Compensating balance is the least or minimum balance that an organization or an individual needs to keep with the lender. The primary objective of such a balance is to reduce the lending cost of a borrower. For instance, a company takes a loan of $50,000 from a bank and agrees never to use $5,000. It means the effective loan amount is $45,000 only.
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How Compensating Balance Works?
Such a requirement is a common phenomenon with corporate loans. The need to maintain the balance could be in a savings account, certificate of deposit or checking account, depending on the terms of the contract.
The lender can use this left amount to earn interest by loaning it at a higher interest or using it for any other investment opportunities. For the borrower, this results in a loss. As the borrower has to pay the interest on the full loan amount. Or, we can say, it raises the cost of capital for the company taking a loan.
Example of Compensating Balance
Company ABC has a loan of $100,000 million from Bank A. The terms of the loan include an interest rate of 5% and a compensating balance of $10,000. The borrower should keep this amount in a non-interest bearing account with the same bank.
In this case, interest on the loan in dollar terms is $5,000. Though the interest rate is 5%, the effective interest rate will be higher as the borrower only gets to use $95,000. Thus, the effective interest rate is 5.3% ($5,000 / $95,000).
Need for Compensating Balance
There could be several reasons why a bank or a lender may require the borrower to keep a compensating balance. These are:
- A pre-requisite to grant a loan.
- A borrower has a low or poor credit rating.
- It acts as a surety that the borrower will repay the lender.
- It’s a condition pre-requisite for the loan from the borrower. For example, a borrower promises to keep $2 million in a checking account if the bank agrees to grant him a credit of $8 million at an interest rate lower than the market rate.
- Reduces the borrower’s overall risk in granting the loan.
- It helps to lower the cost of lending.
Accounting Treatment of Compensating Balance
A company must reveal compensating balances (if any) in its financial statements. As per the accounting rules, if the amount of compensating balances is material, then a company must reveal compensating balances separate from the cash balances in the financial statements. As to what constitutes a material amount, the rules say the amount should be significant enough to influence a person’s opinion.
Usually, a company needs to report any such balance as restricted cash. It is cash that a company holds for a specific objective, and thus, it is not accessible for regular business use. A point to note is that a compensating balance is not the same as restricted cash.
Restricted cash is the one that a company sets aside on its own for a specific purpose. On the other hand, compensating balance is the minimum amount that an organization needs to keep due to a contractual agreement with the bank.
Another difference between the two is that a company has control over the restricted cash, while it has no control over compensating balances. Instead, the bank or the lender has control over the compensating balances.1–3