A bank lends 500,000 at 6 percent and requires the borrower to keep 50,000 on deposit for the life of the loan. The borrower has 450,000 to use and pays interest on 500,000.
The stated rate is 6 percent. The effective rate is 30,000 divided by 450,000, or 6.67 percent. Nothing about the loan document says 6.67, and a reader comparing stated rates across two lenders will get the comparison wrong.
Reporting depends on how firm the arrangement is. A legally restricted compensating balance against a short-term borrowing is reported separately among current assets. One against a long-term borrowing is reported as a noncurrent investment. An informal understanding with no legal restriction stays in cash and is disclosed in the notes.
The disclosure exists because the alternative misleads in a specific way. Cash is the asset a reader trusts most, and a compensating balance is the part of it that cannot be used to pay anyone.
ASC 210-10-S99-2 provides SEC staff guidance for compensating-balance and short-term borrowing disclosures. Apply it only to an entity within its scope. The Linden Peak cash close keeps the deposit restriction separate from the bank-account reconciliation.
Put the concept to work
Understand this concept
- Explain what a compensating balance obliges a borrower to do, how it is reported, and why it raises the effective interest rate on the related borrowing.
Apply this concept
- Compute the effective interest rate on a borrowing that carries a compensating balance requirement, and state the reported cash the borrower can actually use.
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Build on these ideas
- Cash — Understand
To understand this concept: Required. The obligation is a limit on the entity's own cash.
- Compensating balance — Understand
To apply this concept: Required. Computing the effect requires knowing what the arrangement does.
- Restricted cash — Understand
To understand this concept: Required. A compensating balance is a species of restricted cash.
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- Compensating balance — Apply
Required level here: understand. Required. Computing the effect requires knowing what the arrangement does.