Once the LOC is in place, the clothing store needs to manage cash flow to minimize the interest expense it’s paying for use of the LOC. The compensating balance cuts down on the risk to the lender by allowing for recovery of part of the loan in cases of default. Compensating errors occur when errors in equal amounts but opposite in effect are made in different accounts. If there are 2 or more errors made in a way that the over-all effect of these error on the credit and debit is nil, these errors are called compensating errors . To correct compensating errors, each error must be corrected individually. Then the excess debit of $500 in the advertising account is set off against the excess credit in the interest account.
In practical terms, when setting up a compensating balances plan, you will be asked to maintain a minimum account balance for a specified duration. This balance can be kept in various account types, including checking, savings, or money market accounts, depending on the requirements set by the bank. The amount needed as a compensating balance is typically a percentage of your average monthly balance or a predetermined flat amount. A compensating balance is a minimum bank account balance that a borrower agrees to maintain with a lender. The borrower may also benefit from being granted a somewhat lower interest rate. However, the borrower is also paying interest on a net loan balance that is smaller than the amount of the loan, so the effective interest rate for the entire arrangement is higher.
You would still pay interest each month on 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. For the bank, the extra $20,000 compensating balance serves as security for the loan. For the borrower, this extra $20,000 reduces the interest rate they can get on this loan. However, they also have to bear extra interest on the additional $20,000 balance.
- Once the LOC is in place, the furniture store needs to manage cash flow to minimize the interest expense it’s paying for use of the LOC.
- Be sure to check with your bank or lender to see what their compensating balance arrangements are.
- The amount needed as a compensating balance is typically a percentage of your average monthly balance or a predetermined flat amount.
- The articles and research support materials available on this site are educational and are not intended to be investment or tax advice.
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 compensating balance definition account, a certificate of deposit (CD), or another holding account. The most frequent compensating balance structure is usually fairly basic.
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For the borrower, however, a compensating balance is restricted funds. The borrower cannot access these funds until the loan’s maturity. Usually, borrowers set the compensating balance as a percentage of the total loan value. It is essential for businesses to account for the compensating balance correctly to maintain accurate financial statements and meet regulatory standards. Accounting rules dictate that the bank does not pay interest on compensating balance.
Compensating balance definition
A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation. In 2018, the average compensating balance needed amounted to $4,354,000, while the amount required on 30 December 1978 was $4,008,000 after adjustment for estimated average float. The same disclosure is required if the impact on the effective interest rate is “significant.” One has no compensating balance requirement, but the other calls for $200,000 to be left on deposit at all times.
As the excess debit is compensated with the excess credit, the trial balance does not reveal the errors. When an already-committed error is offset by another error (or set of errors), the latter error is known as a compensating error. Compensating errors occur when errors in equal amount but opposite in sense cancel each other. Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise.
It’s intended to reduce the cost of lending for the lender because it allows them to invest the cash in the compensating balance account and keep all or a portion of the proceeds. A compensating balance may also benefit you as a borrower because you’ll likely be able to secure a lower interest rate. Most businesses experience seasonal fluctuations in the revenues they bring in and the expenses they pay out. They need cash on hand to get them through the dry periods, and they usually get it by obtaining a line of credit, maintaining a savings account, or both.
Understanding a Compensating Balances Plan
The money is usually kept in a deposit account, such as a checking or savings account, a certificate of deposit (CD), or another type of holding account. The financial accounting term restricted cash and compensating balances refers to monies that are reserved and not generally available to the company. Restricted cash can include minimum balances on bank accounts, while compensating balances include money needed to repay a loan. A compensating balance is a form of collateral to be maintained with a lender that enables the borrower to secure a line of credit or installment loan.
If the compensating balance is not legally enforceable (the creditor can terminate it at will), then footnote disclosure is required (like any other non-enforceable agreement). The volume and dollar amounts of compensating balances are, by themselves, immaterial and require no additional footnote disclosure (if they result in increased effective rates). The borrower who agrees to hold a compensating balance promises the lender to maintain a minimum balance in an account. As a result, the bank is free to apply the compensating balance to other borrowers’ loans. The compensating balance is often expressed as a percentage of the entire loan amount.
To keep things simple, a compensating balance acts as collateral for lenders and helps to compensate for any risks. This allows them to pay out a lower amount, but still receive the full amount of interest on the loan or line of credit. Be sure to check with your bank or lender to see what their compensating balance arrangements are. A compensating balances plan is a type of insurance policy that allows the insured business to withdraw a portion of the premiums paid for the policy.
Or are you just now looking into what some of your options are and came across a few terms you aren’t familiar with? There can be any number of reasons for you to take out a loan or get a line of credit. The business gets a low-cost source of funds to help keep its operations going. The term “cumulative error” refers to any error that happens in the same direction during the chaining operation. It is also possible for two or more errors of this kind to be made in the books, which cancel out each other’s effects.
Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia. The trial balance extracted on 31 December 2017 from the books of a wholesaler does https://personal-accounting.org/ not agree, and so the difference was allocated to a suspense account. For example, if both the sales book and purchases book are overcast by $1,000, the net effect in the ledger will be nil.
The amount that is available for withdrawal is deposited into a separate bank account. The insured has access to the account as a source of working capital. 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. Since the store needs the $20,000 cash balance for other expenses, the owner borrows $40,000 from the LOC to purchase inventory.