The former tends to be used for lines of credit and the latter for instalment loans. A bank account balance that a corporation agrees to maintain with a current or potential lender. At a minimum, compensating balances must be disclosed in the notes to the corporation’s financial statements.
What is a Compensating Balance?
We’ll answer these questions and more, so you can see how a compensating balance could impact your financial decisions. 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. These materials were downloaded from PwC’s Viewpoint (viewpoint.pwc.com) under license. Founded in 2002, our company has been a trusted resource for readers seeking informative and engaging content.
Basically, it’s a balance agreement that acts as collateral for the lender which helps avoid insufficient balances. 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.
- The bank is free to use the compensating balance in loans made to other borrowers.
- This restriction means the funds aren’t fully liquid, which can affect the company’s ability to quickly access cash.
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- For the borrower, the compensating balance is a mixed blessing.
While it technically belongs to the borrower, they can’t use it freely; it must stay in the account, serving as a guarantee for the lender. 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. Yes, the terms of a compensating balance can often be negotiated as part of the loan agreement. In some cases, borrowers with strong credit or a solid relationship with the lender may be able to negotiate a lower compensating balance or even have it waived entirely.
The bank instead offers you a line of credit for $60,000, which includes a $10,000 compensating balance. If a compensating balance is not explicitly mentioned or is “silent” in the loan agreement, it can lead to ambiguity and potential disputes between the borrower and the lender. In such cases, the borrower might not be aware of the requirement to maintain a specific balance, which could lead to unexpected financial obligations or penalties. It’s crucial for both parties to clearly define and understand all terms in the loan agreement to avoid misunderstandings.
A compensating balance is a specific amount of money that a borrower is required to keep in a bank account as part of a loan agreement. By holding this balance, the lender ensures that they have some funds on hand if the borrower faces difficulties in repaying the loan. This balance is not just a formality—it serves as collateral, giving the lender more confidence in the loan’s security. In addition to loans, a compensating balance approach may be used to secure a line of credit. In the event that the balance drops below that minimum, the interest rate is adjusted upward and usually does not drop back down, what is the journal entry to record prepaid rent even if the minimum balance to the account is restored. The average balance arrangement requires a borrower to ensure that they maintain a minimum average balance over an agreed period.
Perhaps an offer with a compensating balance provides you with an overall better deal. This restriction means the funds aren’t fully liquid, which can affect the company’s ability to quickly access cash. To fully understand the impact of this arrangement, you can apply the compensating balance formula to calculate the effective interest rate. It’s not uncommon for borrowers to commit to a compensating balance without knowing it. Before you take out a loan, be sure to read the fine print and find out whether you’ll be responsible for a compensating balance.
Examples of Cash Management
The borrower, therefore, has the flexibility to use the whole line of credit for part of this period. They must, however, ensure that the money is repaid within the agreed time frame. Yes, a compensating balance is classified as a current asset in accounting because it is money that the company holds in a bank account.
You would still pay interest each month on tax deductible pregnancy medical expenses 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. Primarily, a compensating balance helps safeguard the lender while providing the borrower with access to necessary funds.
Just like your individual credit, you also need to build up a solid credit history with your business. Having a poor credit rating can lead to a lending cost that isn’t ideal. But in some instances, you might even decide to agree to a compensating balance on your own. If you want to take out a loan or qualify for a line of credit, there are obligations for you to meet. A compensating balance is a certain balance that you need to keep to qualify for instalment loans or a line of credit.
AccountingTools
The borrower ends up receiving a reduced amount from the lender, but the lender still receives interest on the full amount of the loan. In this example, we assume a nominal interest rate—the percentage that a lender charges on the total loan amount, expressed as a yearly rate—of 10%. This figure is chosen for illustrative purposes to make the math easy to follow and to clearly demonstrate how a compensating balance impacts the true cost of borrowing. Often, you’re forced to accept a compensating balance as a borrower. Maybe you’re a new small business and don’t have a credit history, so this is your only option.
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A compensating balance is a minimum bank account balance that a borrower agrees to maintain with a lender. The lender requires this arrangement in exchange for lending funds to the borrower. The amount of funds to be held at the bank is typically set at a percentage of the loan balance. A material amount is defined as an amount large enough to affect the opinion of a person reading a financial statement. In principle, compensating balances only need to be reported separately from regular cash balances if the compensating balance is ‘material’. That is to say, if it could influence the judgement of a person reading the company’s financial statements.
When the two sides of the arrangement are netted, the loan is actually $4,750,000. This calculation reveals that while the nominal interest rate is 10%, the actual cost of borrowing—considering the funds that are tied up in the compensating balance—is 12.5%. This higher effective interest rate reflects the fact that the borrower is paying interest on the full loan amount, even though they only have access to $80,000 of it. It plays a crucial role in many loan arrangements, affecting both borrowing costs and a company’s financial strategy. 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.
Smith’s Bank offers to provide a £110K line of credit with a £10K compensating balance on the average balance arrangement. Hotshot Fashions, therefore, has to pay interest on £10K each month, regardless of whether or not it accesses the line of credit. If it does access the line of credit it pays interest on what it borrows plus the £10K compensating balance. 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.
Accounting Rules on Compensating Balances
The compensating balance purpose is to ensure some level of liquidity for the lender in case the borrower defaults. A compensating balance acts as collateral for the lender, allowing them to take on less risk when lending money. 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.