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Chapter7: Cash and Receivables

Restricted Cash and Compensating Balances

We discussed the classification of assets and liabilities in Chapter 3. You should recall that only cash available for current operations or to satisfy current liabilities is classified as a current asset. Cash that is restricted in some way and not available for current use usually is reported as a noncurrent asset such as investments and funds or other assets.

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   Restrictions on cash can be informal, arising from management's intent to use a certain amount of cash for a specific purpose. For example, a company may set aside funds for future plant expansion. This cash, if material, should be classified as investments and funds or other assets. Sometimes restrictions are contractually imposed. Debt instruments, for instance, frequently require the borrower to set aside funds (often referred to as a sinking fund) for the future payment of a debt. In these instances, the restricted cash is classified as noncurrent investments and funds or other assets if the debt is classified as noncurrent. On the other hand, if the liability is current, the restricted cash also is classified as current. Disclosure notes should describe any material restrictions of cash.

   Banks frequently require cash restrictions in connection with loans or loan commitments (lines of credit). Typically, the borrower is asked to maintain a specified balance in a low interest or noninterest-bearing account at the bank (creditor). The required balance usually is some percentage of the committed amount (say 2% to 5%). These are known as compensating balances a specified balance (usually some percentage of the committee amount) a borrower of a loan is asked to maintain in a low-interest or noninterest-bearing account at the bank. because they compensate the bank for granting the loan or extending the line of credit.

 The effect of a compensating balance is a higher effective interest rate on the debt.

   A compensating balance results in the borrower's paying an effective interest rate higher than the stated rate on the debt. For example, suppose that a company borrows $10,000,000 from a bank at an interest rate of 12%. If the bank requires a compensating balance of $2,000,000 to be held in a noninterest-bearing checking account, the company really is borrowing only $8,000,000 (the loan less the compensating balance). This means an effective interest rate of 15% ($1,200,000 interest divided by $8,000,000 cash available for use).

   The classification and disclosure of a compensating balance depends on the nature of the restriction and the classification of the related debt.4 If the restriction is legally binding, the cash is classified as either current or noncurrent (investments and funds or other assets) depending on the classification of the related debt. In either case, note disclosure is appropriate.

 A material compensating balance must be disclosed regardless of the classification of the cash.

   If the compensating balance arrangement is informal with no contractual agreement that restricts the use of cash, the compensating balance can be reported as part of cash and cash equivalents, with note disclosure of the arrangement. Graphic 7-2 provides an example of a note disclosure of a compensating balance for CNB Financial Services, Inc., a bank holding company incorporated in West Virginia.

Disclosure of Compensating Balances—CNB Financial Services, Inc.

Real World Financials


Note 10—Lines of Credit (in part)

The Bank entered into an open-ended unsecured line of credit with Mercantile Safe Deposit and Trust Company for $3,000,000 for federal fund purchases. Funds issued under this agreement are at the Mercantile Safe Deposit and Trust Company federal funds rate effective at the time of borrowing. The line … has a compensating balance requirement of $250,000.

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Cash and Cash Equivalents. In general, cash and cash equivalents are treated similarly under IFRS and U.S. GAAP. One difference relates to bank overdrafts, which occur when withdrawals from a bank account exceed the available balance. U.S. GAAP requires that overdrafts typically be treated as liabilities. In contrast, IAS No. 7 allows bank overdrafts to be offset against other cash accounts when overdrafts are payable on demand and fluctuate between positive and negative amounts as part of the normal cash management program that a company uses to minimize their cash balance.5
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For example, imagine LaDonia Company has two cash accounts with the following balances as of December 31, 2011:

National Bank: $300,000 
Central Bank:  (15,000) 

Under U.S. GAAP, LaDonia's 12/31/11 balance sheet would report a cash asset of $300,000 and an overdraft current liability of $15,000. Under IFRS, LaDonia would report a cash asset of $285,000.


Cash often is referred to as a nonearning asset because it earns no interest. For this reason, managers invest idle cash in either cash equivalents or short-term investments, both of which provide a return. Management's goal is to hold the minimum amount of cash necessary to conduct normal business operations, meet its obligations, and take advantage of opportunities. Too much cash reduces profits through lost returns, while too little cash increases risk. This trade-off between risk and return is an ongoing choice made by management (internal decision makers). Whether the choice made is appropriate is an ongoing assessment made by investors and creditors (external decision makers).

   A company must have cash available for the compensating balances we discussed in the previous section as well as for planned disbursements related to normal operating, investing, and financing cash flows. However, because cash inflows and outflows can vary from planned amounts, a company needs an additional cash cushion as a precaution against that contingency. The size of the cushion depends on the company's ability to convert cash equivalents and short-term investments into cash quickly, along with its short-term borrowing capacity.

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Companies hold cash to pay for planned and unplanned transactions and to satisfy compensating balance requirements.

   Liquidity is a measure of a company's cash position and overall ability to obtain cash in the normal course of business. A company is assumed to be liquid if it has sufficient cash or is capable of converting its other assets to cash in a relatively short period of time so that current needs can be met. Frequently, liquidity is measured with respect to the ability to pay currently maturing debt. The current ratio is one of the most common ways of measuring liquidity and is calculated by dividing current assets by current liabilities. By comparing liabilities that must be satisfied in the near term with assets that either are cash or will be converted to cash in the near term we have a base measure of a company's liquidity. We can refine the measure by adjusting for the implicit assumption of the current ratio that all current assets are equally liquid. In the acid-test or quick ratio, the numerator consists of “quick assets,” which include only cash and cash equivalents, short-term investments, and accounts receivable. By eliminating inventories and prepaid expenses, the current assets that are less readily convertible into cash, we get a more precise indication of a company's short-term solvency than with the current ratio. We discussed and illustrated these liquidity ratios in Chapter 3.

   We should evaluate the adequacy of any ratio in the context of the industry in which the company operates and other specific circumstances. Bear in mind, though, that industry averages are only one indication of acceptability and any ratio is but one indication of liquidity. Profitability, for instance, is perhaps the best long-run indication of liquidity. And a company may be very efficient in managing its current assets so that, say, receivables are more liquid than they otherwise would be. The receivables turnover ratio we discuss in Part B of this chapter offers a measure of management's efficiency in this regard.

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   There are many techniques that a company can use to manage cash balances. A discussion of these techniques is beyond the scope of this text. However, it is sufficient here to understand that management must make important decisions related to cash that have a direct impact on a company's profitability and risk. Because the lack of prudent cash management can lead to the failure of an otherwise sound company, it is essential that managers as well as outside investors and creditors maintain close vigil over this facet of a company's health.<a onClick="'/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/818573/orange_dot.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (0.0K)</a>

  A manager should actively monitor the company’s cash position.

4FASB ASC 210–10–S99–2: SAB Topic 6.H–Balance Sheet—Overall—SEC Materials, Accounting Series Release148 (originally “Amendments to Regulations S-X and Related Interpretations and Guidelines Regarding the Disclosure of Compensating Balances and Short-Term Borrowing Arrangements,” Accounting Series Release No. 148, Securities and Exchange Commission (November 13, 1973)).

5“Statement of Cash Flows,” International Accounting Standard No. 7 (IASCF), as amended, effective January 1, 2009, par. 8.

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