Difficulty: Introductory to Intermediate | Prerequisites: Introductory Financial Accounting (ACCTG 211 or equivalent). Familiarity with debits, credits, and the basic accounting equation.
Cash and receivables are the most liquid assets on the balance sheet and typically the first items a reader's eye lands on. Chapter 7 covers what counts as "cash" under GAAP, how companies safeguard it through internal controls, and the situations where cash is restricted or tied up in compensating-balance arrangements. If you are comfortable with the accounting equation and basic journal entries, you have everything you need to start here. This material feeds directly into later chapters on revenue recognition and financial-statement analysis, so getting it right now pays off throughout the course.
"Cash" on the balance sheet includes currency, checking-account balances, and items awaiting deposit, plus short-term liquid investments (cash equivalents) such as Treasury bills and money-market funds. Companies protect cash through segregation of duties over receipts and disbursements. Cash can be restricted (set aside for a specific purpose) or tied up in compensating balances that effectively raise the cost of borrowing.
Cash
Currency, coins, balances in checking accounts, and items for deposit (cheques, money orders). In simple terms, anything a company can spend or deposit immediately.
Cash equivalents
Short-term, highly liquid investments that can be readily converted to a known amount of cash, typically with original maturities of three months or less. Examples: money-market funds, Treasury bills, commercial paper. Think of these as "almost cash" investments that are so safe and liquid they are lumped together with cash on the balance sheet.
Restricted cash
Cash that is set aside for a specific, designated purpose and is not available for general use. Often contractually imposed, e.g. a debt covenant requiring the borrower to maintain a sinking fund. In simple terms, the money is in your account but you cannot touch it freely.
Compensating balance
A minimum balance a borrower must maintain at the lending bank as a condition of a loan or line of credit. The balance sits in a low-interest or non-interest-bearing account and effectively raises the borrower's cost of borrowing above the stated interest rate.
Segregation of duties (internal controls)
The principle of dividing responsibilities for receiving, recording, and reconciling cash among different employees to reduce the risk of errors and fraud. Think of it as "no single person handles cash from start to finish."
Petty cash
A small fund of cash kept on hand for minor, day-to-day expenses that are too small to warrant writing a cheque. The only type of disbursement not required to go through the cheque-writing process.
Currency and coins on hand
Balances in checking accounts
Items awaiting deposit: customer cheques, money orders
Cash equivalents (reported together with cash on the balance sheet):
Money-market funds
Treasury bills
Commercial paper
Must have an original maturity of three months or less
The goal is to make sure all cash received ends up recorded and deposited.
Separate the responsibilities for receiving cash, recording cash transactions, and reconciling cash balances across different employees
Match the amount of cash received with the amount of cash deposited
Closely supervise all cash-handling and cash-recording activities
The goal is to make sure cash goes out only for authorised purposes.
All disbursements, except petty cash, should be made by cheque
Separate responsibilities for preparing disbursement documents, authorising cheques, signing cheques, and maintaining records
Only authorised individuals should sign cheques
Cash becomes restricted when it is earmarked for a specific purpose and cannot be used for day-to-day operations.
May be voluntarily set aside (e.g. a plant-expansion fund)
Often contractually imposed by a debt covenant requiring the borrower to maintain a sinking fund or escrow balance
Classified as a current or non-current asset depending on the nature of the restriction and when the cash will be used
A compensating balance is the price a borrower pays for access to credit, beyond the stated interest rate.
The bank requires the borrower to keep a specified minimum balance in a low-interest or non-interest-bearing account
The required balance is typically a percentage of the committed loan amount
Because the borrower cannot use the compensating balance freely, the effective interest rate on the loan is higher than the stated rate
Must be disclosed in the financial statements if the arrangement is significant
Students often think any investment can be a cash equivalent. It cannot. Only investments with original maturities of three months or less qualify. A six-month Treasury bill purchased with three months remaining is still not a cash equivalent because the original maturity exceeded three months.
Students sometimes assume restricted cash is reported the same way as unrestricted cash. It is not. Restricted cash must be separated and classified according to the nature and timing of the restriction (current vs. non-current).
A compensating balance does not reduce the loan amount. The borrower still owes the full principal. The compensating balance simply raises the effective cost of the loan because a portion of the borrowed funds cannot be used.
Segregation of duties is not optional best practice. It is a fundamental internal control requirement. Exams frequently test whether students can identify which duties should be separated.
Expect questions asking you to classify items as cash, cash equivalents, restricted cash, or none of the above.
Be prepared to calculate the effective interest rate on a loan that requires a compensating balance.
Internal-control scenarios are a frequent source of multiple-choice and short-answer questions: you may be given a description of a company's cash-handling process and asked to identify the control weakness.
The distinction between current and non-current classification of restricted cash is testable and often overlooked.
True or False: A six-month Treasury bill is always classified as a cash equivalent. (False, the original maturity exceeds three months.)
Fill in the blank: The principle of ______ requires that no single employee handles cash from receipt through to reconciliation. (Segregation of duties)
True or False: Restricted cash is always classified as a non-current asset. (False, classification depends on when the restriction will be lifted.)
Fill in the blank: A compensating balance causes the borrower's ______ interest rate to exceed the stated rate. (Effective)
True or False: Petty cash disbursements must be made by cheque. (False, petty cash is the one exception to the cheque requirement.)
Q: A company borrows $200,000 from its bank and is required to maintain a compensating balance of 10% in a non-interest-bearing account. The stated interest rate is 8%. What is the effective interest rate on the usable funds?
A: The company can use only $180,000 ($200,000 less $20,000 compensating balance). Annual interest is $16,000 ($200,000 x 8%). Effective rate = $16,000 / $180,000 = 8.89%.
Q: Which of the following would be classified as a cash equivalent: (a) a 90-day Treasury bill, (b) a 6-month certificate of deposit, (c) equity securities held for trading?
A: Only (a). The 90-day Treasury bill has an original maturity of three months or less. The CD's original maturity exceeds three months, and equity securities are not debt instruments with a known maturity.
Q: Identify the internal-control weakness: the same employee opens the mail, records customer payments, and prepares the bank reconciliation.
A: There is no segregation of duties. The employee who receives cash should not also record it or reconcile the bank statement. Combining these functions allows errors or fraud to go undetected.
Q: A debt covenant requires a company to maintain $50,000 in a separate bank account until the loan matures in three years. How should this cash be reported?
A: As restricted cash, classified as a non-current asset (since the restriction extends beyond one year).
Cash controls tie directly to the bank reconciliation process covered in introductory accounting. Restricted cash and compensating balances reappear when you study long-term debt covenants (Ch. 14) and the statement of cash flows (Ch. 21), where correct classification of restricted cash affects operating, investing, and financing categories.
cash and cash equivalents, cash controls, segregation of duties, internal controls over cash, restricted cash, compensating balance, effective interest rate, petty cash, money market funds, Treasury bills, commercial paper, ACCTG 471, intermediate financial accounting, Chapter 7, Penn State, balance sheet classification, current vs non-current assets