Companies own current assets that help them generate revenues. These assets typically last fewer than 12 months in a normal business. Accountants also use designations for specific items in the current asset classification. One such designation is cash equivalents. This designation indicates a company owns assets that are similar to cash in nature and must have specific characteristics.
Cash equivalents include any short-term investments that have a high credit rating. They also carry a low investment risk, meaning the chance of default is low. Common types include U.S. Treasury bills, certificates of deposit, corporate commercial paper, money markets and certain types of savings accounts.
Accountants can only classify highly liquid investment instruments as cash equivalents. High liquidity indicates a company can convert investments to cash in a short time period. In some cases, a company may be able to assign the rights of these instruments to another party. This can also meet the liquidity requirement.
Companies use cash equivalents to earn interest on cash balances. This can help a company earn small amounts of interest while retaining high cash balances. Companies will only invest in short-term cash equivalent instruments if they plan to use the cash within the next few months. Retaining cash for longer time periods can result in searching for higher returns on investments.
Accountants report cash equivalents below the company’s cash account on the balance sheet. Only the historical money spent on the instruments go on this balance sheet line. Interest earned from the investments go on the company’s income statement as interest revenue.
- "Fundamental Financial Accounting Cencepts"; Thomas P. Edmonds, et al.; 2011