GAAP call for the presentation of information about restricted cash balance. These restrictions may include amounts set aside in escrow accounts which can be used only for a specified purpose. These amounts should be excluded from cash and from current assets if appropriate.
There may be an informal restricted cash arising from management intent to use a certain amount of cash for a particular purpose. This type of restriction seldom produces a formal segregation on the balance sheet because of its non-binding nature. If the amount is material, special footnote disclosure may be justified.
A major restriction may be placed on cash by a bank in connection with a loan or a commitment to loan (known as a line of credit). Specifically, the depositor must leave a stated amount on deposit in an account (either checking or savings). These compensating balances result in the borrower paying a higher effective interest rate because the bank has the use of the money.
For example, suppose that the Sample Company has two separate $1 000,000 loans bearing interest at 12 percent. One has no compensating balance requirement, but the other calls for $200,000 to be left on deposit at all times. This analysis shows how the effective interest rate is affected:
Disclosures about compensating balances have not been addressed in any authoritative pronouncements. This publication from GAAP (which is binding for SEC filings) requires that an enforceable compensating balance agreement be disclosed by segregating the amount from cash if it is greater than 15 percent of total cash and marketable investments.
The same disclosure is required if the impact on the effective interest rate is “significant.” If the arrangement is not enforceable, or not more than 15 percent of cash and marketable investments, or does not have a significant effect on the effective interest rate, note disclosure is appropriate. The GAAP does not require disclosure of the effective interest rate. From the practical standpoint, formal segregation seldom occurs because the agreements are virtually always informal and nonbinding. Thus, their existence is generally disclosed in a footnote. Presented below is the note provided by Dan River, Inc., to describe its compensating balances:
Note 2: Compensating Balances—Informal lines of credit agreements with several banks require the Company to maintain average cash compensating balances principally equal to 20% of the average outstanding short-term bank loans or 10% of the amount of the credit line, whichever is higher. The agreements require interest on the loans at the prime rate and are subject to review from time to time and can be terminated at the option of either party.
In 2018, the average compensating balance required to be maintained amounted to $4,354,000 and the amount required on December 30, 1978, was $4,008,000 after adjustment for estimated average float. The average amount of outstanding loans amounted to $9,461,000, and the maximum amount outstanding at the end of any month was $16,631,000. The unused available borrowings under the lines of credit agreements amounted to $58,150,000 at December 30, 1978. The weighted average interest rate on the short-term bank loans during the year amounted to 8.59%.
Notice that the arrangement lacks legal enforceability.