Accounting: The Language of Business - Vol. 2 (Intermediate: Part 137)

The shrinking of the country thanks to the railroads and the introduction of uniformity encouraged investment, which, in turn, put more focus on accounting. Up to the 1800s, investing had been either a game of knowledge or luck. People acquired issues of stock in companies with which they were familiar through industry knowledge or acquaintanceships with the owners. Others blindly invested according to the encouragement of relatives and friends. There were no financials to check if you wanted to invest in a corporation or business; thus, the risks involved ensured that investing was only for the wealthy—a rich man’s sport, tantamount to gambling. This image persists today (Investopedia).

 Short-Term Operating Assets: Cash and Receivables (Part B)

by

Charles Lamson

Restricted Cash and Compensating Balances

Cash is one of the only assets that typically does not involve any questions as to measurement. However, proper classification can be an issue. Two classifications—restricted cash and compensating cash balances—limit the use of cash in operations.

Restricted Cash. A company classifies cash as a current asset on the balance sheet unless it is restricted from use in the current operating cycle. Cash balances that may involve restrictions on withdrawal include foreign bank accounts, collateral for certain obligations, or cash held by a third party for a specific purpose. Examples include a long-term debt sinking fund when the third party holds cash to make payments on the company's debt or an escrow account when the third party holds cash to pay the company's real estate taxes or make insurance payments.

When cash is legally restricted from use in the current operating cycle, the company reclassifies the restricted amount from the regular cash line item on the balance sheet into restricted cash as follows:

1. If the restriction extends beyond one year from the balance sheet date, classify the restricted funds account as a noncurrent asset and include it in the other assets section of the balance sheet.

2. If the balance is held against long-term debt, reclassify the amount of cash held as a noncurrent asset on the balance sheet.

In either case, companies cannot combine the legally restricted compensating balances with regular cash on the balance sheet.

If the compensating balances are not part of our contractual agreement, companies must disclose the amounts, terms, and length of the arrangement in the footnotes to the financial statements. However, a classification out of regular cash on the face of the balance sheet is not required.

Regardless of the accounting treatment, a compensating balance requirement increases the entity's effective cost of borrowing. That is, the entity will have less cash to use but is still required at 10% interest. The required cash interest payment is $100 for the year (10% * $1,000). Due to an unsatisfactory credit rating, the creditor requires the business to leave 4% or $40 of the loan on deposit at the lending institution as security. It must keep $40 on deposit and can use only $960 ($1,000 - $40). Given that the annual interest payment is $100 and ignoring the time value of money due to the short-term nature of the loan, the annual cost of borrowing increases from 10% to 10.42% ($100 / $960).

Cash and Cash Equivalents: IFRS

Under International Financial Reporting Standards (IFRS), bank overdrafts are permitted to be included in cash and cash equivalents as a reduction if the overdraft balance is part of an integrated cash management strategy. This treatment allows for differences in banking systems and practices across countries. For example, banks in some countries may allow companies to have a negative cash balance that is repayable on demand.

Required Disclosures for Restricted Cash and Cash Equivalents

Accounting standards require separate disclosure for cash and cash equivalents that are restricted from withdrawal or use in operations. Companies describe the provisions of any restrictions in a note to the financial statements. Companies disclose informal compensating balance arrangements in the notes to the financial statements. These disclosures must describe the specific arrangements and the amount involved, if determinable, for the most recent audited balance sheet.

In 2016 Financial Statements, Tesla, Inc., the electric car designer and manufacturer, included $106 million of restricted cash in current assets and $268 million of restricted cash in noncurrent assets on its balance sheet. Exhibit 9.1 contains Tesla Inc.'s footnote disclosure discussion of its restricted cash balance. 

EXHIBIT 9.1 Restricted Cash Disclosure. Tesla, Inc., Annual Report, December 31, 2016 

Source: Tesla, Inc., Annual Report, December 31, 2016

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 444-446*

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