Chapter 2: Cash and cash equivalents

A cash flow statement should focus on identifying the cash effects of transactions with parties that are external to the reporting entity and their impact on its cash position. Only those transactions that involve a cash flow should be reported in the cash flow statement. Cash flows are defined as “inflows and outflows of cash and cash equivalents”.

Central to the cash flow statement preparation are the definitions of ‘cash’ as “cash on hand and demand deposits” and ‘cash equivalents’ as “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”.

Classification of demand deposits Question: What instruments are included as ‘demand deposits’ in the definition of ‘cash’? Answer: The definition of ‘cash’ includes cash on hand and demand deposits. No guidance is given for the definition of ‘demand deposit’. However, these are generally accepted to be deposits with financial institutions that are repayable on demand and available within 24 hours, or one working day, without penalty. Demand deposits will include accounts where additional funds could be deposited at any time and funds withdrawn at any time without prior notice (For example, a bank current account).

Examples of instruments classified as cash equivalents Question: What instruments can be included in ‘cash and cash equivalents? Answer: Investments that qualify as cash equivalents are not restricted to investments with financial institutions, such as banks, but might include short-term gilts, certificates of deposits, certain money market instruments and short-term corporate bonds, where these meet the definition of cash equivalents. Items that are denominated in foreign currencies might also be cash and cash equivalents.

Interpreting the ‘cash’ and ‘cash equivalents’ definitions Question: What is meant by “short-term, highly liquid investments”, “readily convertible to known amounts of cash” and “subject to an insignificant risk of changes in value” in the definition of ‘cash equivalents? Answer: Many short-term instruments are readily convertible to known cash amounts, but only those highly liquid instruments that are also subject to insignificant risk of changes in value can be classified as cash equivalents. The term ‘readily convertible’ implies that the investment would be convertible into cash without an undue period of notice and without incurring a significant penalty on withdrawal. An investment with a maturity period of three months or less from the acquisition date will generally qualify as a cash equivalent, provided that it is used for cash management purposes. Any investment, such as a government bond or a deposit certificate, purchased with a maturity period of more than three months, without an early redemption option, will not be a cash equivalent, because its maturity period exceeds the short-term period suggested by the standard. Moreover, such an investment will not become a cash equivalent when its remaining maturity period (measured from a subsequent balance sheet date) becomes three months or less, because the maturity period is measured from the acquisition date. The limit on maturity is arbitrary, but it reinforces that the amount of cash receivable should be known at the time of the initial investment and be subject to an insignificant risk of change in value in response to changes in interest rates and capital values. There could be limited circumstances in which deposits with a term of more than three months might be classified as cash and cash equivalents. Term deposits for longer than three months that can be redeemed, subject to the interest income being forfeited, might be classified as cash equivalents if the deposit is held to meet short-term cash needs and there is no significant risk of a change in value as a result of an early withdrawal. The deposit terms should be considered carefully, to determine whether there is a more than insignificant risk of changes in value. The longer the deposit’s term, the less likely it becomes that the instrument is being held to meet short-term cash needs and is subject to insignificant changes in value. Judgement is necessary to determine the appropriate classification. Monies deposited in a bank account for an unspecified period, but which can only be withdrawn by advance notice, should be evaluated carefully, to determine whether they meet the definition of ‘cash and cash equivalents. Factors to be considered include whether there are other restrictions on the withdrawal, the advance notice period, the risk of significant change in value during that period, and whether management intends to use the deposits to meet short-term cash commitments. A deposit having a short maturity period, with no early redemption option, might still be considered ‘readily convertible’, and be included as cash and cash equivalents, if the other conditions are met. In most cases, a deposit subject to negative interest rates would still meet the definition of ‘cash equivalents’ if it is considered to be ‘readily convertible’. Each situation’s facts, including how management intends to use the deposits, should be taken into account, to determine the deposit’s classification in the cash flow statement. For example, a deposit that is repayable with 24 hours’ notice, without loss of interest earned, would qualify as a cash equivalent, because it has a short maturity (repayable with 24 hours’ notice) and there is an insignificant risk of change in value (no loss of interest). This contrasts with a two-year term deposit with a bank, whereby the deposit is repayable with 24 hours’ notice but the entity incurs a penalty with the loss of all interest earned. Although the principal remains unchanged, the entity will lose accumulated interest over the two years on the underlying deposit. Management should consider whether the loss of all interest is significant and exposes the instrument to the risk of a change in value, in determining whether it will qualify as a cash equivalent. Deposits for periods in excess of three months, and that forfeit interest in early redemption, will often not qualify as cash equivalents.

Assessing short-term investments with substantial credit risk Question: Can a short-term investment be classified as a cash equivalent where the counterparty is experiencing financial problems? Answer: Where the counterparty to any short-term investment experiences financial problems, there might be doubt over its ability to fulfil the agreement’s requirements. In such circumstances, the investment should not be classified as a cash equivalent, because there is a risk that the instrument will not be readily convertible or that the redemption obligation will not be met.

Mandatory average minimum deposits Question: Are mandatory average minimum deposits classified as ‘cash and cash equivalents? Answer: Entities are sometimes required, either by their banks or by regulators, to maintain an average minimum cash balance on a rolling basis. For example, an entity might be required to maintain an average minimum cash balance over a period of 20 days, instead of maintaining a minimum cash balance at the end of each day. The entity might be permitted to have balances below the threshold for certain days, so long as adequate surplus exists on other days to make good the average minimum balance for the period. Such balances that are subject to mandatory minimum deposits are treated as cash and cash equivalents. An average cash balance is required to be maintained for the period, although the balance can be withdrawn on demand, similar to a demand deposit. On this basis, we consider that such balances meet the definition of “cash comprises cash on hand and demand deposits”. Entities should consider disclosing information regarding the arrangement, including any amounts that the entity is unable to use at the reporting date due to past shortfalls.

Bank overdrafts that are repayable on demand and that are integral to the entity’s cash management can be included as a component of cash and cash equivalents. A characteristic of such banking arrangements is that the bank balance often fluctuates from being positive to overdrawn.

Balance sheet classification of bank overdrafts that are cash and cash equivalents Question: If a bank overdraft is repayable on demand and integral to an entity’s cash management, should the bank overdraft be classified as ‘cash and cash equivalents’ in the balance sheet? Answer: No, unless the conditions for offset in paragraph 42 of IAS 32 are met. Instead, the bank overdraft is included within financial liabilities in the balance sheet. The fact that the bank overdraft is classified as ‘cash and cash equivalents’ for the purpose of the cash flow statement does not mean that the overdraft should be removed from the liability side of the balance sheet and offset against the cash balance on the asset side (or vice versa). The components making up the cash and cash equivalents’ total opening and closing balances in the cash flow statement should be disclosed and reconciled to the appropriate balance sheet line items.

Short-term loans and credit facilities Question: An entity has a banking arrangement whereby it can place cash on deposit or draw down amounts under the credit facility to meet short-term cash needs. The terms of the arrangement are that any amount drawn can be demanded by the bank with 14 days’ notice. Can amounts borrowed under the credit facility be presented as a component of cash and cash equivalents? Answer: No. IAS 7 requires any bank borrowings included as a component of cash and cash equivalents to be repayable on demand and to form an integral part of the entity’s cash management. This was confirmed by the IFRS IC in an agenda decision in June 2018.

To be a cash equivalent, an investment will normally have a ‘short maturity’. The standard suggests that a short maturity period would be three months or less, commencing from the investment’s acquisition date. The use of a short maturity period, when considering investments as cash equivalents, incorporates the fact that the investments should be so near to cash that there is insignificant risk of changes in value.

Furthermore, for a security to be a cash equivalent, it should not only be readily convertible and have a short maturity but it should also be considered as a cash equivalent by the entity that holds it. That is, the entity considers it as a means of settling liabilities and not as an investment or for any other purpose.

Short-term investments as cash equivalents Question: Can a short-term investment be classified as a ‘cash equivalent’? Answer: Short-term investments will meet the definition of ‘cash equivalents’ and will be presented as cash equivalents only where they are held only as a means of settling liabilities, and not as an investment or for any other purpose. For example, banking entities might decide to treat all short-term highly liquid investments, excluding those which are held within a business model under IFRS 9 whose objective is achieved by selling the investment, as cash equivalents; in contrast, an investing entity might decide to treat all of its short-term highly liquid investments as investments rather than cash equivalents.

Consideration of maturity period from acquisition date Question: An entity purchased a bond on 1 October 20X6. The bond’s maturity date is 28 February 20X7 and the entity’s financial year end is 31 December 20X6. The bond cannot be withdrawn early under any circumstances. Should the bond be classified as a cash equivalent at the year ended 31 December 20X6? Answer: No. At the acquisition date, the bond’s maturity is five months. This does not comply with the requirement for a short maturity of three months or less from the acquisition date. The fact that the bond matures less than three months from the balance sheet date will not result in its classification as a cash equivalent at that point. The maturity period is assessed from the acquisition date, and not from the balance sheet date.

Auction rate securities Question: Can auction rate securities (ARSs) be classified as ‘cash equivalents? Answer: An entity purchases ARSs. The interest rate on the securities is reset every 28 days, based on market demand. The contractual maturity is one year. However, the ARSs are priced and subsequently traded like short-term investments, because of the interest rate reset feature. The ARSs are bought and sold in the market through a bidding process, and there is a liquid and active market for them. ARSs’ investors rely on third parties, and not the issuer, to provide current liquidity. However, regardless of this, the securities’ legal maturity period is greater than three months on the acquisition date. Therefore, the securities do not meet the ‘cash equivalents’ definition.

The standard specifically excludes equity investments from cash equivalents, unless they are, in substance, cash equivalents. This is due to the high risk of changes in capital value, despite the instruments being readily marketable and convertible into cash. An investment in shares, For example, could be classified as a cash equivalent where preference shares have been purchased with a set redemption date and a short maturity period.

Money market funds Sometimes, instead of investing separately in money market instruments, an entity might invest in a money market or liquidity fund (MMF). An MMF is an open-ended mutual fund that invests in short-term debt instruments (typically one day to one year) such as treasury bills, certificates of deposit, bonds, government gilts and commercial paper. The main goals are the preservation of principal, high liquidity and a modest incremental return over short-term interest rates or a benchmark rate. Therefore, an MMF’s per unit net asset value remains fairly constant over time. Question: Can an investment in an MMF be classified as a cash equivalent? Answer: MMFs can be classified as debt or equity instruments, depending on their characteristics. This classification would be made by applying the guidance in IFRS 9. Entities need to assess whether MMFs meet the definition of ‘cash and cash equivalents. This is a separate assessment from the classification required under IFRS 9. The IFRS IC noted, in an agenda decision, that some MMFs could, in substance, meet the definition of cash equivalents, where the purpose is to meet short-term cash commitments, the MMF is convertible into a known amount of cash, and it is subject to an insignificant risk of changes in value. This means that the cash amount that will be received on redemption should be known at the time of the initial investment. It is not sufficient that the instrument itself is readily convertible into cash and has a determinable market value. Instead, it means that, at the time of the initial investment, the entity is satisfied that the risk of changes in value is insignificant and that therefore the amount of cash to be received on redemption is known. Possible approaches to such an assessment include either of the following: Approach 1: ‘Look to’ the fund unit to establish whether the unit qualifies as cash and cash equivalents Strict stated fund management policies and controls mean that the investment in the fund unit itself meets all of the criteria for classification as cash equivalents (that is, it is short term, highly liquid, readily convertible to known amounts of cash, and subject to an insignificant risk of changes in value). This usually implies that those policies have been established by a local regulator, that a process and controls exist to ensure an effective application of these policies, and affiliation to, or membership of, a money market association that ensures maintenance of high standards. Examples of policies and controls that might be expected in combination to meet IAS 7 criteria include the following: 1. Short term and highly liquid a. Policies and controls to ensure that the investment is short term: The MMF investment is puttable, with no more than a short notice period. b. Policies and controls to ensure that the fund is able to honor redemption requests from    investors, including during times of market stress: Those policies might cover matters such as minimum daily / weekly maturing assets, stress testing and ‘Know your Investor’ procedures. Liquidity gates designed to limit redemptions in times of market stress should be carefully assessed, but they would not necessarily preclude classification as cash and cash equivalents. c. Policies and controls to ensure that the investment is readily convertible to known amounts of cash and subject to insignificant risk of changes in fair value that are listed at (2) below: This reflects that a lower risk of changes in fair value indicates that it is more likely that the investment is liquid. 2. Readily convertible to known amounts of cash and subject to an insignificant risk of changes in value Policies and controls to ensure a linear performance, with an objective to limit volatility to a very small percentage (typically, no greater than 0.5%), which is supported by actual performance and that suggests an insignificant risk of changes in value. Such policies and controls should also ensure: a)      Low credit risk exposure: For the fund, a high available credit rating for the fund if it is rated itself, when compared to a demand deposit at a banking institution in the territory in which the fund is based that would itself be cash and cash equivalents. For the underlying assets of the funds, policies and controls to ensure that the portfolio comprises investments in high-quality (and, typically, short-term) assets and is highly diversified (that is, typically no more than 10% per issuer). In assessing credit risk, both the level of diversification of the portfolio and its weighted average life (WAL) should be considered, since the level of diversification does not address the risk of a market-wide change in the price of credit risk. The WAL measures the weighted average residual maturity of the MMF’s portfolio and is a measure of its credit and liquidity risk. The higher the WAL, the higher the exposure to both credit and liquidity risk, because there is a longer period of time before both the returns on the MMF’s assets are adjusted to current credit spreads and the assets held by the MMF mature. b)     Low interest rate risk exposure: A return benchmarked to short-term money market interest rates. The weighted average maturity (WAM) measures the weighted average period until the next repricing of the assets held by the fund. It is used to assess the sensitivity of the assets to changes in the benchmark interest rate. The higher the WAM, the higher the exposure to benchmark interest rate risk, because there is a longer period of time before the assets held by the MMF reprice to current benchmark interest rates. Investments that have a WAM higher than 90 days would be presumed to fail this criterion. The Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO) highlighted that, in stress conditions, the difference between the CNAV of the fund and the VNAV of the fund could trigger substantial and sudden redemption requests; the fund will have to sell its assets at their fair value to honor redemptions, and the differences between their amortized cost and fair value will have to be spread over fewer investors, which will amplify the losses in the value of the fund. Therefore, entities should pay particular attention to controls to honor redemption requests and to ensure liquidity (as listed in 1(b) or (c) above) for CNAV funds. For CNAV funds, such policies and controls should be based on the variable net asset value of the fund which is disclosed by the asset manager rather than on the CNAV. Liquidity fees designed to limit redemptions in times of market stress should be assessed in order to ensure that their amount does not preclude there being an insignificant risk of changes in value. Taking into account all of the considerations above, the definition of a cash equivalent might be met. Approach 2: ‘Look through’ the fund to establish whether substantially all of its investments qualify individually as cash and cash equivalents This approach is only acceptable for funds that contain a put option exercisable with a short notice period, and it should cover all potential investments allowed by the investment rules set for the fund, and not only the assets that the fund holds as of the evaluation date. Investments whose maturity is more than three months typically do not qualify individually as cash and cash equivalents. Whichever of the two approaches is used, where a third party, such as an MMF institution, has suggested a classification for a particular MMF category, the entity should assess that suggestion against the definition of cash and cash equivalents and the guidance above. Entities should also confirm the classification of MMFs at each reporting date.

Recognition and measurement of cash and cash equivalents Question: At what amount should cash and cash equivalents be recognized? Answer: Cash is recognized initially at the amount received by the entity or the amount received into the entity’s bank account. Cash equivalents should initially be recognized at fair value in accordance with IFRS 9. Fair value would normally be the transaction price paid to acquire the cash equivalent.

An entity should disclose the policy that it adopts in determining cash equivalents. Changes to that policy are treated as a change in accounting policy.

Transfers of monies between deposits or investments that qualify as cash and cash equivalents do not result in cash inflows and outflows on the cash flow statement but are merely movements within the overall cash and cash equivalents balance.

Transfers between demand deposits and overdrafts Question: An entity transfers amounts from a demand deposit account to reduce its overdraft. Is this transfer reflected as a cash flow in the cash flow statement? Answer: Where the overdraft forms part of cash and cash equivalents, this transfer is an intra-cash and cash equivalents movement that would not be reflected as a cash flow.

Charges and credits on accounts or investments qualifying as cash and cash equivalents Question: Should an entity reflect charges and credits on accounts or investments qualifying as cash and cash equivalents in the cash flow statement? Answer: All charges and credits on accounts or investments qualifying as cash and cash equivalents represent the reporting entity’s cash inflows and outflows. This includes bank interest, bank fees, deposits or withdrawals other than movements wholly within them. As such, these items should be reflected in the cash flow statement.

Changes in exchange rates will increase or decrease the cash and cash equivalents balances where the entity holds foreign currency cash and cash equivalents. These changes do not give rise to cash flows. However, these gains or losses are presented on the face of the cash flow statement (to reconcile the cash and cash equivalents at the beginning and end of the period) separately from cash flows from operating, investing, and financing activities.

The components making up the cash and cash equivalents’ total opening and closing balances in the cash flow statement should be disclosed and reconciled to the appropriate balance sheet line items for cash and cash equivalents.

Reconciliation of cash and cash equivalents in the cash flow statement to balance sheet line items Question: What information should be shown to reconcile cash and cash equivalents in the cash flow statement to balance sheet line items? Answer: The reconciliation between opening and closing cash and cash equivalents is relatively straightforward; the cash and cash equivalents’ opening balance, together with the increase or decrease in cash and cash equivalents as shown in the cash flow statement, equals the closing balance. However, the totals for cash and cash equivalents might not be readily identifiable if they relate to different balance sheet accounts. Cash and cash equivalents according to the cash flow statement are not necessarily the same as the single figure on the balance sheet. For example, bank overdrafts that are treated as cash equivalents, but are included elsewhere within current liabilities, should be separately identified in the reconciliation. Where an entity has other short-term highly liquid investments that meet the definition of cash equivalents, the entity might present this as part of the sub-total of cash and cash equivalents on the balance sheet or in the notes to the financial statements. In all cases, sufficient detail should be shown to enable the reconciliation to be understood.