Cash and cash equivalents are not just the amount of currency that a business has in its cash registers and bank accounts; they also include several different types of financial instruments. Cash equivalents include all undeposited negotiable instruments (such as checks), bank drafts, money orders and certain certificates of deposit.
A certificate of deposit, or CD, is a financial product offered by banks to their customers. CDs are similar to savings accounts in that both types of accounts are insured by the FDIC up to a value of $250,000. However, unlike with a savings account, whatever funds a consumer puts into a CD generally cannot be withdrawn prior to a certain date without incurring significant penalties. Demand CDs allow a customer to withdraw funds from the CD whenever the customer wants without incurring a penalty. As a result, demand CDs generally have lower interest rates than CDs that allow the bank to hold onto the money for an agreed upon term. Generally only demand CDs or CDs that will mature within three months of when the financial statements are prepared are cash equivalents.
Certificate of Deposit
An example of an early Certificate of Deposit. A CD may be a "cash equivalent" if it meets certain criteria.
Cash equivalents can also include government and corporate bonds, marketable securities and commercial paper. However, these types of instruments are only included in cash if they mature within three months from when the the financial statements are prepared and there is a minimal risk of these investments losing their value. So if a corporate bond matures within three months, but the company that issued it may not be able to settle the debt, one would not be able to include that as a cash equivalent.
Other investments and securities that are not cash equivalents include postage stamps, IOUs, and notes receivable because these are not readily converted to cash.