Chapter 6: Cash and Cash Equivalents

The purpose of this chapter is to examine how cash and cash equivalents affect businesses, how they are controlled and accounted for, and why their proper accounting is important to corporate income and the quality of information reported in financial statements.
 

What are cash and cash equivalents?

Cash is a resource readily available for use. It includes currency (one-dollar bills, five-dollar bills, etc.), coins, and deposits in bank checking and savings accounts. Cash may be in the form of many different currencies, such as dollars, marks, and yen. Although companies use many different currencies, cash is reported in the financial statements in terms of one currency. For example, Exxon Mobil Corporation uses many forms of currency in its world-wide operations, but reports cash on its balance sheet in terms of United States dollars. DaimlerChrysler AG, on the other hand, reports cash and cash equivalents in Euros.

Cash equivalents are also resources. They are low risk investments that can be converted into known amounts of cash within 90 days or less. Common examples of cash equivalents are certificates of deposits and treasury bills. Companies invest in cash equivalents in order to earn higher interest than can be earned in bank savings or checking accounts.

In terms of the accounting equation, cash and cash equivalents are resources and are reported as assets as shown below. In following chapters, additional assets, liabilities, and stockholders' equity accounts will be added to the accounting equation.
 

Resources

=

Sources of Resources

Assets

=

Liabilities

+

Stockholders' Equity

Cash and cash equivalents

 

 

 

 


 

Sources of Cash: Companies obtain cash through borrowing, owners' investments, management operations, and by converting other resources. Each of these sources of cash is examined below.

Borrowing cash: Companies borrow cash primarily through short-term bank loans and by issuing long-term notes and bonds. For example, assume that on June 16, a company borrows $12,000 for 90 days. Show the effects of borrowing on the company's resources and sources of resources.

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

+ $12,000
cash

=

+ $12,000
notes payable

 

 

 

 

When the company receives $12,000 cash, its resources (assets) increase. Since the cash was borrowed, the company's sources of borrowed resources, liabilities, also increase by $12,000.

Remembering that assets increase with debits and that debits equal credits, prepare the journal entry to record the $12,000 borrowing.

Date

Description

Post.
Ref.

Debits

Credits

June 16

Cash

 

12,000

 

 

     Notes Payable

 

 

12,000

 

Bank loan, 90 days

 

 

 

 

Cash was debited in the above journal entry because cash increased, cash is an asset, and assets increase with debits. The credit required because debits must equal credits was to the liability account notes payable, short-term. If you remember that liabilities increase with credits, you support this credit to notes payable, short-term because this liability did increase when the cash was borrowed.
 

The cost of borrowing cash: When borrowed cash is used, there is a cost associated with it, called interest expense. For example, assume on June 16 the $12,000 was borrowed for 90 days at an annual interest rate of 10%. The total cost of borrowing the $12,000 would be calculated as follows.

Interest = principal x interest rate x time.

Interest = $12,000 x .10 x 90/365.

Interest = $295.89.

The 90/365 represents the number of days (90) in the year (365) for which the money was borrowed. If the interest is to be paid to the bank at the end of 90 days, the company would pay the bank $12,295.89 ($12,000 + $295.89).

At the end of June, however, the company would recognize that it had used the bank's money for only 15 days (June 16 through June 30). Thus, the company would recognize a $49.32 ($12,000 x .10 x 15/365) increase in its sources of resources for its liability to the bank (interest payable). The company would also recognize a decrease in its sources of resources because it used up the bank's services provided in June (interest expense). These effects could be seen as follows.

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

 

 

+ $49.32
interest payable

 

 

+

- $49.32
interests expense

 

Remembering that assets increase with debits and that debits equal credits, prepare the journal entry to record June's cost of borrowing the $12,000.

 

Date

Description

Post.
Ref.

Debits

Credits

June 30

Interest Expense

 

49.32

 

 

     Interest Payable

 

 

49.32

 

June Interest

 

 

 

 

Expenses reduce stockholders' equity. Stockholders' equity increases with credits and decreases with debits. Thus, interest expense was debited for $49.32 in order to reduce stockholders' equity. The credit required because debits must equal credits was to the liability interest payable. The interest will be paid after the $12,000 has been used for the full 90 days. If you remember that liabilities increase with credits, you support the credit to interest payable because this liability did increase when the company kept the bank's $12,000 cash and used it for 15 days in June.


** You now have the background to do text exercise 6.1.
 
 

Obtaining cash from owners: As evidence of their investments in corporations, owners most often receive shares of common stock. For example, if owners invest $50,000 in a corporation on June 10, show the effects on the company's resources and sources of resources.

 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

+ $50,000
cash

=

 

 

+ $50,000
common stock

 

 

 

When the company receives the $50,000 cash, its resources (assets) increase. Since the cash was invested by owners, the company's sources of resources from owners, stockholders' equity, also increase by $50,000.

Remembering that assets increase with debits and that debits equal credits, prepare the journal entry to record the $50,000 owners' investment.

Date

Description

Post.
Ref.

Debits

Credits

June 10

Cash

 

50,000

 

 

     Common Stock

 

 

50,000

 

Owners' investment

 

 

 

 

Cash was debited in the above journal entry because cash increased, cash is an asset, and assets increase with debits. The credit required because debits must equal credits was to the stockholders' equity account common stock. If you remember that stockholders' equity increases with credits, you support this credit to common stock.
 

Cash generated by management: Management generates cash mainly by servicing customers. For example, if managers provide services to customers on June 11, and receive $1,500 cash, show the effects on the company's resources and sources of resources.

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

+ $1,500
cash

=

 

 

 

 

+ $1,500
fees revenue

 

When the company receives the $1,500 cash, its resources (assets) increase. Since the cash asset was generated by management providing services to customers, the company's sources of resources, stockholders' equity, also increase by $1,500. Stockholders' equity increases because owners have a right to resources generated through management operations. The specific stockholders' equity account affected is fees revenue.

Remembering that assets increase with debits and that debits equal credits, prepare the journal entry to record the $1,500 cash received for services.

Date

Description

Post.
Ref.

Debits

Credits

June 11

Cash

 

1,500

 

 

     Fees Revenue

 

 

1,500

 

June fees

 

 

 

 

Cash was debited in the above journal entry because cash increased, cash is an asset, and assets increase with debits. The credit required because debits must equal credits was to the stockholders' equity account fees revenue. If you remember that stockholders' equity increases with credits, you support this credit to fees revenue.
 

Obtaining cash by converting other resources into cash: Companies often receive cash by converting other resources, usually accounts receivable, into cash. For example, if managers collect $800 on June 18, from customers for services provided to them in May, show the effects on the company's resources and sources of resources.

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

+ $800
cash

- $800
accounts receivable

 

 

 

 

 

 

 

When the company receives the $800 cash, its resources (assets) increase. Since the cash was received by converting accounts receivable into cash, the company's resources (accounts receivable) also decrease by $800. Thus, the company's total resources and sources of resources remain unchanged by the conversion of one resource into another.

Remembering that assets increase with debits and that debits equal credits, prepare the journal entry to record the $800 cash received from customers.

Date

Description

Post.
Ref.

Debits

Credits

June 18

Cash

 

800

 

 

     Accounts Receivable

 

 

800

 

Accounts receivable collection

 

 

 

 

Cash was debited in the above journal entry because cash increased, cash is an asset, and assets increase with debits. The credit required because debits must equal credits was to the asset accounts receivable. If you remember that assets decrease with credits, you support this credit to accounts receivable.


 

Practice Exercise

During March, the Christopher Corporation engaged in many transactions, three of which were the following. $15,000 cash was received for services provided to customers in March. $11,000 services were provided to customers on account. $8,000 cash was collected from customers for services provided to them in January and February.

1. Determine the total dollar amount of cash the Christopher Corporation received from customers during March.

Cash received for services provided in March

$15,000

Cash received for services provided in January and February

$8,000

Total cash received in March

$23,000

 

The $11,000 services provided to customers on account did not result in cash coming into the Christopher Corporation in March.

2. Determine the total dollar amount of the Christopher Corporation's March fees revenue.

Services provided in March for cash

$15,000

Services provided in March on account (accounts receivable)

$11,000

Total March fees revenue

$26,000

 

Revenue is recorded when services are provided to customers. Resources increase and stockholders' equity increases. The $8,000 cash collection from customers serviced prior to March did not result in an increase in resources in March. The $8,000 cash collection was simply the conversion of one resource (accounts receivable) into another resource (cash).


** You now have the background to do text exercise 6.2.

 

 

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