Cash Equivalent Treatment: Understanding the Basics
When a company purchases a security, it is often considered a cash equivalent outflow. In other words, it is treated as if the company had spent that same amount of money on another type of asset or investment. The reason for this is to ensure that the company’s financial statements accurately reflect its cash flow and liquidity position.
However, there are some important considerations to keep in mind when determining the cash equivalent treatment of security purchases. In this article, we will explore the key factors that impact the cash equivalent treatment of security purchases and provide real-life examples to illustrate these points.
Cash Equivalent Treatment: Understanding the Basics
When a company purchases a security, it is typically recorded as an asset on its balance sheet. However, in certain circumstances, the purchase of a security may be treated as if it had been spent on another type of asset or investment. This is known as cash equivalent treatment, and it can have significant implications for a company’s financial statements.
There are several key factors that determine whether a security purchase will be treated as cash equivalent. These include:
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Type of Security Purchased: The type of security purchased plays a critical role in determining its cash equivalent treatment. For example, common stock is generally not considered cash equivalent, while treasury bonds may be treated as cash equivalent due to their liquidity and relatively low risk profile.
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Market Value vs. Book Value: Another important factor is the difference between the market value and book value of the security. In some cases, a company may purchase a security at a premium or discount to its book value, which can affect how it is treated for cash equivalent purposes.
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Hold-to-Maturity vs. Marketable: The holding period for a security also impacts its cash equivalent treatment. If a company holds a security until it matures (i.e., it does not plan to sell it), it may be classified as held-to-maturity, which typically results in a lower cash equivalent treatment. Conversely, if a company plans to sell a security in the near future, it will be classified as marketable, which can result in a higher cash equivalent treatment.
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Fair Value Measurement: Finally, the method used to measure the fair value of a security can also impact its cash equivalent treatment. For example, if a company uses the mark-to-market method (i.e., adjusting the value of the security based on current market prices), it may result in a more volatile cash equivalent treatment than other methods.
Real-Life Examples: Cash Equivalent Treatment in Practice
Now that we have a basic understanding of the key factors that impact cash equivalent treatment let’s look at some real-life examples to see how these principles play out in practice.
Example 1: Purchasing Common Stock as Part of an Acquisition
Suppose Company A is acquiring Company B for $100 million, and as part of the acquisition, it also purchases $20 million worth of Company B’s common stock at a market price of $5 per share. In this case, the purchase of the common stock would not be considered cash equivalent treatment because Company A is not holding the shares with the intention of selling them in the near future. Instead, the common stock would be recorded as an asset on Company A’s balance sheet.
Example 2: Purchasing Treasury Bonds
Suppose Company C is looking to increase its liquidity and reduce its risk profile by purchasing $50 million worth of treasury bonds at a market price of 100 basis points above the current yield on similar-maturity government securities. In this case, the purchase of the treasury bonds would be considered cash equivalent treatment because they are highly liquid and have relatively low risk.
Example 3: Purchasing Preferred Stock at a Premium
Suppose Company D is looking to generate a steady stream of dividend income by purchasing $10 million worth of preferred stock from Company E at a premium of 5% above the current market price.