Record The Adjusting Entry Related To Outstanding Checks If Necessary

Outstanding checks represent a unique situation in the realm of accounting, where the balance reflected in a company’s books doesn’t immediately align with the bank’s records. Understanding how to account for and record adjusting entries related to these outstanding checks is crucial for maintaining accurate financial statements. This article delves into the intricacies of outstanding checks, explaining their nature, why they occur, and, most importantly, how to record the necessary adjusting entries.

Understanding Outstanding Checks

An outstanding check is a check that has been written by a company and recorded in its cash disbursement journal, but it has not yet been presented to the bank for payment by the payee. In simpler terms, the check has left the company’s hands, reducing its book balance of cash, but the bank is unaware of this transaction because the recipient hasn't cashed or deposited it.

Why Do Outstanding Checks Occur?

Several reasons can contribute to the existence of outstanding checks:

• Timing Differences: This is the most common reason. Checks are often written at the end of a month, and the recipient may not deposit it until the beginning of the next month.
• Mail Delays: Checks sent via mail may take several days to reach the recipient, delaying the deposit.
• Recipient's Delay: The recipient may simply delay depositing the check due to various reasons, such as being busy or waiting to accumulate multiple checks before making a bank deposit.

Impact of Outstanding Checks

Outstanding checks cause a discrepancy between the company's cash balance per books and the cash balance per the bank statement. This discrepancy needs to be reconciled to ensure accurate financial reporting. Ignoring outstanding checks can lead to:

• Inaccurate Cash Balance: The company's books will show a lower cash balance than what's actually available in the bank.
• Errors in Financial Statements: Incorrect cash balances can distort other financial statement components, such as working capital and liquidity ratios.
• Poor Decision-Making: Based on inaccurate financial data, management may make flawed decisions regarding investments, expenses, and other critical areas.

The Bank Reconciliation Process

Before diving into adjusting entries, it's essential to understand the bank reconciliation process, which is the mechanism for identifying and addressing outstanding checks. A bank reconciliation is a process that compares the cash balance on a company's books to the corresponding bank statement balance to identify any differences and adjust them to arrive at the true cash balance.

Steps in Bank Reconciliation

The typical bank reconciliation process involves the following steps:

1. Obtain Bank Statement and Company Records: Gather the bank statement for the relevant period and the company's cash disbursement journal and cash receipts journal.
2. Identify Deposits in Transit: These are deposits that the company has recorded but haven't yet been reflected on the bank statement. Add these to the bank statement balance.
3. Identify Outstanding Checks: These are checks that the company has issued but haven't been cashed or deposited by the recipient. Subtract these from the bank statement balance.
4. Identify Bank Errors: Look for any errors made by the bank, such as incorrect deposits or withdrawals. Adjust the bank statement balance accordingly.
5. Identify Book Errors: Look for any errors made by the company, such as incorrect recording of deposits or withdrawals. Adjust the book balance accordingly.
6. Identify Bank Charges and Credits: The bank statement may include charges (e.g., service fees) or credits (e.g., interest earned) that the company hasn't yet recorded. Adjust the book balance accordingly.
7. Calculate Adjusted Bank Balance and Adjusted Book Balance: After making all the necessary adjustments, calculate the adjusted bank balance and the adjusted book balance.
8. Compare Adjusted Balances: The adjusted bank balance and the adjusted book balance should be equal. If they are not, it indicates that there are still errors or discrepancies that need to be investigated.

Recording Adjusting Entries for Outstanding Checks

Here's the crucial point: outstanding checks themselves DO NOT require an adjusting entry. This is a common misconception. The company has already recorded the expense (or asset purchase) and the corresponding decrease in cash when the check was initially written. The bank reconciliation process simply highlights the difference between the company's records and the bank's records.

The reason why outstanding checks don't need adjusting entries is that the initial entry was correct. The company did issue the check and reduce its cash balance accordingly. The problem lies in the timing of when the bank acknowledges that transaction.

However, the bank reconciliation process may reveal other items that DO require adjusting entries, and these items can be related to outstanding checks indirectly. Here are some scenarios:

Scenario 1: Error in Recording the Check Amount

Let's say a company wrote a check for $150 to pay for office supplies. However, the bookkeeper mistakenly recorded the amount as $130 in the cash disbursement journal. During the bank reconciliation process, this error is identified.

• Impact: The company's book balance is overstated by $20 ($150 - $130).

• Adjusting Entry:

  • Debit: Office Supplies $20
  • Credit: Cash $20

  This entry corrects the underreporting of office supplies expense and reduces the cash balance to the correct amount.

Scenario 2: Check Marked as Void but Never Actually Voided

A company writes a check for $200 to a vendor. Later, they decide to cancel the check and issue a new one. The original check is marked as "void" in the company's system, but the check is not properly voided with the bank. The vendor unexpectedly deposits the "voided" check.

• Impact: The company's bank balance is reduced by $200 without a corresponding entry in the company's books.

• Adjusting Entry:

  • Debit: Accounts Payable $200
  • Credit: Cash $200

  This entry recognizes the payment to the vendor and reduces the cash balance. You would also need to investigate why the check was not properly voided.

Scenario 3: Stale-Dated Check

A check remains outstanding for an extended period (e.g., over six months). Banks often have a policy of not honoring "stale-dated" checks. The company needs to determine if the underlying obligation is still valid.

• If the Obligation is Still Valid: The company needs to contact the payee and reissue the check. No adjusting entry is needed immediately, but a note should be made to reissue the check. If the company is certain the original check will never be cashed, then you can reverse the original entry.

  • Debit: Cash $XXX
  • Credit: Expense/Liability Account $XXX

  (Where $XXX is the amount of the original check.) This entry effectively restores the cash balance and reverses the original expense or liability.

• If the Obligation is No Longer Valid: The company can reverse the original entry and recognize a gain.

  • Debit: Cash $XXX
  • Credit: Gain on Abandoned Check $XXX

Important Considerations:

• Documentation: Always maintain thorough documentation to support all adjusting entries. This includes the bank reconciliation statement, copies of checks, and any relevant correspondence.
• Materiality: The materiality of the amount should be considered when deciding whether to make an adjusting entry. Small, immaterial differences may not warrant an entry. However, consistently ignoring even small discrepancies can lead to larger problems over time.
• Internal Controls: Implementing strong internal controls over cash disbursements can help minimize the occurrence of outstanding checks and errors. This includes proper authorization of checks, segregation of duties, and regular bank reconciliations.
• Regular Reconciliation: Perform bank reconciliations on a regular basis (e.g., monthly) to identify and correct errors in a timely manner. The longer errors go undetected, the more difficult they become to resolve.
• Reviewing Old Outstanding Checks: Regularly review a list of outstanding checks that have been outstanding for a long time. Investigate why these checks haven't cleared and take appropriate action.

Common Mistakes to Avoid

• Making an Adjusting Entry for the Outstanding Check Itself: As mentioned before, this is incorrect. The initial entry was correct when the check was written.
• Ignoring Bank Charges and Credits: Bank charges and credits reflect real changes in the cash balance that need to be recorded.
• Failing to Investigate Discrepancies: Don't just assume that a discrepancy is due to an outstanding check. Investigate the matter thoroughly to identify the root cause.
• Not Segregating Duties: Having the same person responsible for writing checks, reconciling the bank statement, and making adjusting entries creates a risk of fraud.

Example of a Bank Reconciliation and Potential Adjusting Entries

Let's assume a company, "Sunshine Corp," has the following information:

• Cash balance per bank statement: $12,500
• Cash balance per books: $9,000
• Outstanding checks: $4,000
• Deposit in transit: $1,500
• Bank service charge: $25
• Note collected by bank (including interest): $3,050
• Error: Sunshine Corp. recorded a check written for $120 as $210

Here's a sample bank reconciliation:

Bank Side:

• Balance per bank statement: $12,500
• Add: Deposit in transit: $1,500
• Deduct: Outstanding checks: $4,000
• Adjusted bank balance: $10,000

Book Side:

• Balance per books: $9,000
• Deduct: Bank service charge: $25
• Add: Note collected by bank: $3,050
• Deduct: Error in recording check: $90 ($210 - $120)
• Adjusted book balance: $11,985

Analysis:

Notice the bank and book side do NOT match. There is most likely an error on our part. Looking at the bank side it is unlikely an error was made so we re-check the math on the book side, we quickly realize an error.

• Corrected Book Side:

  • Balance per books: $9,000
  • Deduct: Bank service charge: $25
  • Add: Note collected by bank: $3,050
  • Deduct: Error in recording check: $90 ($210 - $120)
  • Adjusted book balance: $12,085

With the error fixed we can see the bank and book side STILL do NOT match. So we re-check everything. Finally, after double checking everything we realize the Note collected by the bank includes interest. So we need to break that out in our adjusting entries. This is because the principal of the note is an asset (Note Receivable) and the interest is revenue (Interest Income).

• Corrected Book Side:

  • Balance per books: $9,000
  • Deduct: Bank service charge: $25
  • Add: Note collected by bank: $3,050
  • Deduct: Error in recording check: $90 ($210 - $120)
  • Adjusted book balance: $12,085

Adjusting Entries Required (Based on the Book Side of the Reconciliation):

1. To record bank service charge:

   • Debit: Bank Service Charge Expense $25
   • Credit: Cash $25

2. To record note collected by bank:

   • Debit: Cash $3,050
   • Credit: Notes Receivable $3,000
   • Credit: Interest Income $50

3. To correct error in recording check:

   • Debit: Cash $90
   • Credit: The expense account the check was for $90 (e.g., Supplies Expense)

The Importance of Robust Internal Controls

While understanding how to record adjusting entries is crucial, preventing errors in the first place is even more important. Strong internal controls over cash management can significantly reduce the frequency of bank reconciliation discrepancies and the need for adjusting entries.

Key Internal Controls:

• Segregation of Duties: Separate the responsibilities of authorizing payments, writing checks, reconciling the bank statement, and maintaining accounting records. No single person should have control over all aspects of the cash disbursement process.
• Prenumbered Checks: Use prenumbered checks and account for all check numbers. This helps to detect missing or unauthorized checks.
• Check Authorization: Require proper authorization for all check requests. This ensures that payments are only made for legitimate business purposes.
• Supporting Documentation: Require supporting documentation (e.g., invoices, purchase orders) for all payments. This provides evidence that the payment is valid and accurate.
• Regular Bank Reconciliations: Perform bank reconciliations on a regular basis, preferably monthly. This allows for timely detection and correction of errors.
• Independent Review: Have an independent party review the bank reconciliation and adjusting entries. This provides an additional layer of oversight and helps to ensure accuracy.
• Secure Check Storage: Store blank checks in a secure location to prevent unauthorized access.
• Electronic Payments: Consider using electronic payment methods, such as ACH transfers or wire transfers, which can reduce the risk of errors and fraud compared to paper checks.

Conclusion

While outstanding checks themselves don't require adjusting entries, the bank reconciliation process is essential for identifying errors and omissions that do require correction. By understanding the nature of outstanding checks, implementing robust internal controls, and performing regular bank reconciliations, companies can maintain accurate cash balances and ensure the integrity of their financial statements. Furthermore, paying close attention to discrepancies revealed during the reconciliation process – such as errors in recording check amounts, improperly voided checks, or stale-dated items – allows for the prompt identification and resolution of potential financial misstatements. The key is to remember that the bank reconciliation isn't just a procedural task; it's a critical tool for safeguarding a company's most liquid asset: cash.