Cash and Cash Equivalents

Cash and cash equivalents form the foundation of the cash flow statement. Without a clear definition of what counts as "cash," the entire statement would be ambiguous. The Accounting Standard AS-3 provides this definition, and it is broader than just currency notes and coins.

Cash includes two things:

• Cash in hand (physical currency and coins)
• Demand deposits with banks (money in a savings or current account that you can withdraw on demand, without any notice period)

Cash equivalents are short-term, highly liquid investments that meet two strict conditions:

1. They are readily convertible into a known amount of cash.
2. They carry an insignificant risk of change in value.

The key test for a cash equivalent is its maturity period. An investment normally qualifies as a cash equivalent only if it has a short maturity — specifically, three months or less from the date of acquisition. This three-month rule is measured from when you buy the investment, not from when it was originally issued.

What qualifies as a cash equivalent?

• Short-term marketable securities that can be sold immediately without a significant change in value.
• Preference shares of a company acquired shortly before their specific redemption date, provided there is only an insignificant risk that the company will fail to repay the amount at maturity.

What does NOT qualify?

• Investments in shares are generally excluded from cash equivalents. The only exception is when those shares are themselves substantial cash equivalents — for example, preference shares bought just before redemption, as mentioned above. Ordinary equity shares are never cash equivalents because their value fluctuates significantly.

Why this distinction matters for accounting treatment

The cash flow statement records inflows and outflows of both cash and cash equivalents. When you buy a cash equivalent (like a 3-month treasury bill), you are not making an "investment" in the cash flow sense — you are simply converting one form of cash (bank balance) into another (treasury bill). Therefore, such a purchase does not appear as an outflow in the cash flow statement. Similarly, when the treasury bill matures and you receive cash, it is not an inflow — it is just a conversion back.

The accounting entry for acquiring a cash equivalent

When a company buys a short-term treasury bill (say, for ₹1,00,000) that qualifies as a cash equivalent:

Notice that both accounts are part of "cash and cash equivalents" — one decreases (bank) and the other increases (treasury bills). The total of cash and cash equivalents remains unchanged. Therefore, this transaction does not appear in the cash flow statement.

The accounting entry for selling a cash equivalent before maturity

If the treasury bill is sold before maturity (say, for ₹1,00,500):