For example, it’s used to meet short term obligations such as operating expenses. 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. This is because even though you still need to pay interest on your compensating balance, it might be a lower interest rate.

When the two sides of the arrangement are netted, the loan is actually $4,750,000. 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 month to be $50,000, and $40,000 in inventory needs to be purchased to meet customer demand.

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2. This balance can be kept in various account types, including checking, savings, or money market accounts, depending on the requirements set by the bank.
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Welcome to our Finance category, where we delve into important concepts and strategies to help you make informed decisions about your finances. In this blog post, we will explore the topic of compensating balances plans – a valuable tool for optimizing your financial management. By the end of this article, you’ll have a solid understanding of what compensating balances are and how they can benefit your overall financial goals.

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This is because the over-debit in the purchases account is nullified by the over-credit in the sales account. For example, consider that advertising charges of $1,000 are debited in the advertising account as $1,500. Also, the interest received of $2,000 is credited in the interest account as $2,500. Compensating errors pose greater problems to a business compared to other types of errors. This is because they are not single errors but are combinations of more than one error. Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs.

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All disclosure of non-enforceable formal restrictions on cash balances is required, regardless of their amount. Discover the meaning of a compensating balances plan in finance and how it can impact your financial strategy. Let’s take a practical example to understand how compensating balance works.

Compensating balance is a term used to describe the minimum balance that borrowers must maintain for their loan accounts. For the lender, the compensating balance serves as a way to reduce its lending costs. Lenders can use this amount to reinvest in other ventures or keep some or all of the proceeds. The requirement for a compensating balance is most common with corporate rather than individual loans. The borrower cannot use the money but is required to disclose it in the borrower’s notes attached to its financial statements.

More meanings of compensating

Those applicants might otherwise be charged higher interest rates or be turned down for a loan. In return, the compensating balance cuts down on the risk to 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.

For example, there is a structure known as the 10 and 5 compensating balance. It requires the borrower to have a minimum of 10% of the extended line of credit in the account at the time the credit line is established. To illustrate, consider establishing a credit line of $200,000.00 US Dollars. The borrower’s account must have a minimum balance of $20,000.00 at the time of the credit line commitment (10%). The balance in the compensating account must be $30,000.00 (15%) in the event the credit line is accessed and drawn on.

Is there a materiality threshold for restricted cash?

As a result, compensating balances are typically shown as restricted cash on financial statements. Hence, it is unavailable for immediate or general business usage is referred to as restricted cash. Now, let’s dive into the details of compensating balances plans. Simply put, these plans require a minimum balance to be maintained by the customer in exchange for specific benefits offered by the bank. These benefits can range from reduced service fees and interest rates on loans to enhanced credit lines and favorable terms on other financial products.

However, the customer may still generate interest or revenue from their other account balances that are not subject to the compensating balance requirement. Assume a clothing store needs a $100,000 line of credit (LOC) to manage its operating cash flow each month. The store plans to use the LOC to purchase inventory at the beginning of the month, and then pay down the balance with money brought in by sales throughout the month. Compensating balances are generally reported on financial statements as restricted cash. Restricted cash is money that is allocated for a set purpose and is thus not available for immediate or general business use.

The company requires at least a $200,000 line of credit facility to finance its operations. The bank agrees to provide this loan but also requires a 10% compensating balance. In this amount, ABC Co. must always maintain a $20,000 balance at the bank. A compensating balance is an https://personal-accounting.org/ amount that borrowers must maintain in their accounts. While compensating balance requirements may apply to both individuals and companies, it is most prevalent for companies. Therefore, companies that borrow a loan with a compensating balance must account for it accordingly.

The store incurs an interest expense at a 6% annual rate on the $40,000, and the owner continues to borrow from the LOC at the beginning of each month to purchase inventory. Disclosures about compensating balances have not been addressed in any authoritative pronouncements. Generally Accepted Accounting Principles (GAAP) call compensating balance definition for the presentation of information about restricted cash balance. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

In this situation, you’ll be on the hook for that $10,000 each month, whether you access the line of credit or not. If you do withdraw funds from the line of credit, you’ll be responsible for the interest on what you borrow plus the $10,000 compensating balance. The borrowing agreement states that the corporation will maintain a compensating balance in an account at the bank of at least $250,000.