Cash and cash equivalents
Cash is the most basic form of financial instrument. Some short-term, highly liquid debt investments are considered cash equivalents and can be included in the balance sheet together with cash. There are very few problems with the valuation of cash, although some cash equivalents that are securities may be carried at fair value, and balances in foreign currency must be adjusted to reflect current exchange rates [1].
Cash characteristics
According to the widespread use, cash includes not only cash in hand but also deposits payable on demand at banks or other financial institutions. Cash also includes other types of accounts that have the general characteristics of deposits on demand, in the sense that the customer can deposit additional funds at any time, as well as effectively withdraw funds at any time without prior notice or penalty. All fees and loans on these accounts are cash receipts or payments for both the account owner and the bank that runs it. For example, a bank granting a loan by posting the receipts in the customer's deposit account is the bank's cash payment and the customer's cash receipt at the time of entry [2].
Cash equivalents characteristics
Cash equivalents - short-term, highly liquid investments that have both of the following features [3]:
- easily convertible into known amounts of cash and
- so close to the maturity that they pose a slight risk of changes in value due to changes in interest rates.
In general, only investments with an original maturity of three months or less are eligible under this definition. Original maturity means the original maturity date for the investee. For example, both a three-month US Treasury bill and a three-year US Treasury note purchased for three months from maturity qualify as cash equivalents. However, Treasury note purchased three years ago do not become cash equivalent when the remaining maturity is three months. Examples of items commonly considered to be cash equivalents are [4]:
- Treasury bills,
- money market funds,
- commercial papers,
- federal funds sold (for the entity conducting banking operations).
Balance sheet presentation issues with cash
There are several problems with the presentation of the balance sheet with cash. Cash, the use of which is limited, should be reported separately from unlimited cash and be excluded from current assets in the classified balance sheet. Most types of companies report cash flow in a cash flow statement. A statement of cash flows is prepared in several choices, but as rule receipts and payments should be classified as financing, investing, or conducting business. Generally, cash inflows and outflows should be presented separately (gross), but there are a few exceptions that allow for net cash flow reporting. For example, changes in cash equivalents can be reported net in the cash flow statement. Besides, companies may present cash flows from some short-term, high-turnover financial instruments on a net basis. Exceptions are wider for financial institutions. Usually, the amounts in the deposit for financial institutions cannot be transferred liabilities to the same institutions. However, some financial institutions may value mutual balances with other financial institutions in some circumstances [5].
Examples of Cash and cash equivalents
- Bank Accounts: Cash and cash equivalents include bank accounts such as savings accounts, checking accounts, and money market accounts. These accounts are FDIC insured, meaning they are backed by the full faith and credit of the US government.
- Short-term Debt Investments: Short-term debt investments, such as Treasury bills or commercial paper, are considered cash equivalents as they are highly liquid and can be used to purchase cash quickly.
- Certificates of Deposit: Certificates of Deposit (CDs) are another type of cash equivalent, as they are highly liquid and can be used to purchase cash quickly. CDs typically have a fixed term, meaning they are held for a predetermined period of time.
- Foreign Currency: Foreign currency is also considered a cash equivalent, as it can be converted into the local currency quickly and at a low cost.
- Prepaid Cards: Prepaid cards are another type of cash equivalent, as they can be used to purchase goods and services quickly and with minimal fees.
Advantages of Cash and cash equivalents
Cash and cash equivalents are essential to the financial health of businesses, as they provide liquidity for working capital and other short-term needs. Some of the advantages of cash and cash equivalents include:
- Immediate Accessibility - Cash and cash equivalents can be accessed instantly, providing businesses with the liquidity they need in order to meet their short-term obligations.
- Low Risk - Cash and cash equivalents are some of the safest investments available, with very little risk of loss of value.
- Higher Returns - Cash and cash equivalents, such as money market accounts, certificates of deposit, and other short-term investments, often provide higher returns than traditional savings accounts.
- Liquidity - Cash and cash equivalents are highly liquid, meaning they can be converted to cash quickly and easily.
- Tax Benefits - Cash and cash equivalents can qualify for certain tax benefits, such as lower capital gains taxes.
Limitations of Cash and cash equivalents
Cash and cash equivalents, while a very liquid and convenient form of financial instrument, have several limitations. These include:
- Lack of Return: Cash and cash equivalents offer little to no return on investment, making them unsuitable for long-term investment strategies.
- Inflation: Cash and cash equivalents are subject to inflation, meaning their purchasing power decreases over time.
- Risk: Cash and cash equivalents are subject to counterparty risk, meaning there is no guarantee of repayment. Additionally, cash and cash equivalents are subject to market risk, meaning the value of the investment can change quickly and without warning.
- Liquidity: Cash and cash equivalents are highly liquid, meaning they can be converted to cash quickly and without significant cost. However, this liquidity can also be a disadvantage as it can lead to impulsive spending.
- Tax Implications: Cash and cash equivalents are subject to tax implications and may be subject to capital gains taxes. Additionally, some cash and cash equivalent investments may be subject to withholding taxes.
In addition to cash and cash equivalents, there are several other approaches related to short-term, highly liquid debt investments:
- Money Market Funds - Money Market Funds (MMFs) are mutual funds that invest in short-term debt securities such as government bonds, commercial paper, and certificates of deposit. They are considered to be highly liquid, since investors can buy and sell shares in the fund at any time.
- Commercial Paper - Commercial paper is a short-term debt security issued by corporations to raise capital. It is generally unsecured, and maturities typically range from two weeks to nine months.
- Treasury Bills - Treasury bills are government-issued debt securities with maturities of up to one year. They are typically sold in denominations of $1,000, and the interest rate is determined at the time of auction.
- Certificates of Deposit - Certificates of deposit (CDs) are deposit accounts offered by financial institutions. They typically offer higher interest rates than other types of deposits, but require the investor to keep their money in the account for a fixed period of time.
In summary, there are several approaches related to short-term, highly liquid debt investments that can be included in the balance sheet alongside cash and cash equivalents. These include money market funds, commercial paper, treasury bills, and certificates of deposit.
Footnotes
| Cash and cash equivalents — recommended articles |
| Negotiable certificate of deposit — Held to maturity securities — Core Deposits — Bonds in finance — Quick assets — Sinkable bond — Evergreen Loan — Eurocommercial Paper — External sources of finance |
References
- Flood J.M. (2015), Wiley GAAP 2015: interpretation and application of generally accepted accounting principles, Wiley & Sons Ltd, United States of America.
- McLaney E., Atrill P. (2008), Accounting, Pearson Education Limited, Essex.
- Sangiuolo R., Seidman L.F. (2008), Financial instruments: a comprehensive guide to accounting and reporting, CCH, Chicago.
Author: Magdalena Domalik
