Question

A compensating balance agreement always requires that cash be reclassified as a noncurrent asset?

1) True
2) False

Answer 1

The statement about compensating balance agreements and noncurrent assets is false; compensating balances are still classified as current assets. Money on a bank's balance sheet might not be physically present due to loans and investments. In the secondary loan market, loans are valued based on the borrower's payment history and changes in overall interest rates.

Step-by-step explanation:

The statement 'A compensating balance agreement always requires that cash be reclassified as a noncurrent asset' is false. In a compensating balance agreement, a company agrees to maintain a minimum cash balance in an account in return for which the bank may offer better terms on a loan or line of credit. This requirement does not automatically reclassify the cash as a noncurrent asset. Cash subject to a compensating balance requirement is often reported separately on the balance sheet but is still considered a current asset because it is expected to be used in the normal course of the operating cycle of the business.

The money listed under assets on a bank balance sheet may not actually be in the bank because banks use the money deposited by customers to create loans and other investments. This is due to the fundamental banking principle of an asset-liability time mismatch. Banks expect that not all customers will withdraw their funds at the same time, allowing them to utilize these deposits to earn income through loans, which also appear on their balance sheets as assets.

Regarding the secondary market for loans, the value paid for a loan can vary depending on a number of factors:

1. If the borrower has been late on a number of loan payments, a lower price may be paid because the loan is considered riskier.
2. If interest rates in the economy have risen since the bank made the loan, the loan's value is less attractive compared to new loans at higher rates, potentially lowering the price.
3. If the borrower is a firm that has just declared a high level of profits, the loan might command a higher price because the likelihood of repayment has improved.
4. If interest rates have fallen since the bank made the loan, the loan becomes more valuable as it's at a higher rate than current market rates, increasing its price.