Restricted Cash and Compensating Balances

Cash is also considered a nonearning asset, so management is constantly balancing the need to hold cash with the desire to put it to work. The unused available borrowings under the lines of credit agreements amounted to $58,150,000 on 30 December 1978. The weighted average interest rate on the short-term bank loans during the year amounted to 8.59%. If the arrangement is not enforceable, not more than 15% of cash and marketable investments, or does not have a significant effect on the effective interest rate, then disclosure is appropriate. A loan with a compensating balance may be extended to an individual or a company with a poor credit rating. Those applicants might otherwise be charged higher interest rates or be turned down for a loan.

Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others. Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. The analysis below shows how the effective interest rate is affected. Specifically, the depositor must leave a stated amount on deposit in an account (either checking or savings).

Accounting Rules on Compensating Balances

The company then compares the two totals for cash and cash equivalents. Cash is often reported within the asset category called cash equivalents. Cash equivalents are short-term, highly liquid assets that can readily be converted into known amounts of cash and with little risk of price fluctuations. An example of a short- term cash equivalent asset would be one that matures in three months or less from the acquisition date. They may be considered as “near-cash,” but are not treated as cash because they can include a penalty to convert back to cash before they mature.

Most customers pay in cash or with a credit card, so the LOC can usually be paid off in the last week of the month. Assume, for example, the interest rate on the LOC is an annualized rate of 6% and the store starts the month with a $20,000 cash balance. The store estimates sales for the https://accounting-services.net/effective-interest-rate-in-the-context-of-loans/ month to be $50,000, and $40,000 in inventory needs to be purchased to meet customer demand. The bank loans the clothing store’s compensating balance to other borrowers, profiting on the difference between the interest it earns and the lower rate of interest paid to the clothing store.

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Compensating balances are considered restricted cash and must be reported on a company’s financial statement. The financial accounting term restricted cash and compensating balances refers to monies that are reserved and not generally available to the company. Restricted cash can include minimum balances on bank accounts, while compensating balances include money needed to repay a loan. Accounting rules for financial reporting require that compensating balances be reported separately from cash balances in the borrowers’ financial statements if the dollar amount of the compensating balance is material. A material amount is defined as an amount large enough to affect the opinion of a person reading a financial statement. Remember that all items should be recorded in Canadian dollars on the balance sheet.

Restricted cash may be counted as collateral if both the cash balance is segregated and it has some level of enforceability. If the arrangement is not enforceable, then no additional footnote disclosure is required (if they result in increased effective rates). Marketable debt (bonds) securities with maturities greater than 12 months are classified as long term. The Company classifies its marketable equity (common or preferred shares) securities, including mutual funds, as either short term or long term based on the nature of each security and its availability for use in current operations. Many companies have foreign bank accounts or have bank accounts in other countries, especially if they are doing a lot of business in those countries.

Restricted Cash and Cash Equivalents, Current

It is often the case that restricted cash results from a legally binding agreement. Controlling the physical custody of cash plays a key role in effective cash management. All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents and are combined and reported with Cash. Management determines the appropriate classification of its investments at the time of purchase and reevaluates the designations at each balance sheet date.

• Cash is often reported within the asset category called cash equivalents.
• From a practical standpoint, formal segregation seldom occurs because the agreements are virtually always informal and non-binding.
• Compensating balances are mostly reported on financial statements as restricted cash.
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• Restricted cash can be classified as either a current or non-current asset, depending on the period of restriction.

IAS 7 mandates disclosure of the quantity and a description of the restriction in cases where considerable amounts are not readily usable by the group. A security deposit is a fixed deposit or cash given to the government or any other private enterprise. Certificates of Deposits (CD’s) are usually recorded as short-term investments. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications.