Cash equivalents are financial securities which can be sold quickly and without impairment in value. Common cash equivalent securities include U.S. Treasury bills and commercial paper.
For accounting purposes, cash (bank balances and petty cash) and cash equivalents are lumped together into a single account on the balance sheet. This account is usually called cash and equivalents.
Firms purchase cash equivalent securities for two basic reasons. First, larger bank balances are not explicitly covered by deposit insurance. Second, firms look to capital markets for better returns on their cash.
Large firms have corporate treasury departments to manage their corporate cash. Smaller firms generally outsource this function to financial institutions such as commercial banks and brokerage firms.
To understand cash equivalents, we must understand the concept of liquidity. Liquidity refers to the immediate convertibility of an asset to cash without significant loss of value.
The balance sheet is presented in the order of liquidity. Thus, cash and equivalents, which are the most liquid assets, are presented as the first account on the balance sheet.
Cash equivalents are not completely riskless. Although relatively rare, there have been instances where firms had to recognize value impairment on assets considered “safe as cash.” The most notable example is the case of auction-rate securities. Auction rate securities are variable-rate debt securities whose market was considered liquid enough to classify these securities as cash equivalents. In 2008, the market for auction-rate securities became highly impaired, and firms were forced to recognize losses on these securities.
