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Cash and Cash Equivalents

Cash and Cash Equivalents- understanding cash equivalents

 

What are cash and cash equivalents? 

The cash flow statement shows inflows and outflows of cash and cash equivalents from various activities of an enterprise during a particular period. As per AS-3 and IAS 7, ‘Cash’ comprises cash in hand and demand deposits with banks, and ‘Cash equivalents’ means short-term highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value. An investment normally qualifies as a cash equivalent only when it has a short maturity, of say, three months or less from the date of acquisition.

Investments in shares are excluded from a cash equivalent unless they are in substantial cash equivalents. For example, preference shares of a company acquired shortly before their specific redemption date, provided there is an only insignificant risk of failure of the company to repay the amount at maturity. Similarly, short-term marketable securities which can be readily converted into cash are treated as cash equivalents and can be liquidated immediately without considerable change in value.

‘Cash’:

     – Cash on hand (physical currency held)
     – Demand deposits.

‘Cash equivalents’:

     – Short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.

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What are cash equivalents?

The following discussed are generally related to the nature of assets eligible to become cash equivalents 

  • Demand deposits 

In order to qualify a demand deposit as cash, the related balance needs to have the same liquidity as cash itself, and so funds on ‘demand deposit’ need to be capable of being withdrawn at any time without penalty.

In general, deposits which can be withdrawn without penalty within 24 hours, or one working day, are regarded as being demand deposits. These include amounts deposited at financial institutions (such as funds in a bank current account), and may extend to cover deposits at non-financial institutions such as legal advisers if funds are held for the client in separate and designated accounts that can be called upon by the client at any time. If a deposit does not qualify to be regarded as cash, it may qualify to be classified as a cash equivalent.

  • Short term maturity

Although the reference to three months as eligibility to become cash equivalents might not be viewed as establishing a ‘bright line’ threshold, it is a benchmark that is widely used in practice. One point which is frequently overlooked is that the three-month period to maturity is based on the date on which an entity acquires an asset. Consequently, a one-year fixed-term deposit held by an entity does not become a cash equivalent when the period to maturity has reached three months.

  • Investments in equity instruments

Investments in equity instruments are almost excluded from being classified as cash equivalents because they typically have no maturity and are subject to significant potential changes in value. However, it is possible that an instrument such as a redeemable preference share, which is purchased with a short period remaining to its maturity date, will meet the definition of a cash equivalent.

cash and cash equivalents

  • Changes in liquidity and risk

The definition of a cash equivalent makes reference to them being both highly liquid and subject to an insignificant risk of changes in value. The amounts that initially meet the definition of cash equivalents would not be expected to be subject to a significant risk of adverse changes in liquidity and changes in value. However, it is possible that such changes could take place. For example, a short-term maturity corporate (or government) bond that would otherwise meet the definition of a cash equivalent might be subject to a sudden adverse change in the issuer’s credit status.

  • Cryptocurrencies

IFRS Interpretations Committee has discussed the matter of including cryptocurrency in cash and concluded that a cryptocurrency is not cash.

  • Short-term credit lending and cash and cash equivalent classification

In some circumstances, short-term loans and credit facilities may meet the definition of cash and cash equivalent, and would therefore be presented within cash and cash equivalent, rather than financing cash flows. Based on the fact pattern provided, the IFRS Interpretations Committee concluded that such an arrangement would not be a component of cash and cash equivalents because these facilities are not repayable on demand and the balance does not often fluctuate from being negative to positive (i.e. it is consistently in a negative position where the entity owes the lender). The facilities are a form of financing and their cash flows should be classified as financing cash flows.

 

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Resources on private equity:

– All about private equity – Considerations in selecting a private equity firm
– Private equity Vs Public Equity – Risk consideration in private equity funds
– Private equity offer letter (term sheet) – Glossary of terms and definitions in private equity

 

 

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