Restricted Cash and Compensating Balances
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.
Companies hold cash for a variety of reasons. For example, it's used to meet short term obligations such as operating expenses. It's also needed when unplanned investment opportunities arise. 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.
Cash is considered restricted when it's needed for a specific purpose or as part of a commitment the company has made to another party. Examples of restricted cash include:
- Sinking Funds: money set aside for the purpose of reducing debt, or the repayment of debt coming due to bondholders.
- Lines of Credit and Loans: banks and other financial institutions oftentimes require borrowers to maintain compensating balances in their bank accounts as part of a lending agreement. These are minimum balances held in an account, which are typically a percentage of the loan or line of credit.
If the amount of restricted cash is considered material, it should be shown separately from cash and cash equivalents on the company's balance sheet, and disclosed in the financial statements' notes. Companies have several options to classify these funds, and typically use terms such as "other assets" or "other investments." As is the case with other assets, the sub-classification will be current asset (if the funds are needed in 12 months or less), or non-current, long term asset (if needed in more than 12 months).
Company A has entered into an agreement with First Federal Savings and Loan for a $1,000,000 line of credit. As part of that agreement, Company A is required to maintain a cash account with First Federal in the amount of $100,000. The balance sheet of Company A would include the following:
Note 3: Line of Credit Company A has entered into an unsecured line of credit agreement with First Federal Savings and Loan in the amount of $1,000,000. As long as this agreement remains in-place, Company A will be required to maintain a compensating balance of $100,000 in an interest-bearing savings account at First Federal Savings and Loan.