Question

Which of the following statements correctly describes the reporting of cash? a. Cash cannot be combined with cash equivalents. b. Restricted cash funds may be combined with Cash. c. Cash is listed first in the current assets section. d. Restricted cash funds cannot be reported as a current asset.

Short answer

Statement (c) correctly describes the reporting of cash.

Step-by-step solution

Understanding Cash Reporting in Financial Statements

Before evaluating the given statements, we need to understand how cash is reported on the balance sheet. Cash is typically listed in the current assets section as it is a highly liquid asset. Cash equivalents, such as Treasury bills, can often be reported together with cash if they meet certain criteria (like being short-term and highly liquid). Restricted cash, however, is cash that is not available for immediate use due to certain limitations and usually reported separately, sometimes as a current or a non-current asset.

Analyzing Statement (a)

Statement (a) is as follows: "Cash cannot be combined with cash equivalents." Since cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash, accounting practices typically allow cash and cash equivalents to be reported together. Hence, statement (a) is incorrect.

Analyzing Statement (b)

Statement (b) is: "Restricted cash funds may be combined with Cash." Since restricted cash is subject to specific restrictions and not available for general use, it is typically reported separately when preparing financial statements. Thus, statement (b) is incorrect.

Analyzing Statement (c)

Statement (c) is: "Cash is listed first in the current assets section." Cash is typically the most liquid asset and is therefore listed first in the current assets section of the balance sheet. Statement (c) correctly describes how cash is typically presented in financial statements.

Analyzing Statement (d)

Statement (d) is: "Restricted cash funds cannot be reported as a current asset." Restricted cash can be reported as either a current or non-current asset, depending on the intended use timeline. Therefore, statement (d) is incorrect.

Key concepts

Balance Sheet

The balance sheet is one of the fundamental financial statements used by businesses to report their financial position at a specific point in time. It provides a snapshot of what a company owns and owes, as well as the shareholders' equity. On the balance sheet, assets, liabilities, and shareholders' equity are listed.

• Assets are resources owned by the company. They can be current or long-term.
• Liabilities are obligations the company must pay in the future.
• Shareholders' Equity represents the owners' residual interest after liabilities are subtracted from assets.

The balance sheet must always balance according to the equation: \[\text{Assets} = \text{Liabilities} + \text{Shareholders' Equity}\]Cash, being a highly liquid asset, is a crucial component of the balance sheet. It is usually listed under current assets due to its ease of conversion and essential role in operating activities.

Current Assets

Current assets are all of a company's assets that are expected to be converted into cash, sold, or consumed within a year or within the business's normal operating cycle if it's longer than a year. They provide insight into a company's liquidity and its ability to cover short-term liabilities. Components of current assets typically include:

• Cash and Cash Equivalents: Readily available funds and short-term investments.
• Accounts Receivable: Money owed by customers for sales on credit.
• Inventory: Raw materials, work-in-progress, and finished goods ready for sale.
• Prepaid Expenses: Payments made in advance for services or goods.

On the balance sheet, cash is often listed first due to its liquidity. This position highlights its importance in fulfilling immediate financial obligations.

Cash Equivalents

Cash equivalents are short-term investments that are easily convertible to cash and carry minimal risk of value change. These are crucial for maintaining liquidity, allowing businesses to meet immediate obligations without liquidating other assets. Common types of cash equivalents include:

• Treasury Bills (T-Bills): Short-term government securities with maturities of one year or less.
• Money Market Funds: Pooled funds that invest in short-term debt securities.
• Commercial Paper: Unsecured, short-term promissory notes issued by companies.

For an investment to qualify as a cash equivalent, it must be highly liquid, readily convertible into a known cash amount, and subject to an insignificant risk of changes in value. These are often reported along with cash on the balance sheet under current assets, providing a comprehensive view of a company's liquid resources.

Restricted Cash

Restricted cash refers to funds not available for general use due to imposed constraints, typically by contracts or legal requirements. These restrictions often arise from specific obligations or covenants, like debt arrangements or regulatory requirements. Companies must clearly disclose restricted cash in their financial statements and explain the nature and reasons for the restrictions. It may be classified as either a current or non-current asset based on the period of restriction.

• Current Restricted Cash: If the cash will be unrestricted or used within one year.
• Non-current Restricted Cash: If the restriction lasts beyond one year.

Accurate classification ensures stakeholders understand the limitations on the company's liquidity, influencing financial planning and decision-making. By separating restricted cash from unrestricted funds, businesses enhance transparency and maintain clarity in financial reporting.