Restricted Cash Definition
Restricted cash is that portion of cash which is set aside for a specific purpose and is not available for general business use on an immediate basis.
In the broader sense, it is the portion of money a business entity has in its possession but can’t use it immediately. Instead, that portion of the cash is subjected to special limitations, such as being earmarked for a future use or a waiting period. This cash is usually held in a special account (example escrow account) so it remains separate from the rest of a business’ cash and equivalent. It may represent cash amount on its way into the business, or cash that is being held prior to spending.
Such kind of cash is not available for current use, this is not considered as part of liquidity source and is excluded in the calculation of various liquidity ratio.
It takes many forms, which a balance sheet should note, clearly specifying the source and its uses. Payment deposits are one type of restricted cash which represent cash a business receives from a customer prior to shipping goods or providing services but can’t spend until satisfying the order due to a specified clause in the agreement. Legal fees in the escrow account which will go to an attorney following the completion of a lawsuit is another form of this cash. Businesses can also set money aside to pay the future debt, mentioning it so as not to spend it for other purposes.
Examples of Restricted Cash
- Amounts pledged as collaterals: Sometimes, certain corporation pledges a certain amount of cash as collateral against the risk covered by insurance company. This cash is generally maintained in a separate escrow account.
- Mandatory deposits at central banks: This is the most common deposit of restricted cash where bank needs to deposit a certain amount of cash in the central bank (RBI in India) and this amount is not available to use.
- Contributions to cover pension liabilities: Companies in certain geographies maintain funds to cover some of the employee benefits, like pensions which are to be paid in future.
Restricted Cash Accounting
Restricted Cash on Balance Sheet
Balance sheet for any entity must add all assets and liabilities, including cash and cash equivalents. This cash is generally reported as a separate line item as part of cash and cash equivalents account on a company’s balance sheet, and the reason why the cash is restricted is typically stated in the accompanying notes. This allows a balance sheet to have a balance until the cash is brought in as revenue or paid out as an expense and accounted for normally.
Restricted Cash on Cash Flow Statement
A restricted cash on cash flow statement is another form of financial statement in which a corporation uses to account for such cash and keep its accounts balanced.
Cash flow refers to the rate at which cash moves in and out of a business. Normally, change in cash and cash equivalent is presented in the final reconciliation at the end of cash flow statement as the purpose of the restricted cash on cash flow statement is to explain how and why the balance of cash moved.
When there is such cash which is not presented as part of the cash balance in the balance sheet, change in restricted cash would be presented either in the cash from operating activities, cash from investing activities or in the cash from financing activities, depending on the reason of maintaining the restricted cash in the balance sheet.
For example, changes in the cash because the repayments of borrowings are reported under cash flow from financing activities.
Changes in deposits which is taken from clients to construct an asset are normally related to the main operation, and thus are covered under operating activity.
In cases where it is expected to be used after one year from the balance sheet date, it should be classified as the non-current asset. However, if it is expected to be used within 12 months from the balance sheet date, it should be classified as a current asset.
Restricted Cash on Balance Sheet Example
Restricted Cash on Balance Sheet Example 1
ABC Inc. which is engaged in large equipment manufacturer received an order from one of its customer for a piece of equipment to be finished and shipped within the next three months. For the same, the customer has made an advance payment (deposit) to ABC. As per the customer contract, ABC must transfer this deposit in a separate bank account which cannot be used until the equipment is shipped. This advance payment received from the customer can be classified as restricted cash on the ABC’s balance sheet because it cannot be used by the company until a future event occurs (the shipment of equipment). Once the equipment is shipped, This cash is available to the company for its normal operation.
Restricted Cash on Balance Sheet Example 2
XYZ Inc. sets aside a certain amount of cash each month for payment of a long-term debt which is to be paid off in two years. The amount of cash set aside is restricted in nature as it can be only used for debt repayment in the future only, and thus represents restricted cash. When the time of loan settlement comes, the company will use the restricted funds to pay off the debt.
Compensating balance is a minimum cash balance that a company is required to maintain in an account especially maintained as part of a contractual agreement with a potential or current lender. A compensating balance is generally used to offset bank’s costs partially when lending out money which is typically calculated as a loan percentage. For example, a company agrees to keep $800,000 in a bank account in exchange for that bank extending $8 million credit line. Compensating balances are often considered as restricted cash and must be reported on a company’s balance sheet.
This has been a guide on what is Restricted Cash, examples and its definition. We also look at restricted cash accounting – balance sheet and cash flows and its associated examples. You may learn more about advanced accounting from the following articles –
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