Week 9 · Chapter

Chapter 9 — Cash and the Bank Reconciliation

Financial Accounting Free sample edition

The module's primary reading · ~35–45 minutes · Objective 6 (describe internal control and its components, and account for cash, including the bank reconciliation, and for receivables, including the allowance method and notes receivable), with Objective 2 (analyze business transactions with the accounting equation and record them in a journal using double-entry bookkeeping, post them to the ledger, and prepare a trial balance) called back · Read it first this week; the lecture, the slides, the tutorial, the quiz, and the workshop all build on it.

In plain language

Cash is the asset every sale and every bill passes through, so a business needs everyday habits that keep it safe. Those habits are control activities (the actions a business builds into its daily work to protect its assets and its records). Each month the business also compares its own cash record with the bank's record in a bank reconciliation (a schedule that explains every difference between the two). This week you learn both, and you use them to find the bicycle shop's true cash at the end of Month 3. You also learn which differences need a journal entry and which do not.

Why you already care about this

Picture the bicycle shop at the end of Month 3. Its bank statement says the account holds $8,450. Its own Cash account says $8,851. That is a gap of $401, and both numbers cannot be the shop's cash. A founder wants to know which one to trust before paying the month's bills.

You have probably met a smaller version of this. Your banking app shows one balance, but you know you wrote a check to your landlord that has not been cashed yet. A friend paid you back by transfer, and it has not landed. Your own running total and the bank's total are both honest, and they still disagree, because each side records the same cash at a different moment.

By the end of this chapter you will be able to:

name six of the Green Book's common categories of control activities and match each to a cash example;
explain segregation of duties and the limit collusion puts on it;
describe the controls over cash receipts, cash payments, and a petty cash fund;
prepare a bank reconciliation in which both sides reach the same adjusted balance;
spot a transposition error by a difference evenly divisible by 9;
journalize only the reconciling items that need an entry, and report the true cash on the balance sheet.

Carry this sentence with you: the bank side waits; the book side gets the entries.

Where we are

Already covered: Week 3 taught you to journalize and post with debits and credits. Week 4 adjusted the books at the month's end. Week 5 prepared the balance sheet. Week 8 introduced internal control and its five components.
This week: the control activities applied to cash, the petty cash fund, the bank statement, the bank reconciliation, the entries it requires, the transposition error, and cash and cash equivalents on the balance sheet.
How they connect: the reconciliation is one of Week 8's control activities at work, and its entries use Week 3's journal and Week 5's balance sheet.
Where we're going next: Week 10, Receivables, starts a new stretch on the money customers owe, beginning with the allowance method.

Week 8 gave you the frame. Internal control is the set of policies and procedures a business uses to protect its assets, keep its records reliable, run efficiently, and follow the law. Its five components are the control environment, risk assessment, control activities, information and communication, and monitoring. This week you zoom in on the third component and point it at the shop's cash. You also lean on Week 4's rule that an accrual or deferral adjusting entry never touches Cash. This week's entries do touch Cash, and you will see why that is no contradiction.

1. Use six categories of control activities on cash

Think about a coffee shop you know. The person at the register has a drawer only they use. The safe in the back is locked. The manager counts the drawer at closing. None of that feels like accounting, but every one of those habits protects cash and the records of cash.

Those habits have a name.

Control activities are the actions a business builds into its policies and daily procedures to meet its control goals, such as limiting access to cash, splitting duties, and reconciling records.

The U.S. Government Accountability Office (GAO) publishes a guide to internal control called the Green Book (GAO-25-107721). Paragraph 10.04 and its Table 1 list common categories of control activities, and the Green Book says the list is not all inclusive. This course teaches six of them. Each one comes with a bicycle-shop example from Dataset E, the internal control set.

Worked example — Dataset E applied to the shop's cash. Read each row as "this kind of control, done this way at the shop."

Six of the Green Book's common categories of control activities, each with an illustrative bicycle-shop example (Dataset E)
Common category of control activities (Green Book)	Bicycle-shop example (illustrative)
Access restrictions to and accountability for resources and records	Each clerk uses a separate cash drawer and register login
Segregation of duties	The person who opens the mail and lists checks received is not the person who records receivables
Control activities over information processing	Prenumbered repair tickets, with every number accounted for
Physical control activities over vulnerable assets	A locked stockroom for bicycles and a safe for cash
Control activities over complete, accurate, and timely recording of valid transactions	A monthly bank reconciliation prepared by someone who does not handle cash
Management of human capital	Background checks before hiring, and training and supervision for employees who handle cash

Walk two rows to see how they protect cash. A separate drawer and login mean that if a drawer comes up short, the shop knows whose shift it was. Prenumbered repair tickets mean that if one ticket number is missing from the stack, someone asks where its cash went. In words: each control makes a missing dollar visible to someone, fast.

Notice where the bank reconciliation sits. It is a control activity in its own right, the one over complete, accurate, and timely recording. Most of this chapter teaches you to prepare it.

Misconception check. Students often think the Green Book's list is a complete checklist, so a business that does these six things is "done." The Green Book itself says its list is not all inclusive. These six are the ones this course teaches, because they map cleanly onto cash. A real business picks controls that fit its own risks.

2. Split the duties, and know the limits

Imagine a student club where one treasurer collects the dues, deposits them, writes the checks, and keeps the only record. If a dues payment goes missing, who would ever notice? Nobody, because the one person who could notice is the person who lost it.

That is the problem the second category solves.

Segregation of duties divides the work on an asset among different people. It keeps any one person from both handling an asset and keeping its records.

At the bicycle shop, the person who opens the mail and lists the checks received is not the person who records receivables. The list from the mail and the entries in Accounts Receivable are made by two people. If they disagree, one of them spots it.

Worked example — the mail-room list. A customer mails a check to pay what it owes the shop.

Person one opens the mail, lists the check on the day's receipts list, and sends the check to be deposited.
Person two records the payment in Accounts Receivable from the remittance slip.
At the month's end, the person who reconciles the bank account compares the receipts list with the deposits on the bank statement.

In words: the check passes through three pairs of hands, and no one of them could hide it without the other two seeing a gap.

Here is the honest limitation. Internal control gives reasonable, not absolute, assurance: people make mistakes, and two employees can collude to defeat segregation of duties. If person one and person two agree to hide a check together, splitting the work no longer catches it. Controls lower the risk; they never remove it.

Misconception check. Students often read segregation of duties as a sign that the owners distrust their employees. It is tempting, because the control does assume something could go wrong. The cure is to see who it protects. When a drawer comes up short, a clerk with a separate login and a second person checking the count can show the shortage was not theirs. Splitting duties protects the employees as well as the cash.

Pause and think. Choose one: (a) Think of a group you belong to, such as a team, club, or household, that handles shared money. Which two jobs would you split, and why? (b) Think of a job you have held or would like to hold. Which control from the table would have protected you if cash went missing on your shift?

3. Guard cash coming in and going out

Cash moves in two directions, and each direction gets its own controls. Controls over cash include prompt deposits, payment by check or electronic transfer with approval, a petty cash fund with receipts, and a monthly bank reconciliation prepared by someone who does not handle cash.

Start with cash coming in. A farmers' market stall takes cash all morning into a cash box. At closing, two people count the box together and both sign the count slip. The next morning one of them deposits the cash at the bank. Later, someone who did not count the box compares the slip with the bank's deposit. Cash spent the night in a locked place, it was counted by two people, and it reached the bank fast.

Now a business that rarely touches paper money. A dog-grooming service takes most payments by card. Its card sales reach its bank account as deposits. The owner, who does not take payments at the front desk, compares the deposits with the day's sales records. If the front desk recorded a sale that never reached the bank, the gap shows up.

Then cash going out. The bicycle shop pays its bills by check or electronic transfer, never from the cash drawer, and a founder approves each payment. A payment that needs approval leaves a record, and a record can be checked.

Worked example — following one dollar in and one dollar out. Take a cash sale and a bill.

In: a walk-in customer pays cash for a repair. The clerk rings it up on a prenumbered ticket in their own drawer. The cash is deposited promptly, and the deposit later appears on the bank statement.
Out: a supplier's invoice arrives. A founder approves it, and the shop pays by check. The check appears on the bank statement when the bank pays it.

In words: every dollar in and every dollar out leaves a trail that someone other than the person who handled it can follow to the bank statement.

Misconception check. Students often think controls matter only for paper cash, so a card-only business needs none. The dog-grooming service shows why that is wrong. Card deposits can still be missed, recorded twice, or recorded at the wrong amount. The control is the comparison by a second person, and it works the same way for cards as for bills and coins.

4. Run a petty cash fund

Every business has tiny payments: postage for one package, a tip for a delivery, a few dollars of cleaning supplies. Writing a check for each one would be slow. So a business keeps a small box of cash for them.

That box has a name.

A petty cash fund is a small, fixed amount of cash held by one custodian for payments too small for a check. Every payment out of it is backed by a receipt.

The fund works on one rule: the receipts plus the cash left always add back to the fund's set amount. If they do not, something is missing, and the one custodian answers for it.

Worked example — setting up and refilling the fund (in words). Follow the fund through its two entries.

Setting it up: the business writes a check to the custodian for the fund's set amount. Debit Petty Cash; credit Cash. One asset goes up, another goes down by the same amount.
Paying from it: the custodian pays for postage and keeps the receipt. No journal entry yet. The cash in the box goes down, and the stack of receipts goes up by the same amount.
Refilling it: when the box runs low, the custodian hands over the receipts, and the business writes a check that brings the cash back to the set amount. Debit each expense the receipts show, such as Postage Expense; credit Cash.

In words: the expenses reach the books when the fund is refilled, and the Petty Cash account keeps its set amount the whole time.

Misconception check. Students often think each refill is debited to Petty Cash, because cash is going into the box. The box is only being brought back to its set amount. The receipts show what the money was spent on, so the refill debits those expenses. Petty Cash is debited only when the fund is set up or made larger.

5. Read the bank statement

Your bank sends you a statement every month, even if you only read it in an app. The bicycle shop gets one too.

A bank statement is the bank's own record of a business's account for a period. It lists the deposits the bank received, the checks and transfers it paid, its fees, any interest it paid, and the ending balance.

Here is the key idea of the week. The bank and the shop record the same cash at different moments. The shop records a check the day it writes it. The bank records it the day the check reaches the bank. So at the month's end, the two balances differ even when no one has made a mistake.

That is why the shop prepares a bank reconciliation, a schedule that explains every difference between the balance on the bank statement and the balance in the Cash account. It adjusts each side until both reach the same true cash balance.

Worked example — the shop's two starting balances (Dataset F, illustrative). At the end of Month 3, the Cash account shows $8,851 and the bank statement shows $8,450, a difference of 8,851 − 8,450 = $401. Your job in the next three sections is to explain all $401 of it.

One caution about words on the statement. Banks often label a deposit a "credit" to your account, because to the bank your deposit is money it owes you. That label is about the bank's books. In the shop's books, a deposit is still a debit to Cash.

Misconception check. Students often think the bank's balance is "the right one," because a bank seems more official than a small shop's books. Neither starting balance is right yet. The bank does not know about checks the shop wrote yesterday. The shop does not know about the fee the bank took this morning. Both sides need adjusting before either one shows the true cash.

6. Adjust the bank side: deposits in transit and outstanding checks

Start with what the bank does not know yet. The shop has recorded some items that had not reached the bank when the bank printed the statement. Those items adjust the bank side.

A deposit in transit is cash the business has recorded and deposited that the bank had not yet added to the account when it prepared the statement. You add it to the bank side.
An outstanding check is a check the business has written and recorded that the bank had not yet paid when it prepared the statement. You subtract it on the bank side.

Worked example — the shop's bank side (Dataset F, illustrative). Begin with the bank statement's balance and adjust it.

Balance per bank statement: $8,450.
Add the deposit in transit: 8,450 + 1,200 = $9,650.
Subtract the outstanding checks: check No. 211 for $400 and check No. 214 for $750 total 400 + 750 = $1,150, so 9,650 − 1,150 = $8,500.

In words: once the bank catches up on the $1,200 deposit and the two checks, the shop's account will hold $8,500, the adjusted bank balance.

Misconception check. Students often put an outstanding check on the book side, because the check feels like the shop's own item. It is the shop's own item, and that is exactly why the shop's books already show it. The shop subtracted the $400 and the $750 from Cash the day it wrote the checks. Only the bank has not caught up, so the outstanding checks belong on the bank side.

7. Adjust the book side, and catch the transposition error

Now turn to what the shop does not know yet. The bank statement shows items the shop had not recorded. Those items, plus any recording mistakes of the shop's own, adjust the book side.

A bank service charge is a fee the bank takes directly from the account. The shop learns of it from the statement. You subtract it.
An NSF check is a customer's check that the customer's bank refused to pay because the account did not have sufficient funds. The shop had added it to Cash when it deposited it, so you subtract it, and the customer owes the shop again.
Interest the bank pays on the account raises cash. You add it.
The shop's own errors are corrected on the book side, in whichever direction fixes them.

One error has a shape worth knowing. A transposition error is a recording mistake in which two digits of a number are swapped, such as 95 written as 59. The difference between the correct and the recorded amounts is always evenly divisible by 9.

Here is why the 9 rule holds. Call the tens digit a and the ones digit b. The correct number is 10 × a + b, and the swapped number is 10 × b + a. Subtract them and you get 9 × a − 9 × b, which is 9 × (a − b). Any whole number times 9 divides evenly by 9.

Worked example — the shop's book side (Dataset F, illustrative). Begin with the Cash account's balance and adjust it, one item at a time.

Balance per books: $8,851.
Subtract the bank service charge: 8,851 − 25 = $8,826.
Subtract the NSF check from a customer: 8,826 − 300 = $8,526.
Add the interest earned: 8,526 + 10 = $8,536.
Correct the error on check No. 209: the check was written for $95 and recorded as $59, so 95 − 59 = $36 too little was taken out of Cash, and 8,536 − 36 = $8,500.
Test for a transposition: 36 ÷ 9 = 4, a whole number, so the $36 difference is evenly divisible by 9. Using the digits, 9 × (9 − 5) = 36.

In words: once the shop records what the bank already knew and fixes its own swapped digits, its Cash account holds $8,500, the adjusted book balance.

Now put the two sides together. The adjusted bank balance is $8,500, and the adjusted book balance is $8,500, so the reconciliation is complete.

The bicycle shop's bank reconciliation at the end of Month 3, in dollars; amounts in parentheses are subtracted (illustrative, Dataset F)
Bank side		Book side
Balance per bank statement	$8,450	Balance per books (Cash)	$8,851
Add: deposit in transit	1,200	Less: bank service charge	(25)
Less: outstanding check No. 211	(400)	Less: NSF check from a customer	(300)
Less: outstanding check No. 214	(750)	Add: interest earned	10
		Less: error on check No. 209 (written $95, recorded $59)	(36)
Adjusted bank balance	$8,500	Adjusted book balance	$8,500

Check that the schedule explains the whole gap. The bank side adds a net 1,200 − 1,150 = $50, and the book side removes a net 25 + 300 − 10 + 36 = $351, and 50 + 351 = $401, the whole starting gap.

In practice (your tools). In a free spreadsheet such as Google Sheets, put the bank side in columns A and B and the book side in columns D and E. Type each item once, with a minus sign on the subtractions. Total each side with a formula, such as =SUM(B2:B5) and =SUM(E2:E6), and add a check cell, =B7-E7, that should show 0. If the check cell shows a number evenly divisible by 9, look for two swapped digits first.

Misconception check. Students often think a difference divisible by 9 proves a transposition error. The rule runs one way only: a transposition always gives a difference divisible by 9, but other mistakes can too. A divisible-by-9 gap tells you where to look first. It does not tell you what you will find.

8. Record only the book-side entries

The reconciliation is a schedule, not a journal entry. Now you decide which of its items reach the journal.

Journal entries are needed only for the book-side items. The bank-side items are already in the shop's books. The $1,200 deposit and checks No. 211 and No. 214 were recorded when they happened, and they will clear the bank next month without any help. The book-side items are news to the shop's books, so each one needs an entry.

Worked example — the four book-side entries (Dataset F, illustrative). Walk each one the same way: what happened, which accounts change, the debit and the credit.

The four journal entries the bicycle shop's end-of-Month 3 bank reconciliation requires, in dollars (illustrative, Dataset F)
Entry	Account	Debit	Credit
1	Bank Service Charge Expense	25
	Cash		25
	Records the bank's monthly fee.
2	Accounts Receivable	300
	Cash		300
	The customer's NSF check bounced, so the customer owes the $300 again.
3	Cash	10
	Interest Revenue		10
	Records the interest the bank paid.
4	Accounts Payable	36
	Cash		36
	Corrects check No. 209, written for $95 and recorded as $59.

Entry 4 needs one more word. Check No. 209 paid a supplier on account (an illustrative detail). The shop recorded the payment at $59, so it lowered Accounts Payable by only $59. The other $36 of the payment also lowers what the shop owes.

Each entry balances, and so do the four together: debits 25 + 300 + 10 + 36 = $371 and credits 25 + 300 + 10 + 36 = $371.

Post them to the Cash account: 8,851 − 25 − 300 + 10 − 36 = $8,500. That matches both adjusted balances.

In words: the shop's true cash at the end of Month 3 is $8,500, so the shop records four book-side entries that lower its Cash by a net $351, and the bank side needs no entry at all.

Every one of these entries touches Cash. Week 4 taught you that an accrual or deferral adjusting entry never touches Cash, and that rule still holds. These four entries are not accruals or deferrals. They are corrections to Cash, bringing the shop's record up to date with what already happened in the bank.

Misconception check. Students often think every reconciling item needs a journal entry, because every item is on the same schedule. Ask one question of each item: does the shop's Cash account already know about it? The deposit in transit and the outstanding checks are already in the books, so they need no entry. Only the four book-side items are new to the books.

9. Report cash and cash equivalents

The reconciliation's last job is to hand the balance sheet a number it can trust.

Some businesses park spare cash in very safe, very short investments. Those count as nearly cash.

Cash equivalents are short-term, highly liquid investments so near to maturity that their value is unlikely to change. They are reported together with cash on the balance sheet line cash and cash equivalents.

Worked example — the shop's cash on its balance sheet (Dataset F, illustrative). The bank statement said $8,450. The books said $8,851. The reconciled figure, $8,500, is the shop's Cash at the end of Month 3. That is the figure Week 5's balance sheet would list for Cash, and it is the figure a lender would read.

One caveat: the reconciliation proves the two records agree with each other, at one moment. It does not prove that every sale was recorded in the first place. That is why it works alongside the other five control activities, not in place of them.

Misconception check. Students often think the balance sheet should show the bank statement's balance, because the bank holds the money. The bank's $8,450 is missing a deposit it had not added yet and includes checks it had not paid yet. The balance sheet reports the reconciled $8,500.

Pause and think. Choose one: (a) If you were lending the shop money, would you rather see its bank statement or its reconciliation, and why? (b) If you were the founder, which one reconciling item from this month would you ask about first, and why?

Key terms

Control activities — The actions a business builds into its policies and daily procedures to meet its control goals, such as limiting access to cash, splitting duties, and reconciling records. (first used: 1. Use six categories of control activities on cash)
Segregation of duties — A control activity that divides the work on an asset among different people so that no one person both handles the asset and keeps its records. (first used: 2. Split the duties, and know the limits)
Petty cash fund — A small, fixed amount of cash held by one custodian for payments too small for a check, with a receipt for every payment. (first used: 4. Run a petty cash fund)
Bank statement — The bank's own record of a business's account for a period, listing deposits, checks and transfers paid, fees, interest, and the ending balance. (first used: 5. Read the bank statement)
Bank reconciliation — A schedule that explains every difference between the balance on the bank statement and the balance in the Cash account, adjusting each side until both reach the same true cash balance. (first used: 5. Read the bank statement)
Deposit in transit — Cash a business has recorded and deposited that the bank had not yet added when it prepared the statement; it is added on the bank side. (first used: 6. Adjust the bank side: deposits in transit and outstanding checks)
Outstanding check — A check a business has written and recorded that the bank had not yet paid when it prepared the statement; it is subtracted on the bank side. (first used: 6. Adjust the bank side: deposits in transit and outstanding checks)
Adjusted balance — The cash balance each side of a bank reconciliation reaches after its reconciling items; the adjusted bank balance and the adjusted book balance must be equal. (first used: 6. Adjust the bank side: deposits in transit and outstanding checks)
Bank service charge — A fee the bank takes directly from a business's account; it is subtracted on the book side and recorded with a journal entry. (first used: 7. Adjust the book side, and catch the transposition error)
NSF check — A customer's check that the customer's bank refused to pay because the account did not have sufficient funds; it is subtracted on the book side, and the customer owes the amount again. (first used: 7. Adjust the book side, and catch the transposition error)
Transposition error — A recording mistake in which two digits of a number are swapped; the difference between the correct and recorded amounts is always evenly divisible by 9. (first used: 7. Adjust the book side, and catch the transposition error)
Cash equivalents — Short-term, highly liquid investments so near to maturity that their value is unlikely to change, reported together with cash. (first used: 9. Report cash and cash equivalents)
Cash and cash equivalents — The balance sheet line that reports a business's cash together with its cash equivalents. (first used: 9. Report cash and cash equivalents)

Summary

Control activities are one of internal control's five components.
This course teaches six of the Green Book's common categories; its list is not all inclusive.
Segregation of duties splits handling an asset from keeping its records.
Collusion can defeat it; controls give reasonable, not absolute, assurance.
A petty cash fund pays small bills; its receipts plus cash equal its set amount.
Bank side: add deposits in transit, subtract outstanding checks.
Book side: service charges, NSF checks, interest earned, and the business's own errors.
Both sides reach one adjusted balance: $8,500 for the shop.
Only book-side items get journal entries.
A transposition error leaves a difference evenly divisible by 9.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

A farmers' market stall's month-end bank statement does not yet show the stall's last deposit, and it shows a fee the stall had not recorded. For each item, name the side of the reconciliation it goes on and whether it needs a journal entry.
At a dog-grooming service, the person who takes card payments at the front desk also prepares the monthly bank reconciliation. Name the control category this setup weakens, and suggest one change.
A food truck's petty cash custodian hands in receipts for napkins and parking, and the business refills the box. Name the accounts debited and credited, and explain why Petty Cash is not one of them.
Explain, without any dollar amounts, why a customer's NSF check lowers the business's Cash but raises its Accounts Receivable.

Answers (worked reasoning — read after attempting)

The last deposit is a deposit in transit. It goes on the bank side, added, and it needs no entry, because the stall's books already show it. The fee is a bank service charge. It goes on the book side, subtracted, and it needs an entry: debit Bank Service Charge Expense, credit Cash. The rule at work: the bank side waits; the book side gets the entries.
It weakens segregation of duties, and with it the control over complete, accurate, and timely recording. The person who handles the cash should not be the person who checks it. A fix is to have the owner, who does not take payments, prepare the reconciliation.
Debit the expenses the receipts show, such as Supplies Expense for the napkins and Parking Expense for the parking, and credit Cash. Petty Cash is not touched, because the refill only brings the box back to its set amount; it does not make the fund larger. The expenses reach the books now, at the refill.
When the business deposited the check, it added the amount to Cash and lowered Accounts Receivable, because it thought the customer had paid. When the customer's bank refuses the check, that cash never arrived. So the business takes the amount back out of Cash and puts it back in Accounts Receivable: the customer still owes it. In words, an NSF check undoes a collection; it does not create a new expense.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, the quiz, the discussion, and the assignment; next week the allowance method estimates the receivables customers will not pay.

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