Q.Give the meaning of 'Cash Equivalents' for the purpose of preparing Cash Flow Statement.
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Start your 14-day free trial to unlock the full solution →Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and subject to insignificant risk of changes in value, typically with original maturity of three months or less.
Concept: Cash Equivalents in Cash Flow Statement
When we prepare a Cash Flow Statement under AS 3 (Accounting Standard 3) or Ind AS 7, the objective is to track the movement of cash and cash equivalents during the period. The statement doesn't just report changes in the bank balance or physical cash; it includes certain near-cash items that are so liquid and stable that they function almost like cash itself.
The reason for this treatment is practical. Enterprises often park surplus funds in very short-term instruments that can be converted to cash within days, with virtually no risk of losing value. Excluding these from "cash" would give an incomplete picture of the entity's liquidity position. A company holding ₹10 lakh in the bank and ₹5 lakh in a 7-day treasury bill is, for all practical purposes, holding ₹15 lakh in liquid resources.
Definition and Characteristics
Cash equivalents are investments that satisfy all three of the following conditions:
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Short-term in nature – They are held for the purpose of meeting short-term cash commitments, not for investment or other purposes.
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Readily convertible to known amounts of cash – The holder can convert them into cash quickly (usually within three months or less from the date of acquisition) and the amount receivable is determinable with certainty. There is no uncertainty about how much cash will be received.
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Insignificant risk of change in value – The investment is not subject to material fluctuations in value. This means the market risk is negligible; the value won't swing up or down significantly between purchase and redemption.
The standard specifically states that investments normally qualify as cash equivalents only when they have a short maturity of, say, three months or less from the date of acquisition. This three-month threshold is a guideline, not an absolute rule, but it is widely followed in practice.
Examples of Cash Equivalents
Common items that meet the definition include:
| Item | Why it qualifies |
|---|---|
| Treasury bills (with original maturity ≤ 3 months) | Government-backed, highly liquid, negligible risk |
| Commercial paper (short-term, high-grade) | Issued by creditworthy corporations, matures in 90 days or less |
| Money market funds | Invest in very short-term instruments, redeemable on demand |
| Short-term deposits with banks (original maturity ≤ 3 months) | Can be withdrawn without penalty, value is fixed |
| Certificate of Deposit (CD) (≤ 3 months) | Marketable, short maturity, stable value |
A bank fixed deposit with an original maturity of six months does not qualify as a cash equivalent, even if only two months remain until maturity at the reporting date. The three-month test applies to the original maturity at the time of acquisition, not the remaining term.
What is NOT a Cash Equivalent
Certain items are excluded because they fail one or more of the three tests:
- Equity shares or equity mutual funds – Subject to significant price fluctuations (risk of change in value).
- Long-term bonds or debentures – Not short-term, and market value can vary.
- Inventory or receivables – Not investments; they are operating assets. …
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