Read Along With the VideoTranscript
Let's talk about cash and cash equivalents. What we're talking about here is things that are already cash and things that are so close to being cash that we wanna call them cash, but they're not quite there yet, so we call them cash equivalents. Now, over on the cash side, this one's super straightforward. You've got cash on hand, cash in banks, and then you've got two more that you may not think of right away, and that's undeposited checks, and that includes cashier's checks.
So these two, straightforward enough. Cash on hand and cash in banks clearly fall under cash, so we're just gonna say hopefully you understand this. Undeposited checks and cashier's checks, you may look at that and say, "That's a check. That's not cash." But checks are as good as cash. Just because someone didn't hand you physical green dollar bills doesn't mean they didn't pay you. If they paid you by check, all you have to do is put that check into your bank account, and you have cash. There's no converting needed. There's no time period. You just put it in there, and it gets credited to your account.
On the other hand, we've got cash equivalents, and what we're trying to do here is decide what is close enough to being cash that we can call it a cash equivalent. What is almost cash? And there's a definition for that. So a cash equivalent must be readily convertible to a known amount of cash.
And the way I look at it, there are three important parts in this definition. There's readily, there's convertible, and there's known. When we say readily, what do we mean? Readily means quickly or on demand, basically. But for accounting, we're saying readily means the original maturity was less than or equal to three months. And you gotta remember, that's original maturity. What's an example of that? Well, if you bought a certificate of deposit, a CD, and it had a 12-month maturity, so you knew when you bought it, "I'm gonna have my money locked up for 12 months. I can't get to my money for an entire year."
So you may have bought it for $1,000, and then a year later you're gonna get $1,100 back, meaning you got 10% interest, so you earned $100, but it took 12 months. Well, under our definition, this is not readily convertible because the original maturity was not less than or equal to three months. So even if you're looking at it right here, let's say you're looking at it when you only have one month left. Technically, according to our definition, that is still not a cash equivalent because the original maturity was still 12 months. No matter where you look on this line, assuming this line is time and you're getting closer and closer to maturity, the original maturity doesn't change no matter where you are in this line.
The time left to maturity does change. You could be a month away from your certificate of deposit maturing, but that doesn't matter. That's not what we're looking at. We're looking at original maturity being less than or equal to three months. So make sure you remember that on the test when they say, "Certificate of deposit had a 12-month maturity, but it's only one month away from maturity." Okay. Well, sorry, that doesn't count because it has to be an original maturity of less than or equal to three months. That's what we mean by readily. Now, for convertible, we mean it can turn into cash. We are able to convert it to cash.
So let's look back at these undeposited checks and these cashier's checks. For these, they aren't actually convertible to cash because they're already cash, like we talked about. There's no selling process when it comes to checks. There's no negotiation. There's nothing you have to do to convert it. It's already cash functionally. All you do is you take it to the bank and put the cash in your account. You don't take it to the bank and say, "I would like to sell you this $1,200 check for $1,200 cash." You just take it, and you put it in, and they give you the $1,200 cash.
You're trading one form of cash for another, so it has to be convertible to cash. And of course, the last one is a known amount of cash. You have to know how much cash am I gonna be able to readily convert it to. If you encounter a scenario where you give someone $1,000, and then three months later they're gonna give you anywhere between $2,000 and $2,500, then that's not a known amount of cash. You don't know, is it gonna be $2,000, $2,100, $2,200, $2,300? You don't know. So even though it's readily convertible, it's less than or equal to three months, if you don't know the amount that you're trying to convert it into, then it doesn't count as a cash equivalent because it's not so close to being cash that you can say it's a cash equivalent.
'Cause if I hand you twenty $100 bills, how much money do you have? You have $2,000. That's a very known discrete amount. But here it's not close enough to being cash to say, "Okay, let's count it as a cash equivalent." Let's talk about some examples. What are some cash equivalents that you're gonna see? There are three common types of cash equivalents that you're gonna see. First one is Treasury bills, then commercial paper, and then money market accounts. And these are the three that you're gonna see most often on your test. These are your three cash equivalents. Treasury bills you may also see called T-bills, exact same thing.
T-bills are issued by the United States government, and they have a maturity date. And so what you need to look out for is what is that maturity date? Because you can get a three-month T-bill, a six-month, a year, two years. I don't know how high they go. But if you have a T-bill that has a six-month maturity, well, then that's not a cash equivalent because six is greater than three. But if you see one that has a three-month maturity, well, then T-bills are readily convertible into a known amount of cash, and so you count that as a cash equivalent. Now, commercial paper. Commercial paper is just basically short-term notes issued by a company.
And again, you gotta just watch the maturity date. Money market accounts are offered by financial institutions, and they're basically just better savings accounts. They offer a higher interest rate, but in exchange, they lock up your money for a little bit longer. You can't just go and get all your money out. And so again, you need to watch what's the time period on these money market accounts. That's pretty much it for cash and cash equivalents. We're not gonna spend a whole lot of time on it because it's relatively straightforward. The only thing you need to remember is readily convertible to a known amount of cash, where readily means less than or equal to three months.