Restricted Cash: Definition, Example, and FAQs

What Is Restricted Cash?

Restricted cash refers to cash balances held by a company that are set aside for a specific purpose and are not available for general operational use or discretionary spending. This classification falls under financial accounting and is distinct from readily available cash or cash equivalents. The restriction can stem from legal agreements, regulatory requirements, or internal company policies, ensuring the funds are used only for their designated objective. Companies present restricted cash on their balance sheet as either a current or non-current asset, depending on when the restriction is expected to be lifted.

History and Origin

The concept of distinguishing restricted cash from unrestricted cash has evolved with accounting standards to provide a more transparent view of a company's financial position. Historically, companies had varying practices for how they presented and classified restricted cash on their financial statements, particularly within the statement of cash flows. This diversity in practice led to a lack of comparability across different entities.

To address this, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-18, "Statement of Cash Flows (Topic 230): Restricted Cash," in November 2016. This update aimed to reduce diversity in how restricted cash is classified and presented in the statement of cash flows by requiring that amounts generally described as restricted cash and restricted cash equivalents be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The ASU clarified presentation but notably did not provide a definition for restricted cash itself, leaving that to other Generally Accepted Accounting Principles (GAAP) and industry practices.⁷, ⁸, ⁹, ¹⁰ The Securities and Exchange Commission (SEC) also provides guidance on the presentation of cash and cash equivalents, including considerations for restricted cash, in its Financial Reporting Manual.⁶

Key Takeaways

• Restricted cash is cash earmarked for specific uses, making it unavailable for general operations.
• Restrictions can arise from contractual obligations, legal mandates, or board decisions.
• It is segregated on the balance sheet, classified as a current or non-current asset based on the expected duration of the restriction.
• Its existence provides insights into a company's commitments and the true availability of its liquid funds.
• Accounting standards aim for consistent reporting of restricted cash on financial statements, particularly the cash flow statement.

Interpreting the Restricted Cash

Interpreting restricted cash involves understanding the nature and purpose of the restriction, as well as its impact on a company's overall liquidity and financial flexibility. A significant amount of restricted cash might indicate substantial future obligations or legal requirements. For example, if a company has restricted cash due to debt covenants, it suggests that lenders have imposed conditions to protect their investment, potentially limiting the company's ability to use those funds for other purposes.

The classification on the balance sheet is crucial:

• Current Restricted Cash: If the funds are expected to be used or the restriction lifted within one year, they are typically classified as a current asset. This could include funds held in escrow for short-term acquisitions or specific regulatory deposits.
• Non-Current Restricted Cash: If the restriction extends beyond one year, the cash is classified as a long-term asset. Examples include funds set aside for long-term construction projects or as collateral for long-term debt.

Analysts examine restricted cash to gain a clearer picture of a company’s true available cash and to assess its working capital management.

Hypothetical Example

Consider "Alpha Corp," a construction company. Alpha Corp secures a large contract to build a new civic center. As part of the contractual agreement, the client requires Alpha Corp to set aside 10% of the contract value, or $5 million, in a separate bank account. This fund is an escrow account that can only be accessed by Alpha Corp upon the successful completion of specific project milestones or in the event of unforeseen liabilities during the construction phase. The purpose of this restricted cash is to ensure that Alpha Corp has sufficient funds to cover potential issues or complete the project as agreed, without relying solely on future operational cash flows.

On Alpha Corp's balance sheet, this $5 million would be listed as "Restricted Cash." If the project is expected to take three years, this amount would be classified as a non-current asset because the restriction extends beyond one year. This segregation on the balance sheet provides transparency to investors and creditors, showing that while Alpha Corp has $5 million in cash, it is not freely available for general business activities like payroll or new equipment purchases.

Practical Applications

Restricted cash appears in various real-world financial scenarios across different industries:

• Lending Agreements: Companies often enter into loan agreements that require them to maintain minimum cash balances or set aside funds as collateral for outstanding debt. These funds are restricted and cannot be used for other purposes as long as the loan is active.
• Regulatory Requirements: Certain industries, such as gaming, insurance, or utilities, may be required by regulatory bodies to maintain specific cash reserves to protect customers or ensure financial stability. These funds are legally restricted.
• Legal Settlements: In cases of major legal disputes or class-action lawsuits, companies may be mandated to place funds into an escrow account to cover potential payouts or damages. For instance, Boeing agreed to pay over $2.5 billion in a deferred prosecution agreement related to its 737 MAX aircraft, which involved compensation payments and a crash-victim beneficiaries fund, illustrating funds set aside for specific legal obligations.
  *⁵ Mergers and Acquisitions: During mergers and acquisitions, portions of the purchase price may be held in escrow for a period to cover potential indemnities or post-closing adjustments. This cash is restricted until the escrow period expires or conditions are met.
• Capital Projects: Companies undertaking significant capital expenditures, such as building a new factory, might set aside funds specifically for the project, making that cash restricted for construction-related payments.
• Customer Deposits: Businesses that receive deposits for future services or products, like utility companies or subscription services, may classify a portion of these deposits as restricted cash if there are legal or contractual obligations to refund them under certain conditions.

Limitations and Criticisms

While the segregation of restricted cash enhances transparency, it also presents certain limitations and points of criticism. A primary concern is that a large restricted cash balance might mask a company's true operational cash availability. Investors analyzing a company's liquid assets might initially view a high cash balance favorably, but fail to realize a significant portion is unavailable for everyday operations or strategic investments. This can lead to an overestimation of a company's immediate financial flexibility.

Furthermore, the specific nature of restrictions and their duration are not always immediately clear from the face of the balance sheet. Detailed disclosures in the footnotes of the financial statements are essential for a complete understanding, but these can be extensive and complex. Critics argue that the accounting standards, while improving presentation on the statement of cash flows, still do not universally define "restricted cash," leaving some room for interpretation and potential inconsistencies in how companies identify and report these amounts.

⁴From a liquidity management perspective, a high amount of restricted cash ties up capital that could otherwise be used for productive investments, debt reduction, or shareholder returns. While the restriction serves a purpose, it can limit a company's agility in responding to market opportunities or unforeseen challenges. Effective liquidity management aims to ensure that a company has sufficient cash for its needs while minimizing unproductive idle balances.

³## Restricted Cash vs. Cash Equivalents

Restricted cash and cash equivalents are both categories of liquid assets, but they differ fundamentally in their availability for use.

The key distinction lies in the freedom of use. While both are highly liquid, restricted cash has limitations on its deployment, whereas cash equivalents are essentially as good as cash for a company's immediate and general financial needs.

FAQs

Why do companies have restricted cash?

Companies have restricted cash primarily due to contractual obligations (like loan agreements requiring collateral), legal or regulatory requirements (such as mandated reserves for certain industries), or internal designations for specific, long-term projects like capital expenditures. These restrictions ensure funds are available for their intended purpose.

Is restricted cash a current asset or non-current asset?

Restricted cash can be either a current asset or a non-current asset on the balance sheet, depending on when the restriction is expected to be lifted or the funds are expected to be used. If the restriction is for a period of one year or less, it's a current asset. If it's for more than one year, it's a non-current asset.

How does restricted cash affect a company's financial health?

Restricted cash impacts a company's reported liquidity and its true available funds. While it appears as an asset, it cannot be freely used for general operations or new investments, which can affect a company's short-term financial flexibility and working capital. Analysts must consider restricted cash when assessing a company's ability to meet immediate obligations.

Is restricted cash part of the cash flow statement?

Yes, restricted cash is part of the cash flow statement. Accounting standards, particularly FASB ASU 2016-18, require that a company's statement of cash flows explain the changes in the total of cash, cash equivalents, and restricted cash during a reporting period. However, transfers between unrestricted cash and restricted cash are generally not presented as operating, investing, or financing activities.

¹, ²### Can restricted cash become unrestricted?

Yes, restricted cash can become unrestricted once the conditions that led to the restriction are met or expire. For example, if cash was restricted as collateral for a loan, it becomes unrestricted once the loan is fully repaid. Similarly, funds held in escrow are released once the associated agreement's terms are fulfilled.