Understanding cash and cash equivalents

Cash and cash equivalents usually appear first on a company's balance sheet and are central to its cash flow statement. Many see this as the best measure of a business's immediate liquidity. While the line appears straightforward, the rules for what counts as cash or a cash equivalent are stricter than you might expect.

In this article, we’ll explain how UK accounting standards define cash equivalents, how the three-month rule works in practice, which instruments do and don’t qualify, and how FRS 102 applies the same concepts.

Defining cash and cash equivalents

Cash includes physical money and demand deposits, which are bank balances a business can withdraw at any time without a fee. Cash equivalents are investments that are nearly as safe as cash and are unlikely to lose value before the business needs the money. Both are shown together as a current asset on the balance sheet, and the same total is used at the start and end of the cash flow statement.

The IAS 7 definition

UK listed companies follow UK-adopted international accounting standards, including International Accounting Standard 7, Statement of Cash Flows. IAS 7 defines cash equivalents as "short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value". Each part of this definition is a test that an investment must meet to be counted as a cash equivalent.

The purpose test

IAS 7 also says that businesses should hold cash equivalents to cover short-term cash needs. This means purpose matters as much as the investment's features when deciding how to classify it. For example, a short-term bill bought for trading might not count as a cash equivalent, even if its maturity fits the rule.

How the three-month rule works

IAS 7 says an investment usually counts as a cash equivalent only if it matures in about three months or less from the purchase date. The use of "about" means this is a guideline. In practice, most auditors and companies use three months as the standard, and any exceptions need a good reason.

Why the acquisition date matters

The three-month period starts when the business buys the investment, not when it was first issued. For example, a gilt with only six weeks left until maturity can count as a cash equivalent, even if it was originally for several years. A six-month UK Treasury bill held from the start doesn’t count, even in its last month, because it was held for more than three months. The classification is decided at purchase and doesn’t change as the investment nears maturity.

Common examples of cash equivalents

The following instruments frequently qualify as cash equivalents if they meet all the definition tests when bought:

• UK Treasury bills and other government bills with an original maturity of three months or less.
• Term deposits and notice accounts with a term or notice period of three months or less.
• Commercial paper from highly rated issuers with a short original term
• Certificates of deposit maturing within three months of purchase
• Short-dated reverse repurchase agreements
• Certain money market funds, subject to the assessment described below

Term deposits and notice accounts

Deposits that last more than three months but can be withdrawn early without penalty need careful review, as real access terms matter more than the stated term. If breaking the deposit means losing significant interest or principal, it shouldn’t be counted as a cash equivalent. Notice accounts work the same way, with the notice period acting as the maturity date.

Money market funds

Many UK businesses treat public debt constant net asset value and low-volatility net asset value funds as cash equivalents. UK Money Market Funds Regulation defines these funds as short-term vehicles designed to preserve capital. They aim to keep a stable price and allow same-day withdrawals. Variable net asset value and ultra-short bond funds need more review because their prices can change with the market.

The company and its auditors make the final decision based on the fund's portfolio, liquidity terms, and price history. For more details on these fund types, see our guide to money market funds.

What is excluded from cash and cash equivalents?

Some assets may seem very liquid to a treasurer but don’t meet the accounting definition. Equity investments are left out because their value can change a lot, unless they’re truly cash equivalents. IAS 7 gives the example of preference shares bought just before a set redemption date. Listed shares and most other marketable securities are classified as other financial assets, no matter how quickly they can be sold.

Term deposits and bonds that originally last more than three months are usually shown as short-term investments instead. They still count as current assets but are listed separately, and the group records their purchases and maturities under investing activities in the cash flow statement.

Restricted cash

Large amounts of cash that the group cannot use freely must be disclosed, so restricted cash needs careful attention. In 2022, the IFRS Interpretations Committee confirmed that demand deposits with third-party restrictions can still be shown as cash. However, balances held in escrow or as collateral for long-term obligations usually need to be shown separately.

Bank overdrafts

IAS 7 lets companies include bank overdrafts that can be repaid on demand as part of cash and cash equivalents, if they’re a key part of cash management. One sign is an account that often moves between positive and overdrawn. Overdrafts used for long-term funding are shown under financing activities instead.

Cash equivalents under FRS 102

Most UK private companies use FRS 102, which explains the rules for the cash flow statement in Section 7. Its definition of cash equivalents matches IAS 7, including the purpose test, the three-month rule, and how to treat overdrafts repayable on demand. So, the same classification rules apply under both standards.

Who must present a cash flow statement?

Small companies using Section 1A of FRS 102 don’t have to prepare a cash flow statement, but they can choose to do so. Some entities, usually subsidiaries in published group accounts, can also be exempt. The parent company still uses the definition when making the group's consolidated cash flow statement.

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*TreasurySpring’s blogs and commentaries are provided for general information purposes only, and do not constitute legal, investment or other advice.