Saved Compensating balances represent:
Cash in a bank account that can’t be spent
Accounts on which banks pay interest, e.g. NOW accounts.
Balances in a payroll checking account
Accounts that are subject to bank service charges.
The Correct Answer and Explanation is:
Correct Answer: Cash in a bank account that can’t be spent
Explanation:
Saved compensating balances represent cash in a bank account that cannot be freely spent by the company. These balances are typically held as a requirement by a lender (such as a bank) when a company borrows funds or opens a line of credit. The purpose of these balances is to act as partial security or collateral for the loan or credit facility. The amount is usually specified as a percentage of the total loan and must remain in the borrower’s account during the term of the agreement.
For example, if a company takes a $1 million loan and the lender requires a 10% compensating balance, the company must maintain $100,000 in a designated bank account. This $100,000 cannot be used for operations, payments, or investments, and is effectively restricted cash.
Key Points:
- Not Available for General Use: Since the company cannot access or spend these funds, they are considered restricted and must be reported separately from other liquid cash on financial statements.
- Disclosure Requirement: According to U.S. GAAP and IFRS, compensating balances that are legally restricted should be disclosed in the financial statements. If the restriction is long-term, the balance is classified as a non-current asset; if short-term, it is shown as a current asset but clearly labeled as restricted.
- Not Interest-Bearing: These balances typically do not earn interest or earn minimal interest compared to other deposit accounts. Their primary role is not to generate income but to satisfy a contractual obligation.
- Impact on Liquidity Ratios: Because compensating balances are not available for immediate use, they reduce the effective liquidity of a company. Analysts often adjust liquidity ratios to account for the effect of these restricted funds.
Thus, saved compensating balances reflect restricted cash that serves a financial purpose tied to borrowing arrangements, and are not available for general business operations.
