Restricted Cash Definition Examples How It Works

Restricted Cash Definition

In the broader sense, it is the portion of money a business entity has in its possession but can’t use immediately. Instead, that cash portion is subjected to special limitations, such as being earmarkedEarmarkedEarmarking refers to a fund allocation practice in which an entity, a government, or an individual sets aside a determined amount of funds to use them for a specific goal. One can do it either via collective or individual decisions.read more for future use or waiting period. It may represent cash amount on its way into the business or cash held before spending. Such kind of cash is not available for current use. It is not considered part of the liquidity source and is excluded in calculating various liquidity ratios.

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Examples of Restricted Cash

Let’s discuss the following examples.

Amounts pledged as collaterals.: Sometimes, some corporations pledge a certain amount of cash as collateral against the risk covered by an insurance company. They generally maintain such cash in a separate escrow accountEscrow AccountThe escrow account is a temporary account held by a third party on behalf of two parties in a transaction. It reduces the risk of failing to oblige the transaction by either of the parties. It operates until a transaction is completed and all the conditions are met.read more.Mandatory deposits at central banks.: This is the most common deposit of restricted cash where the bank needs to deposit a certain amount of cash in the central bank (RBI in India), and this amount is not available.Contributions to cover pension liabilities.: Companies in specific geographies maintain funds to cover some employee benefits, like pensions for future payments.

Restricted Cash Accounting

#1 – Balance Sheet

A balance sheet for any entity must add all assets and liabilities, including cash and cash equivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. read more. Companies generally report such cash as a separate line item as part of the cash and cash equivalents account on a company balance sheet Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more. They typically state why the cash is restricted in the accompanying notes. It allows a balance sheet to balance until the cash is brought in as revenue or paid out as an expense and accounted for normally.

#2 – Cash Flow Statement

Restricted cash on the cash flow statement is another form of financial statement that 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 business. The purpose of the restricted cash on the cash flow statement is to explain how and why the cash balance moved. Usually, a change in cash and cash equivalent is presented in the final reconciliationReconciliationReconciliation is the process of comparing account balances to identify any financial inconsistencies, discrepancies, omissions, or even fraud. At the end of any accounting period, reconciliation involves matching balances and ensuring that debits (credits) from one account for one transaction is same as the credit (debits) to another account for the same transaction.read more at the end of the 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 cash that is not presented as part of the cash balance in the balance sheet, a change in restricted cash would be presented either in cash from operating activities From Operating ActivitiesCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more, cash from investing activitiesCash From Investing ActivitiesCash flow from investing activities refer to the money acquired or spent on the purchase or disposal of the fixed assets (both tangible and intangible) for the business purpose. For instance, the purchase of land and joint venture investment is cash outflow, while equipment sale is a cash inflow.read more. Or in cash from financing activities From Financing ActivitiesCash flow from financing activities refers to inflow and the outflow of cash from the financing activities like change in capital from securities like equity or preference shares, issuing debt, debentures or repayment of a debt, payment of dividend or interest on securities.read more, depending on maintaining cash on 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 taken from clients to construct an asset are generally related to the main operation and thus are covered under operating activityOperating ActivityOperating activities generate the majority of the company’s cash flows since they are directly linked to the company’s core business activities such as sales, distribution, and production.read more.

In cases where it is expected to be used after one year from the balance sheet date, it should be classified as a non-current assetNon-current AssetNon-current assets are long-term assets bought to use in the business, and their benefits are likely to accrue for many years. These Assets reveal information about the company’s investing activities and can be tangible or intangible. Examples include property, plant, equipment, land & building, bonds and stocks, patents, trademark.read more. However, if it is expected to be used within 12 months from the balance sheet date, it should be classified as a current assetCurrent AssetCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more.

Example

Example #1

ABC Inc. is engaged in large equipment manufacturing. It received an order from one of its customers for a piece of equipment for finishing and shipping within the next three months. The customer has made an advance payment (deposit) to ABC for the same. ABC must transfer this deposit to a separate bank account as per the customer contract. It cannot be used until the equipment ships. This advance payment received from the customer can classify as restricted cash on the ABC’s balance sheet. The company cannot use it until a future event occurs (the shipment of equipment). Once the equipment ships, this cash is available to the company for its regular operation.

Example #2

XYZ Inc. sets aside a certain amount of cash each month to pay 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 only be used for debt repayment in the future and thus represents restricted cash. When the loan settlement comes, the company will use the restricted funds to pay off the debt.

Compensating Balances

Compensating balance is a minimum cash balance that a company must maintain in an account primarily maintained as part of a contractual agreement with a potential or current lender. A compensating balance is generally used to offset a bank’s costs when lending out money partially. It 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 an $8 million credit lineCredit LineA line of credit is an agreement between a customer and a bank, allowing the customer a ceiling limit of borrowing. The borrower can access any amount within the credit limit and pays interest; this provides flexibility to run a business.read more. Compensating balances are often considered restricted cash and must be reported on a company’s balance sheet.

Restricted Cash Definition Examples How It Works