 Hello and welcome to this session in which we would look at short term financing as it is covered on the BEC section of the CPA exam. This is an opportunity for me to remind you that taking FAR first is important. Why? Because if you already took FAR, this section, short term financing, should be fairly simple. And that's why I always advocate to take the FAR section first because it's the base for all other sections, BEC, audit, of course, and reg. So that's the reason that this is going to be a living example why I always make this argument. Now, whether you are studying for BEC, FAR, reg or audit, I could always help you, farhatlectures.com. If you are a CPA candidate, I strongly suggest you take a look at my website. I don't replace your CPA review course. Most likely you pay thousands of dollars for this. I don't replace it. But if you are listening to this recording, there's a good chance you found me because you are looking for alternative explanation. So to kind of help you out, check out my website, farhatlectures.com. I can be a supplement. I can be that alternative explanation for your CPA review course. I can add 10 to 15 points by helping you understand the material better. Your risk to try me is a month. Try me. If not, you can cancel. Your potential gain is passing the exam. I do have resources for other courses and exam sections as well. Connect with me on LinkedIn. Take a look at my LinkedIn profile. See what other people say about my material, especially when you look at my LinkedIn recommendation, like this recording. Connect with me on Instagram, Facebook, Twitter and Reddit. So let's take a look at short-term financing. Short-term financing, you should be thinking right now about current liabilities. Again, if you studied far, you should know exactly what current liabilities are. Those are short-term obligations. Short-term obligation means something you have to pay off within the next 12 months. So that short-term obligation is giving you some pressure on your cash flow. So it's a good thing you're borrowing on short-term basis. That's the good part. You can borrow to pay, but also short-term basis is you have to repay it on the short-term basis. Now, since we're going to be discussing current liabilities, basically their natures are the same. So I'm going to go over the advantages and disadvantages of each of these options. But hey, they're going to repeat. Don't worry. Repeat is good. It's going to help you remember the material. And we're going to be looking as far as current short-term financing. We're going to discuss trade or accounts payable, you know, as accounts payable, accrued accounts payable. We're going to look at short-term notes payable, line of credit, revolving credit and letter of credit, commercial paper, pledging and factoring of receivable and inventory secured loans. Starting with trade or accounts receivable, and I hope you are familiar with this concept, accounts payable, accounts payable. Well, what is accounts payable? Account payable is used to finance your day-to-day operation. You might buy supplies. Usually you will buy inventory on account. The seller to encourage you to buy, they would say, we're going to give you 30, 60 days to pay later. And what happened is a result, you will take advantage of this financing and you will buy the material or the supplies needed for you and you will pay them later. This is basically what is accounts receivable, accounts payable. Now accounts payable comes with a discount and the discount is written something like this, a number 2 slash 10 and 30. And usually what it means, it means we're going to give you 2% if you pay, if paid within 10 days, if paid within 10 days or you have 30 days to pay the full amount. Simply put, you have, let's assume this is the 30 days. This is day 1 to day 30. If you pay within day 10, this is the discount period. So we're going to give you a discount within 10 days. However, you have, if you don't pay within 10 days, this is the credit period. We're giving you 30 days to pay. So 30 days to pay, you have 10 days to get the discount and the discount is 2%. And the discount is very beneficial to the buyer to take advantage of the discount. Simply put, you are saving 2% every 10 days. Over a period of a year, your savings could be up to 30%. Now on the next session, I'll have another session where I would work examples, numbers that deals with the discount. In this session, I'm only going to go over the theory, but this is how it actually works. So you need to know how the discount work. Now again, I do cover this in my FAR section. It's covered in FAR. It's covered in my financial accounting. But I will work few CPA questions that illustrate some computation for this session. And I will, obviously I have questions on my website, farhatlectures.com, if you really want to practice this concept, practice questions about this. In addition to your CPA exam questions, what are the advantages of the accounts payable? Well, there's no signature. You don't need to sign anything. Basically, it's based on your full faith. Based on your full faith, you don't have to make it like, it's not like you're signing a contract. There's no signature. I'm sorry, not contract. It's not formal. That's what I meant to say. There might be a contract or may not be a contract, but accounts payable is contract-based. Contract-based means you can set the terms with the lender, with the seller. You can tell them what terms do you want. And there is no interest. And when I said no signature, what I meant to say, in a sense, there is no interest. Why? Because when we talk about notes, receive notes payable, notes payable, which we're going to be talking about in a moment, it's always confused notes payable with accounts payable. Notes payable is more formal. So notes payable, you'll have to sign for the note. Here, you really, you don't have to sign for anything. Usually, the supplier will say, these are my terms. It's a contract-based. And let's move on. Now, it's unsecure, too. So you don't have to put any collateral against that financing opportunity. The disadvantages is it's short-term, 30 or 60 days. And this is going to appear again and again. This is the disadvantages of short-term financing. If you did not pay within the discount period, you could be losing a lot. And you can only finance certain transactions. So accounts payable only incurred as a result of buying goods and services. So it's related to a specific purchase. So you cannot use it for general cash use. Accrued liabilities, what are accrued liabilities? Again, hopefully, you know this from far, if not, those are expenses that were incurred but not yet paid. Simply put, you don't receive your cell phone bill until next month. If we are in, what month are we in now? We are in March. So you don't receive your March bill until April. Well, by the end of March, you do have an expense for your cell phone bill, but you're not going to pay till April, maybe 20th. Well, that's an accrued payable. So what happened is you will not pay your bill until 20 days after the month ended. So what happened is you have a liability, you have cold accrued. It's an expense that happened in March, your cell phone bill, but you're not going to pay for it. Now in the real world, those expenses add up to a lot. And as a result, it's a form of short-term financing for the company. Simply put, they are not paying for expenses as they are incurred. Good example of them is salaries and wages payable. Sometimes your employee work for 10 days and you don't pay them until two weeks later. So that's a form of financing. Tax is the same thing. You have a tax bill, but you have 30 days to pay or 45 days to pay. Unearned revenue, it's when someone pays you the money upfront and they say, you know, perform the work later. Well, you have the money. That's an accrued payable. You can use it and you have to perform the service later. So it gives you a form of short-term financing and this is the advantage of it. It arises from a day-to-day operation. It's contract-based. Contract-based means what's your agreement between you and the people that works for you, is that you pay them every 14 days, every seven days, every 30 days. No asset is involved here. You don't have to commit any asset. Disadvantages, again, it's 30 to 60 days. And for some of them, like for salaries and wages payable, no employee waits more than two weeks. The disadvantage is you have an expense, an expense that was incurred. So this is the problem with accrued payables is you have an expense. Short-term notes payable, think of a loan. Think of a loan, not a loan. Think of a loan. This is basically what short-term payable is. Simply put, if you have loan, interests are involved. So you need to know how to compute the interest amount on a loan. And the way you compute the interest amount, I don't like to give acronyms, but it's, I call it PIT. PIT is principal times interest times time. You just have to be careful for short-term notes payable when you compute the time. Let's assume you borrowed $10,000 at 10% for six months. For six months, 6 is 6 out of 12. So express the time as a fraction of the year, or if they're telling you it's for 35 days, it's 35 divided by 365. Unless you are told to use 360 in the denominator, you would divide the number of days by 365. So this formula is important to compute the interest that's related to that loan. So it's PIT. Again, I don't like to use acronyms, but I'm going to do that now. Okay. Might require a demand deposit. In other words, you have to put some money up against that loan. This is an advantage, actually. Advantages. If you have a good credit, you can get a loan easily. You can easily refinance. Usually they are at a lower rate. Short-term loans, they have a lower rate because there's less risk for the lender. It sounds usually they're unsecured. Short-term notes are unsecured, and it gives you cash. And what does that mean? It means you can use it for anything. It's not like accounts payable. Accounts payable, you buy supplies and inventory. Here you're actually borrowing the green box and you can do anything you want with it. Disadvantages. We already kind of discussed one. It could be costly if you have a bad credit because if you have a bad credit, they're going to penalize you in a sense that they're going to charge you higher interest rate because you're not credit worthy customer. It's short-term obligation. You have to pay it very fast. A compensating balance is required. This is what I was talking about. I should have moved this one here. And risk of refinancing at a lower rate. It may not be available. So sometime the interest rate could jump or your credit worthiness could go down. As a result, your interest cost will increase. Three other forms of in-quote lending on a short-term basis. Line of credit, revolving credit and letter of credit. You need to know what they are. Basically, a line of credit is a preset borrowing amount that limit that can be used at any time. Simply put, I have a line of credit on my home equity loan. What does that mean? It means I can go to the bank at any time, take money out because I have a line of credit. It's a preset amount. There's a certain amount. Now, the bank can reduce this amount. I can ask them to increase this amount, but it's a preset. So the borrower can take the money as needed until the limit is reached. Then you have to pay it back. Now, once you pay it back, you could again go back and borrow this money. So this is what a line of credit is. Companies will have a line of credit with the bank. Usually the banks will review this line of credit every six months or every year, depending on what's going on within your industry or what's happening with your company. So the bank monitored this process. How do they monitor this process? They ask you for your either financial statements. If you don't produce financial statements, they'll ask you for your tax return. But generally speaking, when you go to the bank, they'll ask you to prepare financial statement. And this is why you will go to people like future you CPAs to prepare those financial statements for you. Matter of fact, when I was in practice, many of my many of our clients were, they needed the financial statements prepared because they wanted to get a line of credit from the bank. And they say, okay, we'll give you a line of credit, but we need your financial statement on a quarterly, semi-annually or an annual basis. And we were happy as a CPA firm to ask them for a quarter or even monthly. Okay, why? Because we want to charge them as we prepare those financial statements. I mean, this is what you do as a business. I mean, the more work you do, the more you will build your clients. You are selling your time. Revolving line of credit agreement, think of a credit card. That's basically what it is. It sets a credit limit, a maximum account you can spend. You can either choose to pay the full balance or to make payment, a minimum payment. Again, think of credit card. And the credit card for businesses are the same thing. They can be reviewed, increase, decrease, cut, increase the interest rate, reduce and so on and so forth. Letter of credit, not basically the same thing. Usually it's used in international trade. It's a letter from the bank guaranteeing that the buyer payment to the seller will be received on the time and for the correct amount. Simply put, let's assume you are in country A. Let's assume you're in the US and you are buying from someone in China. And you don't know this individual and the other individual doesn't know you. So what happens is you will go to the bank and you will tell the bank, I want a letter of credit. And this letter of credit is accepted by the Bank of China. This letter of credit will tell the Chinese company that look, this guy in the US or this girl in the US will guarantee their payment. And therefore the Chinese company will be willing to sell you their product. That's all what it is. It's like a guaranteed that for the other party that you're going to be paid. What are the disadvantages and advantages of these three form financing? They're easy to obtain if you have a good credit, just like a loan. And you need them only, you use them when need them like for my line of credit. I don't have to use it unless I need it. If I need it, I can tap into it. Unsecured, well, not the home line of credit, the home line of credit. I mean, my example does not apply here, but usually they're unsecured for businesses. But for people, you know, if you have a home line of credit, they can take your house if you don't pay. Line of credit could provide cash. And once you have cash, you could use it for whatever purpose you want to. They are costly now and not available if you have a bad credit. That's a disadvantage of them. Sometimes there is a fee for my line of credit. Again, I go back to my line of credit, although it doesn't apply here. There is no fee. There's only a fee when I established it, but that's beside the point. Again, it's a short-term obligation and sometimes there's a compensating balance. You need to maintain a compensating balance at the bank. And the biggest disadvantage is they can cut at any time or reduce it for whatever reason that they want to. So that's one of the biggest advantages of line of credit. And especially if the economy goes south, banks would want to protect themselves. They will cut down your line of credit, and this is where you really need the money. So that's why it could be dangerous. Commercial paper is basically a form of financing by large corporation. Corporation would really credit worthy credit like Microsoft. So it's a money market security sold by large corporation. Usually they have to have a good credit to obtain funds. If you want to get money on a short-term basis, you want to meet your payroll or you want to pay your suppliers. It's based. You can go to the market and issue commercial paper, simply borrowing money from the market from people who wants to lend you money. Now, because you're selling those commercial paper to people, the SEC registration is required. You have to tell the SEC you have to make certain disclosure because they want to protect the public. Those commercial paper can be sold at a discount or they could be sold at face value. It means let's assume you want to borrow a million dollars. You will tell the lender, give me right now 970,000 and I'll pay you a million. This is discounted. Or you would say I want a million and I will pay you 3% for this period. It doesn't matter whether it's sold at face value or discounted. Just make sure you are familiar with both. And again, we'll work some numbers and examples later. Advantages of this is the interest rate are generally lower because it's short term borrowing. Risk is spread among many. So when you sell commercial papers, you don't sell them to one bank or to one party. Many parties could buy your commercial paper. So you can raise the money from many sources. You don't need any compensating balance. Again, you're buying from selling those to the public and it's unsecured. So that's the nature of the commercial paper is you don't have to have it collateral against that. And it provides cash and cash can be used for anything. Disadvantages. Again, it could be costly if you don't have a good credit and sometimes it's not only costly, not available altogether. It could involve a fee. Of course, it's going to involve the fee. It's a short term obligation. You have to pay that money in the near term and not really refinance, not easily refinance. It's not like you're borrowing money from the bank or you can negotiate it from the bank. This is you sold the money to an investor and they want their money back after the 100 days or 60 days or 250 days. That you promised another form of financing is pledging of receivable. Again, this is what I emphasize. If you went through far, you know, we talked about pledging of receivable a lot. You know, this topic is heavily covered in far. So what is pledging of receivable? Think of pledging your car. Think of pledging your house. You go to the bank. You'd say, I would like to borrow money. The bank would say, okay, I will lend you money. But if you have a collateral, you'll make it easier for me to make that decision. You will tell the bank, okay. I can pledge my receivable. Simply put, if I cannot pay you, you have the right to collect from my client. I'm pledging my receivable as a collateral. Now the key here is the quality of your customers matter because the bank is going to look at your customer. And if your customer, they have bad credit, the bank would say I'm not interested because, you know, it's as if you are lending those people the money to your customers. So that's why they will not give it to you. The advantages of pledging the credit is many options. You have many people that be willing to give you a loan against that pledge. And remember, if you have a counter-receivable, the counter-receivable keep a fresh collateral. So the money always coming and you are always selling. There's no compensating balance. You don't have to put compensating balance. Again, you're getting cash for the general use. And the lender may assume billing and collection services. So that's even better for you. The disadvantages of it is accounts are committed to lenders. So now you have them under not the control, but they have a right to them in case you don't pay your money. It could be very costly if you have customers with bad credit or if you're a new person to this market. They may, for example, if you have 100,000 in an AR, they may only give you 60,000. And that's, they will be fully collateralized and that's bad for you. You are committing 100,000 in assets or good assets and you're getting 60,000. Could be costly, short-term obligation. Again, you're going to have to pay this money in the short term. Factoring of receivable is different. They're both dealing with a counter-receivable. Here is you sell your account receivable. You sell your account receivable for working capital purposes. So you sell your receivable to get money. Now, again, this topic is covered a lot in FAR. And in FAR, you have to make sure when you factor a receivable, whether it's a sale, it's a real sale or not a sale, there are requirements. Again, if you took FAR, you should be very familiar with this. If not, you can go to FARHAT Lectures. I do discuss this topic. So the receivable could be sold without recourse. Basically, the factor bears all the right. The factor is the person that bought it from you. So simply you have 100,000 in receivable. You sell it for 96,000. And that's it. You'd say, give me 96,000. I hope you collect the 100,000 and make the profit in 4,000. That's without recourse. With recourse, the factor has the recourse against the firm. So simply put, you have 100,000 of receivable. The factor gave you $96,000 in cash. But the factor said, look, if I don't collect the 100,000, you have to pay me the money. So this is with recourse. They can come back and take it from you. Now, also, there's a fee when you factor. And the fee depends on many factors, right? The credit worthiness of the customers. If you have a good credit worthy customers, obviously the fee will be lower. How long it's going to take for the factor to collect the money? The longer, the less they're going to give you. And the extent to which the factor assumed risk. Look, if they're going without recourse, well, guess what? They're going to charge you a high fee. If they're going with the recourse, they may charge you a lower fee because they have less risk. Advantages of this form of financing. Again, you have many options just like with pledging. Again, account receivable keep fresh because you're constantly selling, no compensating balances, provide cash for general use, and the buyer generally assuming and collection here. Disadvantages, again, could be costly, very costly sometime. I mean, let's assume you have 100,000. They may only give you 60,000 for that. You lost 40,000. If they know you really need the money, that's what they might do. So it could be costly, especially with recourse. With recourse, it's like you really did not sell it. You still have that responsibility. And customers may not like it. If someone else is reaching out to your customers to collect, you may alienate those customers. Inventory secured loans is basically in a sense like pledging your receivable, but here you're pledging your inventory. So you tell them, look, I'll pledge my inventory for working capital. That's it. Just any asset you can pledge. You can pledge your building, which is long-term assets. You can pledge your equipment. You can pledge your inventory. Now for inventory, because inventory constantly turning around, you have different types of pledging arrangement. One is called floating lien agreement. And you have to know the different types of these agreement. Here the borrower gives a lien against all the inventory to the lender. So I'll give you the lien, but they retain control. Okay. So I'll give you the lien, but I keep the inventory. I control them, but you have a lien over them. Chateau mortgage agreement. The borrower gives a lien against specifically identified inventory. When you think of mortgage, mortgage means there's something specific, like a home mortgage. It's mean the home is a collateral against the loan. When you hear the word mortgage, it means there's a specific assets identified. Okay. You retain the control, but you cannot sell this asset without the lender's approval. Simply put, they would say, okay, here's this inventory. Those 500 computers that we have in our inventory usually companies don't, you know, keep computers as inventory, but just to make the point. Well, guess what? That's fine. They're identified. You cannot sell them without our approval. So we need to know once you are selling them because we no longer have. We no longer have the thing of gold. Think of gold. It's much easier. So if you tell them, you know, I have two bars of gold. Okay. Then this is what I'm pledging as Chateau mortgage agreement. You cannot sell those two bars until you go back to the lender and the lender will approve the sale. Okay. Field warehouse agreement. Okay. Here the inventory used as a collateral remain at the firm warehouse. So warehouse, they remain at the warehouse. It's placed under the control of an independent party. So the lender will bring an independent party and they will, they will, they will control it and help as a security here. Terminal warehouse agreement. The inventory used as a collateral is a move to a public warehouse seat. Now you let it go and it's held as a security. Now they took your inventory. Okay. Because they wanted to be held as a security in a field warehouse. It's still in your warehouse, but under the independent part under independent third party. Okay. Just make sure you know the difference between each type of agreement. And how much does it cost to get, pledge your inventory? It depends on many things. What type of inventory are you pledging? If you're pledging, are you pledging gold versus are you pledging calculators? Right. Two different things. The credit standing of the board, how good is you, how good or not good is your credit and the specific type of security agreement. Well, based on your negotiation skills. What are the advantages of having this type of short term financing? It's used for many inventory, especially if you have cars, oil producers. Many, many companies could use it and a lot of companies can, but this is one of the advantage. Inventory turnover. You constantly have inventory. So that's good. So you could always pledge it. No compensating balance, not a balance balance provides cash for general use, which is good. You have cash. You can do anything with it. Disadvantages is not available for all inventory. Okay. Not available for all inventory could be costly, could be very costly. And remember, depending on the agreement, it could be costly. And sometime you may need that inventory and it's not under your control. That's bad. What does that mean? It means you want to sell it, but you have to get someone else's approval. So that may alienate the seller or that might delay the sale. Again, it's short term obligation. It's a constant pressure on your cash. And not, I'm sorry, not available for all inventory right here. Not available for all inventory. So the inventory under the lender control, that's a disadvantage because you cannot sell it when you want to. Again, at the end of this recording, all worried that I went through the various method of short term financing. In the next session, I might work few multiple choice questions that deals with this topic because you need to know it's mostly theory on the BEC, but you might see some questions about 2 slash 10 and 60. You might see questions about when you pledge collateral, when you pledge your receivables, specifically as a collateral, they might say you received 75% of the face value. There is 2% fee, how much cash did you receive or something like that. So you have to work some multiple choice questions. Again, I do have a lot of multiple choice questions on cpa4hat.com. And I will work maybe a sample cpa questions to show you how it works. At the end of this recording, visit my website. I don't replace your cpa review course. I can be that alternative explanation. Study hard, good luck, and stay safe.