Restricted cash refers to money that is set aside for a specific purpose and is not available for general use by a company or individual. This money is segregated from the regular cash and cash equivalents because of its designated purpose and is often subject to restrictions on its use. Restricted cash is typically reported separately from the regular cash balance on an entity’s balance sheet, often under the current or non-current assets, depending on the expected duration of the restriction.
Reasons for cash to be restricted include:
- Legal or Contractual Requirements: A company may be required by law or contractual agreements to set aside cash for specific purposes.
- Debt Covenants: Lenders might require a borrower to maintain a certain amount of cash as collateral or to ensure future loan payments.
- Future Capital Expenditures: Companies might set aside cash for planned capital projects or future large expenditures.
- Tenant Security Deposits: Landlords often collect security deposits from tenants. This money is typically kept in a restricted account and returned to the tenant at the end of the lease, minus any amounts required to cover damages or unpaid rents.
- Insurance Reserves: Insurance companies may need to maintain certain cash reserves to cover potential claims.
- Escrow Accounts: When buying real estate, funds are often held in escrow (a third-party account) until the transaction is completed. During this period, these funds are considered restricted.
How it’s reported on financial statements:
On the balance sheet, restricted cash can be classified as either a current or non-current (long-term) asset, depending on the nature of the restriction. If the cash is expected to be used or released within a year, it’s considered a current asset. If the restriction is expected to last more than a year, it’s classified as a non-current asset.
For a clearer understanding of the company’s liquidity, some firms may present cash, cash equivalents, and restricted cash together in the statement of cash flows, even if they are presented separately in the balance sheet. This presentation was emphasized and clarified by updates from standard-setting bodies like the Financial Accounting Standards Board (FASB) in the U.S.
Example of Restricted Cash
Let’s use a fictional scenario involving a real estate transaction to illustrate restricted cash.
Scenario: Buying a Property
- Amy, a buyer interested in purchasing a new home.
- David, a homeowner looking to sell his house.
- Escrow Company, a neutral third-party entity that helps in facilitating the transaction.
Amy is interested in buying David’s house, which is listed for $300,000. After negotiations, they agree on a sale price of $290,000. To show her commitment and intent to purchase, Amy agrees to put down a deposit (often called “earnest money”) of $10,000.
This deposit shouldn’t go directly to David because the sale hasn’t been finalized yet. Instead, the $10,000 is placed into an escrow account, managed by the Escrow Company. This money is “restricted” because it can’t be used freely by either party until certain conditions are met.
The agreement specifies the following conditions for the escrow money:
- If Amy proceeds with the purchase and closes the deal, the $10,000 will go towards the purchase price of the house.
- If Amy decides not to proceed because a condition in the purchase agreement isn’t met (e.g., the house doesn’t pass inspection), the $10,000 is returned to Amy.
- If Amy backs out of the deal for reasons not covered in the agreement (e.g., she simply changes her mind), David might have the right to keep the earnest money as compensation for the time the property was off the market.
As they move forward, the home passes inspection, and Amy secures her financing. At closing, the $10,000 held in the escrow account is applied towards the purchase price of the home. After the transaction, the escrow account no longer holds the restricted cash, as it’s been transferred to David as part of the payment for the house.
This example highlights how restricted cash works in the context of an escrow during a property transaction. The money in the escrow account is restricted because it’s set aside for a specific purpose and can’t be used by either party until certain conditions are met.