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.
What is a compensating balance explain its treatment and classification?
A compensating balance is a minimum bank account balance that a borrower agrees to maintain with a lender. The purpose of this balance is to reduce the lending cost for the lender, since the lender can invest the cash located in the compensating bank account and keep some or all of the proceeds.
How are compensating balances classified on the balance sheet?
A compensating balance results in the borrower’s paying an effective interest rate higher than the stated rate on the debt. If restriction is legally binding, the cash is classified as either current or noncurrent (investments and funds or other assets) depending on the classification of the related debt.
Where should restricted cash on the balance sheet?
Quick Summary: Restricted cash refers to cash that is held by a company for specific reasons and not available for immediate business use. Restricted cash is commonly found on the balance sheet with a description of why the cash is restricted in the accompanying notes to the financial statements.
Where does the compensating balance go in a bank account?
The compensating balance required by a lender is usually a percentage of the loan balance. The funds are generally held in a deposit account such as a checking or savings account, a certificate of deposit (CD), or another holding account.
How does a company report its compensating balance?
Key Takeaways 1 Agreeing to a compensating balance allows a company to borrow money at a favorable rate of interest. 2 The compensating balance offsets the bank’s default risk and can be used to make new loans. 3 The business borrower must report the compensating balance in its financial statements, typically as restricted cash.
Is the compensating balance a good or bad thing?
For the borrower, the compensating balance is a mixed blessing. The loan generally will come at a lower rate of interest. However, the borrower must pay interest on the full amount of the loan, including the balance that may not be spent.
How does a clothing store get a compensating balance?
The bank agrees to charge a lower interest rate on the LOC if the clothing store deposits a $30,000 compensating balance. The bank loans the clothing store’s compensating balance to other borrowers, and profits on the difference between the interest earned and the lower rate of interest paid to the clothing store.
