Cash equivalents are:
- Highly liquid
- Short-term investments
- With a maturity of three months or less when they are acquired
These are temporary investments that a company makes with “extra” cash when they have more cash than they will need in the immediate future. The company earns a very low interest rate, but a higher interest rate than letting the money sit in the bank. Also, keep in mind that a very small interest rate applied to a very large number still results in a reasonable amount of interest income.
A cash equivalent is usually an investment of some sort that has a maturity date, so foreign currencies are not cash equivalents. A money market account either in a bank or a money market mutual fund is a cash equivalent, but it does not have a maturity date. Common stock is also not a cash equivalent, though mandatorily redeemable preferred stock may be classified as a cash equivalent if it is acquired shortly before maturity.
For the exam, you need to be aware of how cash equivalents are presented on the balance sheet and on the statement of cash flows.
On the balance sheet, cash equivalents are usually combined with cash and presented as one number labeled “Cash and Cash Equivalents.”
On the statement of cash flows, cash equivalents are not presented. The purchase and sale of cash equivalents are not reported on the statement of cash flow because they are considered to be just transactions “within” cash. This make sense when we consider a small example.
Let us assume that a company has $1,000,000 of extra cash on hand and they invest it in a one-week investment. If they do this each week, this means that they will have spent $52,000,000 purchasing cash equivalents and received $52,000,014 (there will be a small amount of interest) from the sale of cash equivalents. Because of how often these transactions take place, if they were recorded as an Operating (or Investing) activity, this would very possibly be the largest item on the statement of cash flows. But, all the company is doing is, in essence, moving cash from one account to another account.