In financial accounting, cash is defined as the sum of (1) currency and coins, (2) balances in checking accounts, and (3) items acceptable for deposit in these accounts, such as checks received from customers.
Cash equivalents are those short-term investments that can be converted quickly to cash. They include such things as balances in savings accounts and money market funds, short-term certificates of deposit, short-term government securities, (for example, treasury bills), and short-term commercial paper (negotiable notes receivable issued by other companies).
Cash and cash equivalents can be combined on the balance sheet or reported as separate items. Some firms combine cash with short-term investments in marketable equity securities. As a practical matter, efficient financial management results in a very low cash balance because any excess funds are invested in cash equivalents. The availability of highly liquid investments tends to make the distinction between cash and cash equivalents less meaningful.
Impact on the firm
In general, the short-run solvency of a firm is strengthened by having additional cash and cash equivalents because the firm is better able to meet to short-term obligations; correspondingly, having less creates greater risk. An excess of cash redirects management concern from financing to concern with investing. A shortage has just the opposite effect.
The nature of cash and cash equivalents creates needs for two types of management control. First, controls should be implemented to prevent misappropriation of cash. The study of these controls falls within the scope of an auditing course. Second, management attention should be directed to planning future cash flows in order to assure the sufficiency of the balance and to maximize investment income. This subject is covered in management accounting and financial management courses.
In response to statement users’ needs for assessing earning power, accountants report material amounts of investment income separately from operating income. In order to help users assess solvency, the balance sheet reports the balance of cash and cash equivalents. This number (either by itself or in combination with others) can be compared with liabilities that demand settlement in the short run.
To accomplish this goal, GAAP also call for disclosures about restrictions on the availability of cash, in terms of either the purposes to which it can be applied or the time that it must be left invested. The balance of cash is also potentially helpful in assessing earning power in that an excess available for investment may allow the firm to expand or take advantage of other opportunities as they arise.
Accounting practices related to cash and cash equivalents are relatively uncomplicated. The primary reason for this simplicity is the absence of substantive measurement problems. The goal of financial accounting with respect to cash is the disclosure of the balance on hand at the balance sheet date. In most cases, the task of verifying the cash account balance consists primarily of examining bank statements, deposit slips, and canceled checks. Where currency, coins, and undeposited items are material, this verification involves a physical tabulation of the amount.