The statement of cash flows shows the movement in cash and cash equivalents between the start of the period and the end of the period. Therefore, it is evident that the definitions of these terms are extremely important for its proper preparation.
Under IAS 7:
- Cash comprises cash on hand and demand deposits.
- Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and that are subject to an insignificant risk of changes in value.
The standard does not define ‘short-term’, but does state that ‘an investment normally qualifies as a cash equivalent only when it has a short maturity (i.e. 3 months or less from the date of acquisition)’.
This 3 month time limit is somewhat arbitrary, but is consistent with the concept of insignificant risk of changes in value and a purpose of meeting short-term cash commitments.
In limited circumstances, a longer-term deposit with an early withdrawal penalty may be treated as a cash equivalent. In such a case, the terms of the arrangement need to be considered for each deposit.
ABC Ltd decided to deposit $20m with DEF bank in two term deposit accounts as follows:
- $14m into a 12 month term account, earning 3,5% interest. The cash can be withdrawn by giving 7 days’ notice but the entity will incur a penalty, being the loss of all interest earned.
- $6m into a 12 month term account earning 3% interest. The cash can be withdrawn by giving 14 days’ notice. Interest will be paid for the period of the deposit but only at the rate of 2,5%, which is equivalent to the bank’s stated rate for short-term deposits.
ABC Ltd is confident that they will not need to withdraw the cash from the higher-rate deposit within the term, but want to keep easy access to the remaining $6m to cover any working capital shortfalls that might arise.
- The $14m on deposit for 12 months can be withdrawn early, but the penalty (i.e. loss of all interest earned) is so significant as to indicate that the cash is not intended to meet short term cash commitments. Therefore, this investment would not qualify as a cash equivalent.
- In the second case, although the $6m deposit is stated to have a 12 month maturity period, it can be withdrawn with 14 days’ notice. Here, the penalty for early withdrawal is much less severe compared to the first deposit. The reduction in the rate of interest from 3% to 2,5% is unlikely to be considered significant. The intention of management is to keep these funds available for short-term cash needs and so this deposit is likely to qualify as a cash equivalent.