0936211399 HOTLINE 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. Most businesses experience seasonal fluctuations in the revenues they bring in and the expenses they pay out. They need cash on hand to get them through https://personal-accounting.org/retained-earnings-definition/ the dry periods, and they usually get it by obtaining a line of credit, maintaining a savings account, or both. Accounting rules dictate that the bank does not pay interest on compensating balance. However, the customer may still generate interest or revenue from their other account balances that are not subject to the compensating balance requirement.
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- The bank is free to use the compensating balance in loans made to other borrowers.
- The compensating balance cuts down on the risk to the lender by allowing for recovery of part of the loan in cases of default.
- Compensating balances act as a form of collateral for the bank, ensuring that the customer remains committed to their business relationship.
- 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.
For example, companies can tax advantages when paying interest on debt finance. The bank agrees to charge a lower interest rate on the LOC if the clothing store deposits a $30,000 compensating balance. 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.
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To keep things simple, a compensating balance acts as collateral for lenders and helps to compensate for any risks. This allows them to pay out a lower amount, but still receive the full amount of interest on the loan or line of credit. Be sure to check with your bank or lender to see what their compensating balance arrangements are. An average balance arrangement is usually used for lines of credit. A minimum fixed balance arrangement tends to be more common for things like instalment loans. Compensating balance is a term used to describe the minimum balance that borrowers must maintain for their loan accounts.
Compensating balance is commonly used for commercial accounts, primarily businesses and corporations, rather than individual consumers. This requirement serves as a tool for the bank to manage risk and can provide benefits to the customer based on the terms negotiated with the bank. ABC Bank offers you a $70,000 line of credit with a $10,000 compensating balance.
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Accounting standards demand that compensating balances be recorded separately from cash balances in the borrowers’ financial statements. A significant amount is one that is large enough to sway a person reading a financial statement’s opinion. 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. The financial accounting term restricted cash and compensating balances refers to monies that are reserved and not generally available to the company.
How is a Compensating Balance Calculated?
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. While compensating balances can offer significant benefits, it’s important to weigh them against the potential drawbacks. 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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A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation. Compensating errors occur when errors in equal amounts but opposite in effect are made in different accounts. To correct compensating errors, each error must be corrected individually. When an already-committed error is offset by another error (or set of errors), the latter error is known as a compensating error.
What Is a Compensating Balances Plan?
It is essential for businesses to account for the compensating balance correctly to maintain accurate financial statements and meet regulatory standards. 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. The borrowing agreement states that the corporation will maintain a compensating balance in an account at the bank of at least $250,000. When the two sides of the arrangement are netted, the loan is actually $4,750,000. A borrower who has entered into a compensating balance arrangement may need to disclose this situation in the footnotes to its financial statements, if the amount is material.
In this post, we will explore the concept of compensating balance, its definition, examples, and accounting rules. If you’ve ever wondered about the role of compensating balance in managing your finances, you’re in the right place! Since the store needs the $20,000 cash balance for other expenses, the owner borrows $40,000 from the LOC to purchase inventory. Assume a clothing store needs a $100,000 line of credit (LOC) to manage its operating cash flow each month.
Even if it does not constitute a material balance, it is good practice for borrowers to disclose this amount separately. Borrowers need to list this balance under restricted cash in the balance sheet. It allows users of the financial statements to understand the amount may not be available for use. In our example, by maintaining the minimum compensating balance, Company ABC gains access to these benefits. It can utilize the line of credit and enjoy reduced fees or lower interest rates on loans, improving their financial position. The requirement for a compensating balance is most common with corporate rather than individual loans.
