Changes in liquidity and risk of cash equivalents

Cash equivalents are short-term, highly liquid investments with a maturity date that was 3 months or less at the time of purchase. In other words, there is very little risk of collecting the full amount being reported. So if a corporate bond matures within three months, but the company that issued it may not be able to settle the debt, one would not be able to include that as a cash equivalent.

Other investments and securities that are not cash equivalents include postage stamps, IOUs, and notes receivable because these are not readily converted to cash.

Cash equivalents are not just the amount of currency that a business has in its cash registers and bank accounts; they also include several different types of financial instruments. Cash equivalents include all undeposited negotiable instruments (such as checks), bank drafts, money orders and certain certificates of deposit.

This 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. Changes in liquidity and risk of cash equivalents

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.

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. During the credit crises and in subsequent years, a number of governments and financial institutions have seen their credit status decline dramatically within a very short period.

Examples of cash equivalents include:

  • Money market accounts Changes in liquidity and risk of cash equivalents
  • U.S. Treasury Bills Changes in liquidity and risk of cash equivalents
  • Commercial paper Changes in liquidity and risk of cash equivalents

Short term maturity three months

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.

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.

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