What it means
A business that holds surplus cash rarely leaves all of it in a current account. It places some on short-term deposit, buys treasury bills, or invests in a money market fund, earning a return while keeping the money available.
Accounting treats these placements as equivalent to cash, provided they meet the definition, so that a company is not penalised in its reported liquidity for managing its cash sensibly. The definition has three tests.
Short-term: the standards do not fix a period but say that an investment normally qualifies only when it has a short maturity of, say, three months or less from the date of acquisition. A six-month deposit does not become a cash equivalent when it has three months left to run, because the test is applied at acquisition.
Highly liquid and readily convertible to a known amount of cash: the holder must be able to get its money out quickly at a predictable amount, which excludes equities (convertible, but not to a known amount) and instruments without a ready market. Insignificant risk of changes in value: the instrument's value must be stable, which excludes anything whose price moves materially with interest rates or credit spreads, and which is why the three-month maturity guideline exists.
Typical cash equivalents include demand and short-notice deposits, term deposits of three months or less, treasury bills and government securities with three months or less to maturity at purchase, high-grade commercial paper and certificates of deposit of similar tenor, and money market funds that hold such instruments and offer daily liquidity at stable value. Not cash equivalents: deposits over three months (investments), equities and bonds of any maturity (investments), restricted cash held as security or for a specified purpose (usually disclosed separately), and balances in subsidiaries that cannot be remitted (cash, but often disclosed as restricted).
Bank overdrafts repayable on demand are, under IAS 7, deducted from cash and cash equivalents where they form an integral part of the company's cash management; under US GAAP they are liabilities. The classification has consequences.
Cash and cash equivalents is the figure deducted from borrowings to give net debt, which drives leverage ratios and covenants; it is the numerator of the cash ratio; and it is the total whose movement the cash flow statement explains, so anything moved into or out of it (buying a six-month deposit, for instance) appears as an investing cash flow while a three-month deposit does not. Companies with large treasury operations disclose their policy for what they count, and auditors test the classification, since including a longer-dated instrument overstates liquidity.
Judgement remains. A money market fund with daily dealing and a stable unit value qualifies; one with a variable value or notice period may not.
A 95-day notice deposit is longer than three months and is an investment. A deposit that can be broken on demand with a penalty may qualify if the penalty is insignificant.
Companies apply a written policy consistently and disclose it.
In practice
Real-world examples.
Example
A retailer holds $40 million in an overnight money market fund and reports it within cash and cash equivalents.
Example
A technology company's $10 billion of "cash" includes $6 billion of marketable securities with maturities up to two years, reported separately as short-term investments, not cash equivalents.
Example
A construction company's $3 million retention held in a joint escrow account is disclosed as restricted cash outside cash and cash equivalents.
Think of it
“Cash equivalents are investments so safe and short-term they're basically the same as cash.
Formula
Calculation
Cash and Cash Equivalents = Cash on hand + Demand deposits + Investments meeting the definition (short-term, highly liquid, known amount, insignificant risk of value change; normally three months or less from acquisition) minus Bank overdrafts repayable on demand (IFRS, where part of cash management)
Net Debt = Borrowings minus Cash and cash equivalents
Cash Ratio = Cash and cash equivalents / Current liabilities
Worked example. A company's treasury holds the following at year end:
- Current accounts: $3,200,000
- 7-day notice deposit: $5,000,000
- Term deposit, placed 10 months ago for 12 months, 2 months to run: $4,000,000
- Treasury bills bought 2 months ago with 3-month maturity: $6,000,000
- Money market fund, daily dealing, stable value: $8,000,000
- Corporate bonds maturing in 2 months, bought 3 years ago: $2,500,000
- Cash held in escrow as security for a lease: $700,000
- Bank overdraft on a subsidiary's account, repayable on demand, used for daily cash management: $1,100,000
- Listed equity investments: $1,900,000
Classification:
- Cash: current accounts $3,200,000
- Cash equivalents: 7-day deposit $5,000,000; treasury bills $6,000,000 (3-month maturity at acquisition); money market fund $8,000,000. Total $19,000,000
- Not cash equivalents: the 12-month term deposit (maturity at acquisition exceeds 3 months, even though only 2 months remain): investment $4,000,000; the corporate bonds (same reasoning, and price risk): investment $2,500,000; escrow cash: restricted cash $700,000, disclosed separately; equities: investment $1,900,000
- Overdraft: under IFRS, deducted, since it is part of cash management: minus $1,100,000
Cash and cash equivalents (IFRS) = $3,200,000 + $19,000,000 minus $1,100,000 = $21,100,000. Under US GAAP the overdraft is a liability and the figure is $22,200,000.
Effects: borrowings are $60,000,000, so net debt = $60,000,000 minus $21,100,000 = $38,900,000. Had the treasurer counted the 12-month deposit and the bonds as cash equivalents, reported cash would have been $27,600,000 and net debt $32,400,000, understating leverage. The company's covenant defines net debt using cash and cash equivalents under IFRS, so the classification affects the test. Current liabilities are $35,000,000: cash ratio = $21,100,000 / $35,000,000 = 0.60.
Cash flow statement: the purchase of the treasury bills during the year does not appear as an investing outflow (they are cash equivalents); the placing of the 12-month deposit ten months ago did appear as an investing outflow, and its maturity in two months will appear as an investing inflow.Case study
Seen in the real world.
A listed logistics group reported cash and cash equivalents of $85,000,000 and net debt of $110,000,000, comfortably inside its covenant of 3 times EBITDA. Its treasurer had, over two years, placed increasing amounts in a fund that offered a higher yield than money market funds, with monthly dealing and a unit price that moved with the value of the short-dated corporate bonds it held. The fund was classified as a cash equivalent because the treasurer regarded it as "essentially cash".
When the auditors reviewed the classification, they concluded that a monthly-dealing fund with a variable unit price did not meet the definition: its value was not known with insignificant risk of change. The $30,000,000 in the fund was reclassified as a short-term investment. Cash and cash equivalents fell to $55,000,000, net debt rose to $140,000,000, and the covenant ratio moved from 2.4 to 3.1 times, a breach.
The bank waived it for a fee and required the group to adopt a written cash equivalents policy approved by the audit committee, listing permitted instruments (deposits and treasury bills up to three months, money market funds with daily dealing and stable value) and requiring quarterly confirmation that every item within cash and cash equivalents met the definition. The finance director's report noted that the extra yield on the fund had been about $300,000 a year, and the waiver fee $250,000, before counting the cost of the audit committee's time.
Watch out
Common mistakes.
- Classifying an instrument by its remaining maturity rather than its maturity at acquisition. A 12-month deposit with two months left is still an investment.
- Counting restricted or trapped cash as available, or counting bonds and equities as cash equivalents because they can be sold.
- Forgetting that under IFRS an overdraft used for cash management is netted against cash and cash equivalents, so the figure can be lower than the gross cash held.
Questions
People also ask.
What is the three-month rule?
A guideline from the standards: an investment normally qualifies as a cash equivalent only if it matures within about three months of the date the company acquired it, because longer instruments carry more risk of value changes.
Are money market funds cash equivalents?
Usually, if they offer daily liquidity at a stable value and hold short-term, high-quality instruments. Funds with variable prices or notice periods may not qualify.
Why does the classification matter?
It determines reported liquidity, net debt, covenant compliance and what the cash flow statement explains. Overstating cash equivalents overstates financial strength.
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