Cash and Cash Equivalents
According to International Accounting Standard 7 (IAS 7), Cash “comprises cash on hand and demand deposits”. And cash equivalents “are 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”.
Cash is the money in the form of currency. Currency includes currency notes and coins. Any currency notes and coins held by an enterprise are part of the term “cash”.
Demand deposit is a type of an account from which funds can be withdrawn at any time without having to inform the bank or depository institution. Most of the checking and saving accounts are demand deposits.
Cash equivalents are investments that can be readily converted to cash. Common examples of cash equivalents include commercial paper, treasury bills, short term government bonds, marketable securities, and money market holdings. An item should satisfy the following criteria to qualify for cash equivalent.
- The investment should be short term. They should mature in less than three months. If they mature in more than three months they will be classified as other investments.
- They should be highly liquid. This means that they should be easily sold in the market. The buyers of these investments should be easily available.
- They should be convertible to known amounts of cash. This means that their market price should be available and this market price should not be subject to significant fluctuations.
- They should not be too risky. There should be very little risk of changes in their value. This means that equity shares cannot be classified as cash equivalents. But preferred shares purchased shortly before the redemption date can be classified as cash equivalents.
In short, cash and cash equivalents mean the cash and those assets which are immediately convertible to cash. Cash and cash equivalents are the most liquid assets of any business. Cash and cash equivalents are very important for the liquidity of a business. A company should have sufficient cash and cash equivalents to meet its urgent liabilities when they fall due.