preference share redemption fund, Contingency fund, an Insurance fund. Postage stamps Postdated checks and IOU’s (‘I owe you’) or advances to employer | are treated as receivables. Depreciation fund is a form of asset replacement fund whereif | cash payments to the fund are equal to the periodi¢| depreciation charges on the related asset. When the asset i fully depreciated, the fund can be. used to acquire a| replacement. - Restricted funds that are excluded from cash are common!) 4 presented as part of “other assets.” | Unused postage stamps are treated as prepaid supplies. Scanned with CamScannerCash and Cash Equivalents a postdated checks received postdated checks received by an entity do not qualify as cash because postdated checks are not presently available for immediate use. They will only be available for use at a future date. Entities normally record check collections on account by debiting “Cash” and crediting “Accounts receivable,” regardless of whether the checks received are postdated or not. Thus, at the reporting date, an adjustment is necessary to revert back postdated checks to accounts receivable. Example: You received customers’ checks totaling P100,000. The entry to record the receipt of the checks is as follows: Date | Cash 100,000 Accounts receivable 100,000 At the end of reporting period, you determined that a customer’s check of P20,000, included in the collections, is postdated. The adjusting entry is as follows: Date | Accounts receivable 20,000 Cash 20,000 You will report cash of P80,000 (100,000 less postdated check of 20,000) in your financial statements. You might ask “why would I record the postdated check as collection when it is not yet available for use?” Well, it is for internal control purposes and convenience of recording. If not Tecorded, the check might not be presented on time for encashment on due date. You might even forget about the check, misplace it, or someone might take it, and so on. Furthermore, maintaining separate records for postdated checks may be cumbersome. Scanned with CamScannera2 Chapter 2 In practice, all check collections are recorded as cash receipts and adjustments for postdated checks are made only when financial statements are prepared. No separate accounting jg needed for checks that were initially received as postdated but became due and encashed prior to the preparation of financial statements. Unused credit line Unused credit line is not included as cash but rather disclosed only in the notes. Unused credit line is the difference between the amount of line of credit and the amount that was actually borrowed. For example, you applied for a line of credit of P100M ina bank. During the year, you borrowed P70M. The bank automatically credits your account for the P70M borrowed. This is included in your cash. The unused credit line of P30M (P100M less P70M) is disclosed only in the notes because you have not yet received it in cash. Unreleased checks drawn and Postdated checks drawn Entities normally record checks drawn by debiting “Accounts payable” and crediting “Cash.” However, when the checks drawn are either (a) unreleased or undelivered to the payee or (b) postdated, no payment has actually been made. Therefore, an adjusting entry is needed to revert back the unreleased check or postdated check to cash and accounts payable. Example: You wrote the following checks today. © Check #1 is drawn for P10,000 and dated today but yet ! & delivered to payee Mr. A next year. * Check # 2 is drawn for P15,000 and was delivered to payee Mr B today but the check is dated 100 years from now. The entry for the checks drawn is as follows: Scanned with CamScannerCash and Cash Equivalents 43 Date | Accounts payable -MrA Accounts payable = Mr. B 15,000 If financial statements are prepared today, both the checks drawn should be reverted back to cash and accounts payable because: a) There is no way Mr. A can eneash check #1 because you still hold it. b) Mr. B holds check #2 but he cannot yet encash it until after 100 years (if he’s still alive¥). In both cases, you have reduced the balance of cash but no payments have actually been made. Therefore, the following adjusting entry is necessary: Date | Cash 25,000 Accounts payable — Mr. A 10,000 Accounts payable - Mr, B 15,000 You might ask again “why would I record the unreleased check and postdated check as payments when the, payee cannot yet encash them?” Well, again, it is for internal control purposes. (This will be explained on the discussion of “voucher system.”) Or you might ask “why would I draw a check and not deliver it to the payee? or “why would I draw a postdated check in the first place?” Well, in practice, checks drawn by companies should be signed by at least two authorized signatories. Either one of those signatories might not be around when the checks are needed, so some checks are drawn in advance. Stale checks : When checks delivered to payees are not encashed within a relatively long period of time, normally 6 months or more, the checks are referred to as “stale.” It should be noted though that Scanned with CamScannerthe period of time before checks become company policy. Stale checks are reverted back to cash. ale is a matter of ber the following concepts: ts equivalent that is rea sh includes money or available icted u: for unre > Postdated check received w Exelude from cash, from customer. » Undelivered heck drawn. @ Include in cash. > Postdated check drawn. Include in cash. > Stale checks Include in cash. Cash equivalents Cash equivalents are “short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.” (PAS 7.6) Only debt instruments acquired within 3 months or less before their maturity date can qualify as cash equivalents. Examples of cash equivalents: a. Treasury bills, notes, or bonds acquired 3 months before maturity date > Treasury bill is a short-term obligation issued by the government at a discount. Treasury bills normally have a maturity of 90 days to less than a year. > Treasury notes and treasury bonds are long-term obligations issued also by the government. Treasury notes have 4 maturity of 1 year to less than 10 years. Treasury bonds have a maturity of 10 years or more. b. Money market instrument or commercial paper acquired 3 months before maturity date > Money market instruments are investments in portfolios of short-term securities. » Commercial papers consist of short-term, unsecured, notes payable issued in large denominations by large companies with high credit ratings to other companies aM institutional investors. The maturity date of commer¢ Scanned with CamScanner1d Cash Equivalents 45 Cash and paper is normally less than 270 days and is traded in money markets and, thus, is highly liquid. A commercial paper acquired 3 months or less before its maturity date may qualify as cash equivalent. c. 3:month time deposit > Time deposit is a form of a bank deposit normally made in fixed denomination, bears interest higher than that of regular deposits, and has a pre-agreed maturity. A time deposit is evidenced by a certificate of deposit. Illustration: Cash equivalents ABC Co. holds the following short-term investments as of December 31, 20x1: 1) 1-year Treasury bill maturing on March 30, 20x2 acquired on July 1, 20x1. 2) 1-year Treasury bill maturing on March 30, 20x2 acquired on December 31, 20x1. Requirement: Which of the investments’ may qualify as cash equivalent? ; Answer: > Only the second T-bill qualifies as cash equivalent because it is acquired 3 months or less before maturity date, i.e., acquired on December 31, 20x1 and matures on March 30, 20x1. The first T-bill does not qualify as cash equivalent because it is acquired more than 3 months before maturity date, ie. acquired on July 1, 20x1 and matures on March 30, 20x2 - acquired 9 months before maturity. Note that what is important is the date of acquisition which should be 3 months or less before maturity date. Scanned with CamScannerChapter 2 Checks and equity securities / Checks and bank drafts cannot qualify as cash equivalents because these are not short-term investments. When checks and bank drafts are available for unrestricted and immediate use, they ate included as cash but not as cash equivalents. Equity securities (investments in stocks) cannot quality ag cash equivalents because shares of stocks do not have a maturity date. However, redeemable preference shares (preference shares with mandatory redemption) that are acquired 3 months or less before their specified redemption date may qualify as cash equivalents. This is because redeemable preference shares are debt instruments rather than equity instruments. Financial statement presentation Cash and cash equivalents are normally presented as current assets unless they are restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period. Unrestricted cash and unrestricted cash equivalents are combined and presented on the statement of financial position ina single line item described as “Cash and cash equivalents.” The breakdown of the line item is disclosed in the notes. Restricted cash is excluded from cash and presented under other line item as either current or non-current asset depending on the nature of the restriction. For example, restricted cash with restriction of more than 12 months may be presented under “other noncurrent assets.” Measurement of cash ; Cash is measured at face amount (face value). Cash denominated it foreign currency is translated at the current exchange rate at fhe reporting date. 3 Cash maintained in a bank undergoing bankruptcy 5 excluded from cash and presented as receivable measured @ realizable value. Realizable value is the amount expected t? recovered from the deposit and is determined usually by referem Scanned with CamScannerCsi and Cash Equivalents to the insured amount of the deposit. If the realization is deferred, the amount is discounted to its present value, Deposit in foreign banks Unrestricted deposits in foreign banks that are available. for immediate withdrawal are included as cash at face amount translated at the current exchange rate as of the reporting date. Restricted deposits in foreign banks that are not available for immediate withdrawal are excluded from cash and presented as receivable subject to appropriate allowances for uncollectability and impairment, The classification of the restricted deposit as current or noncurrent depends on the nature of the restriction. The nature of the restriction is disclosed in the notes. Compensating balance Compensating balance is a minimum amount that must be maintained in an entity‘s bank account as support for funds borrowed from the bank. The compensating balance can be used by the bank as cushion for the days when cash demands are greatest and deposits fail to materialize. Compensating balances that are legally restricted as to withdrawal by the borrower are excluded from cash and shown as part of other current assets or other noncurrent assets depending on the nature of the restriction. Compensating balances that are not legally restricted as to withdrawal are included in cash. Whether restricted or not, compensating balances are disclosed in the notes. Compensating balances increase both the yield rate for the lender and the effective interest rate for the borrower. £© Remember the following concepts: Cash equivalents ~ debt instruments acquited 3 months or less before wiaturity date, The line item “Cash and cash equivalents” includes only unrestricted cash and cash equivalents. Restricted cash is presented under other line item, “6. receivable or other assets, depending on the nature of the restricted Scanned with CamScannerChapter 2 Illustration: Cash balance The books of ABC Co. show the following balances at Decembe; 31, 20x1: Cash on hand P 100,000 Cash in Bank - current account 350,000 Cash in Bank — peso savings deposit 2,000,000 Cash in Bank — dollar deposit (unrestricted) $ 100,000 Cash in Bank - dollar deposit (restricted) 20,000 Cash in money-market account P 250,000 6-month Time Deposit $ 60,000 Treasury Bill, purchased 12/1/20x1, maturing 2/28/20x2 P 800,000 Treasury Bond, purchased 3/1/20x1, maturing 2/28/20x2 500,000 Treasury Note 200,000 Unused Credit Line 2,000,000 Redeemable preference shares, purchased 12/1/20x1, 370,000 due on 3/1/20x2 Treasury shares, purchased 12/15/20x1, to be reissued on 3/5/20x2 50,000 Sinking fund 200,000 Additional information: * Cash on hand includes a P20,000 check payable to ABC Co. dated January 10, 20x2. * During December 20x1, checks amounting to 60,000 and 40,000 were drawn against the Cash in bank - current account in payment of accounts payable. The P60,000 check is dated January 15, 20x2. The P40,000 check is dated December 31, 20x! but was delivered to the payee only on January 18, 20x2. The Cash in Bank — peso savings deposit includes a deposit * escrow in the amount of P340,000 and a compensating balan amounting to P250,000 which is legally restricted. The Cash in Bank — dollar deposit (unrestricted) account includ® interest of $2,000, net of tax, directly credited to ABC 0" account. The exchange rate at year-end is $1 is to P40. Scanned with CamScanner49 Requirement: Compute for the amount of cash and cash equivalents to be reported in the 20x1 financial statements. Solution: Cash on hand (100K - 20K postdated customer check) 80,000 Cash in Bank — current account (350K + 60K postdated company check + 40K undelivered company check) Cash in Bank — peso savings (2M - 340K deposit in escrow* - 250K restricted compensating balance) Cash in Bank — dollar deposit ($100K x P40) Cash in money-market account Treasury bill, purchased 12/1/20x1, maturing 2/28/20x2 Redeemable preference shares, purchased 12/1/20x1, due on 3/1/20x2 Cash and cash equivalents - adjusted balance % Notes: © The postdated check received is excluded while the postdated check drawn and the undelivered check drawn are included. © *Deposit in escrow is a restricted amount held in trust for another party, e.g., a deposit required by a court of law for a pending labor case. This is excluded from cash because it is Testricted. * The restricted compensating balance is excluded from cash. * The Cash in Bank — dollar deposit (restricted) and Sinking fund are excluded from cash because they are restricted. © The 6-month Time Deposit, Treasury bond, purchased 3/1/20x1, maturing 2/28/20x2, and Treasury Note are excluded because they do not meet the “acquired 3 months or less before maturity” criterion, The Unused Credit Line is disclosed only in the notes. The Treasury shares are excluded because these are not assets but rather contra-equity, i.e, deduction in shareholders’ equity, Scanned with CamScannera ; Chapter, aE EUR Bank overdraft Bank overdraft (cash overdraft) is a negative (credit) balance in the cash in bank account resulting from overpayment of checks in excess of the amount of deposit. Overdrafts occur only in checking accounts; not in savings and time deposits. Overdrafts are payable on demand; thus, they arg presented as current liabilities, except in cases where offsetting is permitted. Some banks offer overdraft privileges on their checking accounts. This means that if a depositor writes a check in excess of the checking account balance, the bank will advance the required funds to “cover” the check, rather than have the check “bounce,” Such advances are considered as current liabilities. When two or more bank accounts are maintained in the same bank and one account results to an overdraft, the overdraft may be offset or deducted from the other bank account with a positive balance - provided the other bank account is also unrestricted. Offsetting is not permitted if the other bank account with a positive balance is restricted. Bank overdrafts that are repayable on demand and form an integral part of the entity’s cash management, are included as component of cash and cash equivalents as deduction or offset. (PAS 7) An example is the zero-balancing checking account, which is a disbursement account offered by some banks. The account is maintained at zero balance until a check comes in. The resulting overdraft is covered by a transfer from a master (parent) account earning interest. Any resulting overdraft at reporting date due ' outstanding checks may be offset to cash. The example above is a form of cash managemett Checking accounts do not normally pay interest (or pay interes but at very low interest rates) so entities would rather maintait cash in savings accounts. ‘ It should be noted that offsetting of assets and liabilities e appropriate only when permitted by a PFRS. Financial assets financial liabilities may be offset if the entity has both: Scanned with CamScannerad Cash Equivalents 51 Ci — a legal right of setoff; and b. an intention to settle the amounts on a net basis or simultaneously Illustration: Bank overdraft The cash balance of ABC Co. comprises the following: Cash on hand 100,000 Cash in bank - savings — BPI 200,000 Cash in bank - current - BPI (80,000) Cash in bank - deposit in escrow - Metrobank 100,000 Cash in bank - current — Metrobank (20,000) Cash in bank - current - BDO (30,000) Total 270,000 Additional information: * Cash on hand includes undeposited collections of P20,000. * The cash in bank — savings maintained at BPI includes a 50,000 compensating balance which is not restricted. Requirement: Compute for the amount of cash to be reported in the financial statements. Solution: Cash on hand - 100,000 Cash in bank - savings — BPI 200,000 Cash in bank - current — BPI (80,000) Adjusted balance of cash 220,000 ¥ Notes: * Undeposited collections ‘are properly included in ‘cash on hand. i © The BPI savings account properly includes the compensating balance because the compensating balance is not restricted. The overdraft in the BPI current account can be properly offset with the BPI savings account. Scanned with CamScannerChapter 2 | a n “ The overdraft in the Metrobank current account cannot be offset with the Metrobank savings account because the savings account is restricted. The overdraft is presented as current liability while the restricted account may be presented jn “other assets.” « The overdraft in the BDO account is presented as current liability. Internal controls over cash Internal control is any action or process effected by management that is designed to help an entity achieve its: objectives. Such objectives may be categorized as follows: a. Reliability of financial reporting, b. Effectiveness and efficiency of operations, c. Compliance with laws and regulations, and d. Safeguarding of assets. Inherent risk is normally higher for cash compared to other assets because cash is exposed more to risk of theft and other types of fraud. Adequate and effective internal controls should be in place to ensure that cash is reasonably safeguarded. Examples of internal controls over cash 1. Segregation of incompatible duties - The duties of (a) authorization, (b) execution, (c) recording, and (d) custody over cash should be segregated. For example, in a typical organization, purchases are authorized by the manager (authorization), purchases at made by the purchasing department (execution), check payments are released to payees by the treasurer (custody), and purchase transactions are recorded by the accountant (recording). The custody over cash should be given only to the treasurer. Neither the purchasing department, manager, 9 the accountant should have access to cash. If the incompatib? Scanned with CamScannerCash and Cash Equivalents ea jxand Cosh Equivalents eee duties are not segregated, the risk of embezzlement is greatly increased. Imprest system — The imprest system requires that all cash receipts should be deposited intact and all cash disbursements should be made through checks. > Collections should be deposited intact within a reasonable period of time from the date of collection and should not be used for any type of disbursement. > Disbursements should be made through checks and not from cash collections. Disbursements for small amounts are made through the petty cash fund. Bank reconciliation - Bank reconciliation should be prepared regularly, immediately upon the receipt of the monthly bank statement, to reconcile on a timely basis the differences between the cash balance per books and the cash balance per bank statement. The differences should be duly investigated and accounted for. . Cash counts — Periodic cash counts should be performed to provide reasonable assurance that actual cash tallies with the balance per records. Reconciliation of any difference should be made immediately after the count. Surprise counts should also be performed at irregular intervals as part of internal audit. . ‘Minimum cash balance - Minimum cash balance should be maintained, especially for cash funds, sufficient only to defray specific business requirements. For example, entities often use imprest bank accounts which are amounts specifically set aside for a limited purpose, such as for the payment of Payroll, interest, or taxes. Maintaining excessive cash balances may increase the risk of embezzlement. » Lockbox accounts — Entities often utilize lockbox accounts to €xpedite cash collections and to ensure that cash collections Scanned with CamScanner54 ___ Chapter are deposited intact. A lockbox is rented for a fee and customers are advised to remit their payments directly to the lockbox account. The bank empties the box at least once a da and immediately credits the entity’s account for collections, 7. Non-encashment of personal checks from petty cash fund ~ encashment of personal checks from the petty cash fund should be prohibited to discourage concealment of cash shortages. 8, Voucher system - The voucher system is an internal control over all cash disbursements. Under this system, a voucher is prepared for every cash disbursement in order to ensure that each disbursement is properly authorized, made for a valid expenditure, and properly recorded. Voucher system Voucher (check disbursement voucher or CDV) is a business document or written authorization that supports every disbursement made by anentity. : Supporting documents (e.g., purchase order, purchase invoice, delivery receipt) are attached to the vouchér to form the “voucher package.” Unpaid vouchers are filed in the order of theif required payment dates so that available cash discounts are not missed. The supporting documents are reviewed and compared to determine their validity before each check disbursement is drawn The individual preparing the check (ie. treasurer) stamps the supporting documents as “paid” to ensure that they are not presented for payment more than once. The check number and journal entry are indicated in the voucher. One check is drawn for each voucher to ensure proper audit trail. Also, vouchers are pre-numbered to help ensure theif completeness. Cancelled vouchers or cancelled checks are 1% destroyed or removed from the file. Scanned with CamScanner