As an IFRS Standards consultant, I was asked by a client – a finance director of a Germany company complying with IFRS – whether it was possible to reclassify a banker’s acceptance (BA) with a maturity date of less than three months from the end of the reporting period, from other receivables into cash equivalents. The BAs have an original six-month maturity date from the acquisition.
Looking at the definition of cash equivalents in IAS 7, Statement of Cash Flows, the quick answer is no. But let’s examine the definition of cash equivalents again: ‘Cash equivalents are 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’ (IAS 7, paragraph 6).
The definition seems scary because we often interpret cash equivalents as short-term government bonds. However, in terms of other marketable securities, judgment needs to be applied.
Let’s look at the three key elements in the definition in turn.
Short-term, highly liquid
The standard suggests a short maturity would be three months or less from the acquisition date. So, to qualify as cash equivalents, BAs should have a three-month or less maturity period from the acquisition date, not the reporting date.
After my client was informed of this requirement, she replied that, to meet this requirement, the company has the policy of negotiating BAs with longer maturity in the secondary market, usually with 5% off their face value. According to their experience, BAs with longer maturity periods were usually redeemed within a month if they were sold at such a discount, ie they are highly liquid.
This makes sense, but to convert BAs with longer maturity into cash equivalents, risks of changes in value should also be considered. This leads us to the next element.
Banker’s acceptances should have a three-month or less maturity period from acquisition date not reporting date
Changes in value
To redeem a longer maturity date, BAs with a larger discount would mean that there is an increased risk of changes in value. In other words, if the company wants to redeem BAs into cash, discounts must be offered with less cash being received. This requirement is not therefore met.
Another example is when the price of equity shares fluctuates a lot and these shares are highly liquid, ie equity shares can be redeemed into cash whenever an investor wants to. However, the investor bears the significant risk of changes in share price.
Readily convertible
‘Readily’ usually means without delay and easily. BAs are usually guaranteed by the banks, which are generally considered to be risk-free. As such, an active market usually exists for BAs. But be careful, as they still bear a risk because smaller commercial banks could go bankrupt. BAs generally meet the third requirement.
So, in summary, BAs held by my client should not be reclassified from other receivables to cash equivalents because they did not have three months or less maturity date from acquisition and also suffered from significant risk of changes in value. Although these are readily convertible to known amounts of cash, all criteria must be met for cash equivalents to be recognised in the account.
In terms of disclosure, companies usually need to disclose the policy of the judgment they applied in defining cash equivalents in the disclosure note. Here is an example from the Bank of England’s annual report:
For the purposes of the statement of cashflows, cash and cash equivalents comprise balances with less than three months’ maturity from the date of acquisition, consisting of cash and balances with other central banks, loans and advances to banks and other financial institutions, amounts due from banks and short‑term government securities.
Cash and cash equivalents held by the subsidiary may not be available for use by the group entity, particularly for those subsidiaries operating in countries with exchange control. This also needs to be disclosed in the note.
The IFRS Interpretations Committee believes that the standard is clear when the three-month criterion is applied by various entities when classifying cash equivalents. However, some complex financial instruments, such as investments in open-ended funds, may still be qualified as cash equivalents if the substance meets the principles in the standard.
