Note 1 Cash and cash equivalents

Definition of cash and cash equivalents

IAS 7.6 includes the following definitions:

Cash’:

  • Cash on hand (physical currency held), and
  • 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.

IAS 7.7 then notes that cash equivalents are held for the purpose of meeting short term cash commitments rather than for investment or other purposes. IAS 7.7 also notes that:

‘…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.’

Demand deposits

Demand deposits are not defined in IFRS. However, in order to qualify 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balance needs to have the same liquidity as cash itself, and so funds on ‘demand deposit’ need to be capable of being withdrawn at any time without penalty.

In general, deposits which can be withdrawn without penalty within 24 hours, or one working day, are regarded as being demand deposits.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 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.

Consider this!

Questions arise about whether investments that can be withdrawn on demand (e.g. money market funds) could qualify to be regarded as cash equivalents.

In general, this is possible, but only in very limited circumstances.

This is because, in addition to the existence of the demand feature, all of the other requirements of IAS 7 need to be met. An interest bearing deposit at a financial institution might result in the amount of cash that would be received being known, and there might be an insignificant risk of changes in value (in particular in the current low interest rate environment), even if there is an early withdrawal penalty.

However, it is also necessary for it to be demonstrated that the investment is being held for the purpose of meeting short-term cash commitments rather than for investment or other purposes (IAS 7.7).

It may be difficult to reconcile this last requirement to the characteristics of the investment, particularly as its maturity (excluding the demand feature) increases.

Short term maturity

Although the reference to three months in IAS 7.7 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.

Consider this!

The reference in IAS 7 to three months is often interpreted as meaning that this time period is by itself sufficient to reach a conclusion that an investment would not be subject to a more than insignificant risk of changes in value.

However, this is not an automatic qualification, and it is still necessary to consider other attributes of short term investments.

It is possible that an entity would be able to invest funds on a short term basis at a high rate of return that would put these funds at a more than insignificant risk of changes in value (for example, investments with low credit ratings such as certain asset backed securities).

In these cases, the investments would not be regarded as being cash equivalents because they are subject to a more than insignificant change in value.

Investments in equity instruments

In almost all cases, investments in equity instruments are excluded from being classified as cash and 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.

Changes in liquidity and risk

The definition of cash equivalents makes reference to them being both highly liquid and subject to an insignificant risk of changes in value. IAS 7 does not include any specific requirement to revisit either of these criteria after the initial recognition of a cash equivalent.

In general, amounts that initially meet the definition of cash equivalents would not be expected to be subject to 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.

Consider this!

This represents a less obvious feature of cash equivalents which is easily missed. At each reporting date, entities need to consider whether there are any indicators that items previously classified as cash equivalents now fail to meet the classification criteria.

In recent years, a number of governments and financial institutions have seen their credit status decline dramatically within a very short period.

Cryptocurrencies

IFRS does not contain specific accounting requirements for cryptocurrencies. However, at its June 2019 meeting, the IFRS Interpretations Committee discussed how existing IFRS Standards apply to holdings of cryptocurrencies and issued an Agenda Decision in which, among other things, it was concluded that a cryptocurrency is not cash.

For the purposes of its discussion, the Interpretations Committee considered cryptocurrencies with the following characteristics:

  • A cryptocurrency is a digital or virtual currency that is recorded on a distributed ledger and uses cryptography for security.
  • A cryptocurrency is not issued by a jurisdictional authority or other party.
  • A holding of a cryptocurrency does not give rise to a contract between the holder and another party.

As part of its analysis, the Interpretations Committee considered whether a cryptocurrency is cash. It noted that IAS 32.AG3 states that:

Currency (cash) is a financial asset because it represents the medium of exchange and is therefore the basis on which all transactions are measured and recognised in financial statements. A deposit of cash with a bank or similar financial institution is a financial asset because it represents the contractual right of the depositor to obtain cash from the institution or to draw a cheque or similar instrument against the balance in favour of a creditor in payment of a financial liability.’

The description of cash in IAS 32.AG3 implies that cash is expected to be used as a medium of exchange (ie used in exchange for goods or services) and as the monetary unit in pricing goods and services to such an extent that it would be the basis on which all transaction are measured and recognised in financial statements.

Although some cryptocurrencies can be used in exchange for particular goods or services, the Interpretations Committee noted that it was not aware of any cryptocurrency that is used as a medium of exchange and as the monetary unit in pricing goods or services to such an extent that it would be the basis on which all transactions are measured and recognised in financial statements. Consequently, the Interpretations Committee concluded that a holding of cryptocurrency is not cash because cryptocurrencies do not currently have the characteristics of 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 a cash and cash equivalent, and would therefore be presented within cash and cash equivalents, rather than financing cash flows.

At its June 2018 meeting, the IFRS Interpretations Committee (the Committee) discussed the circumstances in which short-term loans and credit facilities may be presented as a component of cash and cash equivalents.

In the fact pattern:

  1. The entity has short-term loans and credit facilities that have a short contractual notice period (e.g. 14 days);
  2. The entity says it uses the short-term arrangements for cash management; and
  3. The balance of the short-term arrangements does not often fluctuate from being negative to positive.

The Committee observed that an entity generally considers bank borrowings to be financing activities, not a component of cash and cash equivalents. The Committee observed that bank borrowings are a component of cash and cash equivalent only in the particular circumstances noted in IAS 7.8: the arrangement is a bank overdraft that is payable on demand and forms an integral part of the entity’s cash management. Therefore, a short-term financing arrangement cannot form a component of cash and cash equivalents unless it is due on demand.

The Committee observed that for a facility to form an integral part of the entity’s cash management, it must use the facility in order to meet short-term cash commitments rather than for investing or other purposes. The Committee also noted that if the balance of a banking arrangement does not often fluctuate from being negative to positive, then the arrangement would generally not form an integral part of the entity’s cash management. If the facility is consistently in a negative position, then it is a form of financing.

Therefore, based on the fact pattern provided, the 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.

Cash pool systems

Larger reporting entities often use centralised cash management functions involving sweep accounts, as well as centralised cash collection and payment centers. Although not required by any specific IFRS standard it seems to make sense to separate cash and cash equivalents in a group’s cash pool system from cash and cash equivalents outside the group’s cash pool system.

Restricted cash and cash equivalents

Restricted cash and cash equivalent balances are those which meet the definition of cash and cash equivalents but are not available for use by the group. In practice, these balances may arise when a subsidiary in a group operates in a jurisdiction where there are legal restrictions or foreign exchange controls that restrict the group’s access to, and use of, the subsidiary’s cash balances. They can also arise from ‘pledged’ bank balances and amounts placed in escrow accounts.

Although these types of restrictions do not affect the presentation of the statement of cash flows, IAS 7.48 requires an entity to disclose the existence of any significant restricted cash balances, together with narrative commentary. This is normally included as part of the notes to the financial statements, with a separate line item in the primary financial statements for ‘restricted cash and cash equivalents’.

Interaction with IAS 1

IAS 1 Presentation of Financial Statements paragraph 66(d) requires an entity to classify an asset as current when:

‘…the asset is cash or a cash equivalent (as defined in IAS 7) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period.’

Although most cash and cash equivalents will be classified as current, it is important to understand the effects of any restrictions that are placed over the timing of use of those assets.

Foreign currency differences

Cash flows arising from an entity’s foreign currency transactions are translated into the functional currency at the exchange rates at the dates of the cash flows. Cash flows of foreign operations are translated at the actual rates (or appropriate averages). The effect of exchange rate changes on the balances of cash and cash equivalents is presented as part of the reconciliation of movements therein. [IAS 7 25–28]


That cash (and cash equivalents) matters makes sense: CASH IS KING is not just a saying……

“Better one byrde in hande than ten in the wood.”  -John Heywood, the 16th century collector of proverbs

Bankers love liquidity. Liquidity refers to the rate at which an asset can be converted into cash and cash is king to the banker. If cash is king, then cash equivalents are the heirs to the throne. Cash equivalents represent the highest cushion of protection against a loss for the banker because they offer the highest rate of liquidity.

In other words, cash equivalents are viewed by credit analysts as almost the same as cash. This is why cash equivalents are so important — they are as good as the “one byrde in the hande” to banks. An increase in cash equivalents equals higher liquidity. A company with higher liquidity ratios is considered healthier and poses less of a risk. This company will also receive a lower interest rate on debt borrowings, which translates into higher profitability.

A Lesson From Tulipmania

In 1593 tulips were introduced to the Dutch. Some tulips contracted a virus which created unique color patterns. These color patterns increased the value of tulip bulbs. People went crazy and began trading land, life savings and anything they could to buy these bulbs. The bubble burst in 1637. A panic ensued as dealers refused to honor their contracts and that panic was followed by a depression. Bankers that categorized tulips as a cash equivalent were eventually burned. Tulips were highly liquid investments, but they also had a high risk profile.

Example 1 of disclosure cash and cash equivalents

And here is a more current example disclosure on cash and cash equivalents (IAS 7.8 (bank overdrafts), IAS 7.45 (tables and details), IAS 7.46 (cash equivalents), IAS 7.48 (restricted cash)):

Cash and cash equivalents

 

Example 2 of disclosure cash and cash equivalents

and one other example:

Cash and cash equivalents

Note 3 (in part)

(part of risk management disclosure)

Cash and cash equivalents

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