What Is Petty Cash, How It Works, and How to Manage It

Petty cash is a small amount of money businesses keep on hand to pay for minor expenses. It offers a convenient way of quickly paying for office supplies, providing small reimbursements to employees, and handling other incidental expenses. It simplifies many transactions and avoids creating an administrative burden associated with regular business payments.

In this article, we’ll explore petty cash in depth to see whether it still has uses regardless of digital payments. We’ll explain the whole concept, give you some tips and strategies on how to handle petty cash effectively, provide advantages and drawbacks to using it, and discuss accounting and tax implications associated with petty cash.

What Is Petty Cash, and How Does It Work in a Business?

Petty cash is a small and easily accessible fund that businesses create to quickly pay for low-cost needs. It typically follows the imprest system, which simplifies accounting but still requires diligent documentation.

Now, let’s find out how to set up the fund, what it’s used for, and how.

Setting Up a Petty Cash Fund

Setting up a petty cash fund starts by determining the amount. These funds have fixed balances that usually range between $100 and $500, depending on the size and the needs of a business.

Once the balance is established, the business funds it from the main account, typically by writing a check. The money is placed in a secure spot, and the accountant may debit the “Petty Cash” account while crediting “Cash” via a journal entry.

The next important step is to appoint a custodian who will be in charge of the fund. This company employee is responsible for overseeing and distributing funds, as well as collecting receipts.

Companies may also appoint a cashier to fund the reserve and do the accounting entries. This creates a two-person system, improving overall security and accountability of the petty cash fund.

Common Uses for Petty Cash

Petty cash has many uses for various small business expenses categorized as ordinary and necessary. These need to be small enough to justify not going the traditional purchase order route, creating unnecessary administrative work.

Some of the most common uses for petty cash include:

• Office supplies. Occasional or emergency purchases of pens, paper, printer ink, etc.

• Small employee reimbursements. Petty cash reimbursements should only be used for minor things that employees paid out of their pockets, like parking tickets or taxi fares.

• Hospitality and catering. Purchases of coffee, snacks, or small lunches for a few employees, or flowers and “get well” cards for colleagues.

• Various repairs. Miscellaneous fixes and maintenance around the office that require local technicians.

Petty Cash Transactions

Petty cash transactions need to have a paper trail, regardless of the amount and purpose. Every time a custodian gives cash to one of the employees, they should fill out a petty cash voucher. When an employee makes a payment, they should return the change and provide the receipt.

This is typical for the imprest system, where the total value of cash and receipts in the fund stays the same all the time, and needs to be equal to the original value. Once most of the money is spent, the custodian replenishes the fund while giving receipts to the accounting department.

How to Manage and Track Petty Cash Effectively: Best Practices

While the purpose of petty cash is to simplify things and make small payments quicker, you still need to manage and track it to ensure compliance. Here are some of the best strategies that will help you make the process simple and optimized:

Maintain a Petty Cash Log

The first step toward optimal petty cash management is to maintain a detailed log. This can be a physical ledger stored in a secure place or a digital spreadsheet (e.g., using bookkeeping software).

The log needs to contain all the important details about every transaction, including the date, the name of the person who received the funds, the purpose of the payment, and the exact amount.

Having all this information accessible and organized makes it easy to account for all the spending, to spot patterns in purchases, or to identify any potential discrepancies. Moreover, this data is essential audit documentation.

Conduct Regular Reconciliation

Reconciliation involves verifying that the amount of money in a petty cash fund and the receipts match the records. The fund should be reconciled regularly, at least once a month or whenever it’s being replenished.

The process should involve a person other than a custodian (e.g., a payroll manager or a bookkeeper) to count the cash and sum the receipts. This is a vital step of internal control used to foster accountability and prevent any one person from hiding shortages, errors, or mistakes.

Any discrepancies need to be resolved promptly, while the irregularity is still “fresh.” This is particularly important if the amount is significant and could lead to issues in the future.

Limit Single Transaction Amounts

Limiting single transaction amounts is one of the best ways to prevent big unauthorized purchases and avoid having a fund drained quickly. A hard limit (typically between $25 and $75) encourages the right use of petty cash.

Anything bigger than the limit should require a formal use of the company’s credit card or reimbursement through payroll. As a result, bigger expenditures become much easier to track, since they have to undergo standard procedures and approval processes.

Require Receipts for Every Disbursement

You can only deduct business expenses if you have receipts to prove them. Since the IRS is strict regarding documentation, so should be your company’s policies regarding petty cash. A simple “no receipt, no cash” policy can prevent a lot of problems related to reconciliation and compliance.

Every disbursement needs to come with an original receipt that displays the amount spent, the items purchased, and the date of the transaction. If an employee can’t obtain a receipt, they must fill out an internal voucher to explain the expense. Vouchers and receipts need to be attached to the log to facilitate smooth and accurate petty cash accounting.

Accounting and Tax Considerations for Petty Cash

Petty cash is a part of business expenses, which comes with various accounting and tax considerations. Knowing more about these is critical since the IRS treats these funds with the same level of scrutiny as other expenditures used when conducting business.

Since the main idea of petty cash is simplification from the accounting point, the expenses are only recognized when the fund is replenished. This is when they are added to the general ledger by the accounting team, and when the accountant debits expense accounts (e.g., “Office Supplies”) and credits the main account.

That way, every dollar is categorized and accounted for, just like with regular business expenses. This is essential when looking to leverage tax-deductible expenses.

Petty cash spending can be tax-deductible, as long as it is recognized by the IRS as “ordinary” and “necessary.” This means that the purchases need to be common in your industry and required for your business.

Some notable examples of deductible expenses that can be paid for with petty cash include:

• Postage
• Emergency stationery
• Coffee for clients
• Business-related toll fees

This type of fund can also be used to pay for expenses that aren’t ordinary and necessary. However, it’s critical to note that these aren’t deductible and need to be recorded separately, as mixing them with deductible expenses can lead to trouble with the IRS.

Examples of non-deductible expenses include:

• Personal items
• “Loans” to employees
• Expenses without proof

Ensuring that eligible expenses can be claimed as deductions requires diligent petty cash tracking and detailed record-keeping. If an auditor notices plenty of expenses classified as “miscellaneous,” with no other description or receipts, they may assess back taxes with penalties.

Advantages and Disadvantages of Petty Cash

Petty cash is a good choice mainly because of the many advantages it offers and the way it improves cash handling for small businesses and even larger enterprises. However, there are also some risks and drawbacks that you need to be aware of.

Advantages of Petty Cash

Let’s start with some of the biggest advantages of using petty cash in your business operations:

• Convenience. Petty cash allows employees to make small purchases immediately, without having to wait for a company check or approval from management.

• Speed. Small purchases often need to be made quickly to enable smooth business operations. Petty cash can be used to purchase printer ink or pay for a delivery fee, which could otherwise stall much larger operations.

• Versatility. Having cash on hand allows purchases from small vendors who don’t accept digital payments. It’s also useful for everyday situations, like tipping delivery drivers.

Potential Risks of Petty Cash

Now, let’s look at some of the risks associated with using petty cash:

• Theft or misuse. Physical cash is untraceable once it’s spent, which is why the petty cash fund is susceptible to internal misuse. It is considered a high-risk target for fraud, so there are often custodians tasked with safekeeping the fund.

• Human error. Even with no malicious intent, it’s still easy to spend some cash without a trace because a person forgot to log it or bring a receipt. Couple that with the fact that 18% of accountants make mistakes daily, and these small expenditures can add up over time and cause bigger issues.

• Potentially complex reconciliation. Due to a lack of record-keeping rigor associated with formal payments and no automatic digital trail, reconciliation needs to be manual. This can turn into a time-consuming task similar to payroll reconciliation, especially with no strict petty cash policies in place.

5 Common Petty Cash Mistakes to Avoid

Not making mistakes when handling and using petty cash is of utmost importance if the company wants to ensure compliance with tax laws and maintain the integrity of its financial records.

Here are some of the most common mistakes you should be aware of:

• Not appointing a designated custodian. Not having a person in charge of the petty cash fund and instead allowing multiple people to access it makes it impossible to find who is responsible when there’s a shortage.

• Mixing business and personal funds. Using a business fund for personal purchases (e.g., borrowing from the petty cash box for a private lunch) can lead to inconsistencies and inaccurate record-keeping, raising red flags for auditors.

• Not requiring the receipts. Accepting verbal confirmations and promises of proof instantly makes expenses non-deductible. Plus, it creates an environment in which fraud is much more likely.

• Only replenishing the fund when it’s empty. Waiting until the fund is completely empty to replenish it can lead to issues in cases of emergencies. Employees may be required to spend money out of their own pockets, which would result in complex reimbursement processes.

• Not doing regular reconciliation. Regularly topping off the petty cash box without verifying the receipts and performing reconciliation can leave some mistakes or theft to go unnoticed for weeks or even months.

Final Thoughts

By definition, petty cash is used to make small purchases quickly and effortlessly, and avoid creating complex administrative tasks because of it. However, things can get complicated if you don’t appoint a dedicated custodian, have strict policies when using the fund, and ask for receipts and appropriate documentation every time a purchase is made.

Keep in mind that, even though the amounts are small, they are still categorized as business expenses and can be subject to the same level of scrutiny as any other money you spend. That’s why it’s essential to keep clean documentation for audits and ensure tax compliance.

What Is Petty Cash FAQs

#1. Is petty cash still used?

Yes, petty cash is still used by many businesses, usually for small and immediate transactions, such as postage, local travel reimbursements, or office snacks. While many companies have transitioned to corporate cards, some vendors still don’t accept digital payments, making petty cash necessary.

#2. Who is responsible for petty cash?

The person responsible for petty cash is usually called “petty cash custodian” and is one of the company’s employees. They are in charge of keeping the fund safe, collecting receipts, and maintaining the log. Businesses often employ a separate manager or accountant to perform reconciliations and check the custodian’s work.

#3. Can petty cash be used for employee reimbursements?

Yes, petty cash can be used for employee reimbursements, but only for small amounts. These need to be business-related incidental expenses that employees paid for out of their pockets (e.g., a parking fee). Custodians can reimburse them quickly and efficiently with a provided receipt.