Accounting for bank and book overdrafts and their cash flow presentation

Most businesses have bank accounts. A number of situations can take place in relation to such accounts. For example, a company may have written checks in excess of a bank balance. Or a company may have a zero balance account and any checks that clear the company’s bank account are financed by a revolving line of credit. How should these transactions be recorded on the balance sheet? What about the statement of cash flows? In this article you will find answers to these questions.

1. Description of bank and book overdrafts

Two situations we are going to discuss are bank overdrafts and book overdrafts.

Bank overdraft takes place when a company doesn’t have sufficient funds in a bank account to cover presented checks, but the bank honors them anyway.  This creates a short-term liability because the company will have to settle the obligation with the bank eventually.

Book overdraft is a situation when a company issues checks in excess of what the bank balance is, but those checks have not been presented for clearance to the bank yet.  Thus, this is an overdraft on the company’s books.

2. Balance sheet presentation of bank and book overdrafts

Bank overdrafts represent a company’s short-term liability to a bank and thus should be recorded as a current liability on the balance sheet.  Bank overdrafts are not common in the USA.  For example, if a company has a zero balance in its bank account, checks are presented for an amount of $10,000 and the bank honors the checks, the bank overdraft is $10,000.  This is the amount that will be presented as a short-term liability.

Book overdrafts result in negative cash balances on the books (accounting records) of a company.  Because book overdrafts simply represent checks issued in excess of funds in the bank, they should be re-instated as accounts payable or a separate current liability (e.g., called Checks Issued in Excess of Funds Available).  If a company has funds available in the bank account against which checks have been written and there is a legal right of offset (i.e., the funds can be used to honor checks), but the funds are not sufficient to cover all checks issued, then only the net amount (e.g., outstanding checks less funds available) can be reclassified into accounts payable.  For example, if a company had $24,000 in outstanding checks and zero cash in the bank account, then the $24,000 will create a book overdraft – the cash balance in accounting records will have a negative (credit) balance of $24,000.  The company should move the $24,000 to accounts payable via a journal entry.  On the other hand, if the company has $4,000 in the bank account and $24,000 in outstanding checks, the company can move $20,000 (i.e., $24,000 - $4,000) to accounts payable.

3. Cash flow presentation of bank and book overdrafts

Most companies prepare statements of cash flows using the indirect method, so this is the method we will review here.  A cash flow statement has three categories of cash flows: cash from operating activities, cash from investing activities, and cash from financing activities.  For more information about these categories, refer to the tutorial Introduction to Accounting.  In a simplified form, when a cash flow statement is prepared using the indirect method, balance sheet balances between two periods (i.e., current year end and prior year end) are compared to determine changes in them.  These changes are then reported in one of the three cash flow categories mentioned above.

Bank overdrafts represent short-term loans provided by a bank to a company.  Because this is a form of financing, changes in the bank overdraft balances between two periods are reported as cash flows from financing activities.

Book overdrafts, in substance, represent re-instated accounts payable.  Thus, changes in book overdrafts between two periods are normally reported as cash flows from operating activities.

Sometimes, however, book overdrafts represent cash flows from financing activities.  For example, a company has a zero balance in a bank account and when its checks are presented to the bank, the bank honors them and draws necessary funds from a linked revolving credit facility of the company.  In this case, the book overdraft results in an increase in the company’s short-term obligation to the bank which qualifies the changes in the overdraft balances between two periods as cash flows from financing activities.  Thus, careful consideration of facts should be performed to properly categorize book overdrafts.

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