We're going to discuss cash and cash equivalents, which will typically be the very first line item on a bank's balance sheet. So, here we have an example of a real bank's balance sheet, this example happens to be Goldman Sachs. Right at the top we have a line item headed up cash and cash equivalents. And let's just stress that cash is very deliberately right at the top of the asset section of the balance sheet, as it is the most liquid asset the bank owns. So, what's captured in cash and cash equivalents, and what are the criteria? The definition for US GAAP and IFRS are broadly similar here. They need to be highly liquid financial assets. Further to this, they also need to satisfy two additional criteria. They need to be readily convertible into a known amount of cash and have an insignificant risk of change in value from the amount recorded at inception. So let's take these ideas in turn. What do we mean by highly liquid? Well, the financial assets must have a strong secondary market to facilitate quick buy and sell transactions, and that market must be able to provide investors with accurate price quotes. Further to this, an investment normally meets the definition of a cash equivalent when it has a maturity of three months or less from the date of acquisition. Let's just repeat that point. A maturity of three months or less from the date of acquisition. Let's give an example. A financial asset, say a bond with a maturity of three years at the point of acquisition, will clearly not be classified as a cash equivalent when acquired. However, we should also be clear that as it progresses through its life its maturity will fall, and at some point its maturity will hit that three month threshold. So, what do we do? Well, let's be clear, we don't reclassify it as a cash equivalent. We do absolutely nothing here. We make the decision on this criteria at the point we acquire the financial asset, then we leave it alone. Now, let's think about the other two criteria. As an example, let's compare and contrast an investment in bonds and an investment in equity. We know that on maturity, a bond will redeem at par a known value. We also know that if that bond is redeeming in the very near term, then the risk of changes in value become less significant with its value tending toward par. That's not necessarily to say that changes in value are insignificant, however. Low credit quality corporate bonds near to maturity may unfortunately not be subject to insignificant risk of changes in value, so we could not consider them a cash equivalent. So we're saying that a corporate bond with low credit quality may not meet the criteria, however, three month government treasury bills are highly likely to. Compare that to equities. There is no redemption date, no known value. Furthermore, equities are subject to significant changes in value. Each financial asset is judged on its own merits of course, but we could certainly say that an investment in equities would not meet the definition of a cash equivalent, whilst an investment in bonds could meet the definition of a cash equivalent subject to its satisfying the criteria we just outlined.
