For borrowers in such situations, securing financing, even with these conditions, can be crucial for business growth or personal financial recovery. This requirement, essentially a minimum deposit the borrower maintains, can seem perplexing. Why, when you’re borrowing money, do you need to keep some of it locked away? Understanding the seven key reasons lenders utilize compensating balances can illuminate this financial dance. The requirement for a compensating balance is most common with corporate rather than individual loans.
Accounting Rules on Compensating Balances
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Is there a materiality threshold for restricted cash?
For instance, a competitive industry with volatile cash flows might see higher requirements than a stable industry with predictable income streams. This means the company must always maintain $200,000 ($1 million x 20%) in the account. While they cannot use this money, it reduces their effective borrowing rate to 4% ($5,000 interest / $800,000 available funds). On the other hand, the minimum fixed balance arrangement necessitates that the borrower maintain a set minimum balance with the lender.
- Compensating balances are minimum balances that may be maintained in an account and still meet the requirements for a loan.
- The underwriter requires a 5% compensating balance, meaning the city must deposit $500,000 with them until the bonds are sold.
- This can help you better understand things like loan balance, any administrative costs and the overall cost of borrowing.
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Conversely, they might be more lenient during economic booms, lowering requirements to attract borrowers. Additionally, banks compete for business, which can influence compensating balance requirements. If a borrower has options from multiple lenders, they can negotiate a lower balance. For instance, if the minimum balance requirement is high and the interest rate on the linked account is low, you could miss out on better returns elsewhere. Compensating balances often go hand-in-hand with establishing a banking relationship. By consistently maintaining the required funds, borrowers become valued customers, fostering a stronger rapport with the lender.
2 Cash and Cash Equivalents
It can pay off the difference between the outstanding loan balance and the fair market value of a car. If your insurer is paying for your vehicle under your coverage, you will also have a deductible to pay. Unfortunately, you still must pay your entire car loan even if insurance doesn’t pay you the full amount due. 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.
Recognition, Measurement, and Disclosure
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. In practice, the safest option is to separate out any compensating balances and let the reader decide for themselves whether or not they are material.
The store estimates sales for the month to be $50,000, and $40,000 in inventory needs to be purchased to meet customer demand. Since the store needs the $20,000 cash balance for other expenses, the owner borrows $40,000 from the LOC to purchase inventory. Nearly all customers pay in cash or with a credit card, so the store collects cash quickly, and the LOC is paid off in the last week of the month.
Also, refer back to Chapter 4 for the discussion of the statement of financial position and how assets are classified. Cash equivalents can be reported at their fair value, together with cash on the balance sheet. Fair value will be their cost at acquisition plus accrued interest to the date of the balance sheet.
For this reason, it’s standard to list compensating balances under ‘restricted cash’. This shows readers that the cash is being set aside for a specific purpose rather than being available for general use. The average balance arrangement requires a borrower to ensure that they maintain a minimum average balance over an agreed period.
In the event that the compensating balance drops below the minimum required, the interest rate applied to the loan will rise accordingly. When accounting bench accounting login for compensating balance, companies must understand that they cannot use it. However, they must still present this information to their stakeholders.
Most commonly, however, companies obtain debt from financial institutions, such as banks. Depending on the type of loan arrangement they enter into, borrowers have to meet some criteria. These criteria may also differ according to the lender a company chooses. Opting for a merchant cash advance involves receiving a lump sum from a lender in exchange for a percentage of future sales.
When the two sides of the arrangement are netted, the loan is actually $4,750,000. If your agreement has an average balance agreement, you must maintain a minimum average balance over an agreed-upon term, which is typically 30 days. With a minimum fixed balance, you’ll be required to always keep an agreed minimum balance with the lender.
This can help you better understand things like loan balance, any administrative costs and the overall cost of borrowing. You won’t get hit with any sudden surprises or fees you weren’t expecting. Plus, you can receive cash balances that fit with what you need, all while staying within the accounting rules. As an example of a compensating balance arrangement, a corporation has a $5 million line of credit with a bank. The borrowing agreement states that the corporation will maintain a compensating balance in an account at the bank of at least $250,000.
Let’s take a closer look at what a compensating balance is and how it works, so you can understand how it may apply to your situation. Businesses can raise capital by presenting their ideas to a broad audience, who may contribute funds if interested. Crowdfunding provides access to necessary funds and fosters a supportive community around the business, potentially leading to long-term customer loyalty and engagement. Christy Bieber has a JD from UCLA School of Law and began her career as a college instructor and textbook author. She has been writing full time for over a decade with a focus on making financial and legal topics understandable and fun. Her work has appeared on Forbes, CNN Underscored Money, Investopedia, Credit Karma, The Balance, USA Today, and Yahoo Finance, among others.
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. The borrower may also benefit from being granted a somewhat lower interest rate. While banks set base requirements, borrowers with strong bargaining chips, such as a large loan amount, excellent credit history, or alternative loan offers, can negotiate for lower compensating balances. The specific compensating balance requirements vary depending on the borrower’s creditworthiness, loan amount, and the lender’s risk tolerance. Some lenders might require a minimum balance equal to a percentage of the loan, while others might set a fixed amount.
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The reduced liquidity might hinder your ability to make timely payments, cover unexpected expenses, or seize sudden business opportunities. Imagine a small business owner who juggles operational expenses with loan payments. With a compensating balance, they only https://accounting-services.net/ need to manage one account, eliminating the need for intricate transfers and meticulous record-keeping. This can be especially beneficial for businesses with limited accounting resources or those seeking to optimize efficiency in their financial processes.
Both methods of calculating compensating balances have their advantages and disadvantages. The choice between these methods depends on the preferences and financial circumstances of the borrower and the terms offered by the lender. 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.