A European example of issues arising in identifying cash equivalents

As part of its activities, the European Securities and Markets Authority (ESMA) organizes a forum of enforcers from 42 different European jurisdictions, all of whom carry out monitoring and review programs similar to those carried out here by the Canadian Securities Administrators. ESMA recently published some extracts from its confidential database of enforcement decisions on financial statements, covering eight cases arising in the period from December 2016 to December 2018, with the aim of “strengthening supervisory convergence and providing issuers and users of financial statements with relevant information on the appropriate application of IFRS.” There’s no way of knowing whether these are purely one-off issues or more widespread, but some of them certainly have some relevance to matters discussed within Canadian entities once in a while. Here’s one:

• The issuer is a mining company that had invested in the development of two sites, which achieved commercial production in the reporting period. The issuer disclosed as cash equivalents balances having a contractual maturity greater than three months from the reporting date. These represented funds placed in interest-bearing deposits for six months without the issuer having the contractual right to withdraw the funds before maturity.
• The issuer had disclosed in the prior period financial statements that, in light of the projected cash flows for capital expenditure and debt repayments for the next 12-month period, current investments were reclassified as cash equivalents. The issuer explained that the change of classification arose owing to a change in purpose for the deposits, from funding the projects and providing contingency for potential overruns to holding funds to meet scheduled loan principal and interest payments.
• The issuer considered the six-month deposits to meet the definition of cash equivalents set out in paragraphs 6 and 7 of IAS 7. In particular, the issuer was of the view that IAS 7 gives three months as an illustration of what is meant by ‘short term’, not as a mandatory maximum time. Hence investments with longer maturities may be cash equivalents. The issuer believed that the deposits were held for the purpose of meeting short term cash commitments, were not subject to risk of significant changes in value and were readily convertible to known amounts of cash, despite there being no contractual right to early termination, owing to the issuer’s relationship with the deposit-taking banks.

The enforcer (as ESMA likes to term it) disagreed, noting:

• paragraph 7 of IAS 7 states that “an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less from the date of acquisition”. Therefore, the enforcer considered that extending this to six months is an unwarranted departure from the sense of ‘short term’ in paragraphs 6 and 7 of IAS 7. In particular, the enforcer considered that the lack of contractual right to early termination prevented classification of the deposits as cash equivalents.

While I don’t argue with the conclusion, I find this argument a bit under-developed. It’s interesting that IAS 7 is (I think) the only standard that uses the “say” formulation in expressing a principle. It does turn up elsewhere in IFRS, for example in the first of the illustrative examples accompanying IAS 38:

• A direct‑mail marketing company acquires a customer list and expects that it will be able to derive benefit from the information on the list for at least one year, but no more than three years.
• The customer list would be amortized over management’s best estimate of its useful life, say 18 months.

But in that context, it should be clear to any reader that the best estimate could also be, say, two years, and that the example isn’t addressing how that estimate should be derived in any particular situation: ultimately, it’s just an example which only goes as far it goes. On the other hand, IAS 7.7 is all there is to go by on the topic it addresses. And on a plain reading, a sentence which qualifies itself not once but twice – “normally, “say” – would generally be seen as acknowledging that exceptions to what’s normal may lead to, say, different conclusions.

If nothing else then, ESMA’s use of “therefore” seems unwarranted as a linguistic matter, in that the wording of IAS 7.7 doesn’t appear to inherently exclude extending the concept to six months. Certainly for some fast-moving entities, six months might not realistically be viewed as the “short-term” – but then, by the same token, three months might not be either. In other cases, the difference might hardly matter. Suppose (albeit very hypothetically) a company with ample cash resources and minimal overheads, that’s just biding its time until making a large outflow in a year’s time: in such a case the difference between three months and six months might hardly matter, at least within the wording of the standard.

It’s hard though to argue with the enforcer’s last point, on the significance of the lack of a contractual right to early termination. If the fact pattern were otherwise, so that regardless of the notional six-month maturity date, the issuer had the right to withdraw the funds at any date without penalty, earning an effective return comparable to that available on demand deposits, then the company would have been on stronger ground, in my mind anyway. Albeit maybe not strong enough…

The opinions expressed are solely those of the author