Part 3 – All the money in the bank and…
The ASB recently completed a review of entities’ compliance with GRAP 2 on Cash Flow Statements.
GRAP 2 says that “cash equivalents are held for the purpose of meeting short-term cash commitments rather than for investment or other purposes. For an investment to qualify as a cash equivalent it must be readily convertible to a known amount of cash and be subject to an insignificant risk of changes in value. Therefore, an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less from the date of acquisition.” [Own emphasis added]
The review found that preparers often incorrectly classify financial assets as cash and cash equivalents when preparing the cash flow statement. Preparers often use the “3 months or less” as an absolute rule when classifying items as cash or cash equivalents.
The maturity of 3 months is not a “bright line” that should be applied by preparers. Preparers should consider whether financial assets meet the definition of cash and cash equivalents in GRAP 2 and consider the reason why the financial asset is held.
Definition
There are three elements that entities should consider:
- Short term, highly liquid
Financial assets with a short maturity meet the definition of a cash equivalent. While the Standard refers to an investment with a maturity date of three months or less from the date of acquisition, this does not automatically mean that an investment with a maturity date of more than three months cannot be classified as a cash equivalent. Note that the maturity period is measured from the date of acquisition, not the reporting date.
- Readily convertible to known amounts of cash
A financial asset must be convertible into cash without an undue period of notice and without incurring a significant penalty on withdrawal. “Known amounts of cash” means that the amount of cash that will be received must be known at the time of the initial investment. Financial assets in shares, or units of money market funds that are redeemable at any time, are not considered cash equivalents, even though they can be converted to cash at any time at a market price in an active market. This is because the share price or unit price fluctuates and the amount of cash for which the shares or units of money market funds can be exchanged, are not known at initial acquisition.
- Insignificant risk of change in value
A financial asset must be similar to cash so that any changes in value are insignificant. For this reason, a short maturity period is necessary because a longer maturity period exposes an investment to fluctuations in value. Entities should consider the effect on the redemption amount of e.g. cancellation clauses, termination fees or usage restrictions and whether they create a more than insignificant risk of change in value.
It is important to note that bank overdrafts that are repayable on demand usually form part of an entity’s cash management activities and are part of cash and cash equivalents. Bank borrowings however are not cash and cash equivalents.
Purpose of holding an investment
An entity should assess why it is holding an investment, which would be reflected in the way in which the entity has invested the funds. For example, if the purpose of holding an investment is to meet short-term cash commitments to fund on-going operations or settle liabilities in the short-term, an entity would invest it for only a short period of time in a way that resembles cash.
Accounting policy
As entities may have a variety of cash management practices and banking arrangements that will influence what is classified as cash and cash equivalents, the accounting policy for cash and cash equivalents should explain its composition.
The ASB recently completed a review on compliance with GRAP 2 on Cash Flow Statements and will issue a Research Paper outlining its findings in June 2021
Useful links:
GRAP 2 on Cash Flow Statements: access.
FAQ 3.5 on What items should be included in “cash and cash equivalents”?:access.
Disclaimer
This content has been prepared by the Secretariat of the ASB for information purposes only. It has not been reviewed, approved or otherwise acted on by the Board.