The money is usually kept in a deposit account, such as a checking or savings account, a certificate of deposit (CD), or another type of holding account. 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. A compensating balance is a form of collateral to be maintained with a lender that enables the borrower to secure a line of credit or installment loan.
It’s intended to reduce the cost of lending for the lender because it allows them to invest the cash in the compensating balance account and keep all or a portion of the proceeds. A compensating balance may also benefit you as a borrower because you’ll likely be able to secure a lower interest rate. 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 the dry periods, and they usually get it by obtaining a line of credit, maintaining a savings account, or both.
Therefore, the opening entry in the suspense account was made at $1,590 on the Cr. Ask a question about your financial situation providing as much detail as possible. Your information is kept secure and not shared unless you specify. The analysis below shows how the effective interest rate is affected. Specifically, the depositor must leave a stated amount on deposit in an account (either checking or savings). A major restriction may be placed on cash by a bank in connection with a loan or a commitment to a loan (known as a line of credit).
- Also, the interest received of $2,000 is credited in the interest account as $2,500.
- 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.
- This disclosure covers the accounting for compensating balances.
- However, it may take the effective interest rate of the loan higher.
- Compensating errors occur when errors in equal amounts but opposite in effect are made in different accounts.
In practical terms, when setting up a compensating balances plan, you will be asked to maintain a minimum account balance for a specified duration. This balance can be kept in various account types, including checking, savings, or money market accounts, depending on the requirements set by the bank. The amount needed as a compensating balance is typically a percentage of your average monthly balance or a predetermined flat amount. A compensating balance is a minimum bank account balance that a borrower agrees to maintain with a lender. The borrower may also benefit from being granted a somewhat lower interest rate. However, the borrower is also paying interest on a net loan balance that is smaller than the amount of the loan, so the effective interest rate for the entire arrangement is higher.
The compensating balance is usually a percentage of the loan total. 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. The most frequent compensating balance structure is usually fairly basic.
What is a Compensating Balance?
These compensating balances result in the borrower paying a higher effective interest rate because the bank has the use of the money. Once the LOC is in place, the furniture store needs to manage cash flow to minimize the interest expense it’s paying for use of the LOC. Assume, for example, the interest rate on the LOC is an annualized rate of 7% and the store starts the month with a $35,000 cash balance. The store estimates sales for the month to be $90,000, and $50,000 in inventory needs to be purchased to meet customer demand. However, the borrower must pay interest on the full amount of the loan, including the balance that may not be spent. A loan with a compensating balance may be extended to an individual or a company with a poor credit rating.
Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia. The trial balance extracted on 31 December 2017 from the books of a wholesaler does https://personal-accounting.org/ not agree, and so the difference was allocated to a suspense account. For example, if both the sales book and purchases book are overcast by $1,000, the net effect in the ledger will be nil.
Therefore, companies must disclose the compensating balance requirement in the financial statements as a disclosure in the notes. This disclosure covers the accounting for compensating balances. These are the average balance arrangement and the minimum fixed balance arrangement.
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You would still pay interest each month on your compensating balance of $10,000. But, if you do use your line of credit, you then pay interest on whatever amount you borrow, plus the compensating balance. For the bank, the extra $20,000 compensating balance definition compensating balance serves as security for the loan. For the borrower, this extra $20,000 reduces the interest rate they can get on this loan. However, they also have to bear extra interest on the additional $20,000 balance.
What is an Example of Compensating Balance?
For the borrower, however, a compensating balance is restricted funds. The borrower cannot access these funds until the loan’s maturity. Usually, borrowers set the compensating balance as a percentage of the total loan value. It is essential for businesses to account for the compensating balance correctly to maintain accurate financial statements and meet regulatory standards. Accounting rules dictate that the bank does not pay interest on compensating balance.
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Once the LOC is in place, the clothing store needs to manage cash flow to minimize the interest expense it’s paying for use of the LOC. 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 errors occur when errors in equal amounts but opposite in effect are made in different accounts. If there are 2 or more errors made in a way that the over-all effect of these error on the credit and debit is nil, these errors are called compensating errors . To correct compensating errors, each error must be corrected individually. Then the excess debit of $500 in the advertising account is set off against the excess credit in the interest account.
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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. In 2018, the average compensating balance needed amounted to $4,354,000, while the amount required on 30 December 1978 was $4,008,000 after adjustment for estimated average float. The same disclosure is required if the impact on the effective interest rate is “significant.” One has no compensating balance requirement, but the other calls for $200,000 to be left on deposit at all times.
Or are you just now looking into what some of your options are and came across a few terms you aren’t familiar with? There can be any number of reasons for you to take out a loan or get a line of credit. The business gets a low-cost source of funds to help keep its operations going. The term “cumulative error” refers to any error that happens in the same direction during the chaining operation. It is also possible for two or more errors of this kind to be made in the books, which cancel out each other’s effects.
The amount that is available for withdrawal is deposited into a separate bank account. The insured has access to the account as a source of working capital. Also, when you take out a loan with a compensating balance, you must report the balance as “restricted cash” in your financial statements. Restricted cash refers to money that is reserved for a specific purpose and not available for general or immediate business use. Since the store needs the $20,000 cash balance for other expenses, the owner borrows $40,000 from the LOC to purchase inventory.