 Hello and welcome to the session in which you would look at notes receivable. This topic is covered in financial accounting as well as intermediate accounting. In this session, we will cover this topic from an intermediate accounting perspective. Notes receivable gives students some difficulties for several reasons. One, you have to understand the time value of money. That's the first thing you need to know because notes receivable, if they are long term, they have to be discounted to the present value. So if you are not comfortable with the time value of money, I suggest you stop and look at the time value of money. Notes receivable are subject to valuation, allowance valuation. So if you don't understand the account receivable, how do we do allowance for a doubtful account? You'll find difficulty with dealing with notes receivable. And the third concept, and this is mostly financial accounting, notes receivable are subject to interest rate adjustment. So if you are not familiar with adjustments, you will find difficulty adjusting notes receivable. So in this session, we'll discuss how to value notes receivable from a time value perspective, but you have to be familiar with the time value. Also, we'll look at how to build a schedule for a notes receivable, how to account for that interest revenue. Whether you are an accounting student or a CPA candidate, because this chapter or this concept is covered on the CPA exam heavily, I strongly suggest you take a look at my website, farhatlectures.com. I don't replace your CPA review course, I'm a useful addition to your CPA review course. I explain the material differently. I help you understand the material differently than your CPA review course, which in turn will help you understand your CPA review course, which in turn will help you do better on the exam. Your risk is one month of subscription, you can give it a try, you like it, you keep it, if not, that's fine. 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Take a look at my LinkedIn recommendation, like this recording, share it with other, connect with me on Instagram, Facebook, Twitter and Reddit. So let's talk about notes receivable. Notes receivable sounds like account receivable. Well, it is. It's some sort of a receivable, some sort of a claim. However, it's a formal written claim versus an account receivable where it's not formal against another party to pay a certain amount of money at a, at a certain future date. And what's interesting or what's unique, what makes a difference then an account receivable, it involves interest. You have to pay interest along, along that claim. So how does notes receivable comes to life? So notes receivable is an asset. So we debit notes receivable. So what do we credit? Well, could be many reasons. One, we could lend money, we can give someone money. And as a result, we debit notes receivable, we credit cash. Now we hand, we have a claim against that individual. That's one reason a notes receivable comes into life. We might sell something to someone and make them sign a note. For example, of their new customers, for new customers, that's what we do. We don't sell something unless we make them sign a note or for selling like property, plant and equipment or a large transaction. We don't want to just say, okay, pay us later. We want to also earn some interest. So we don't want to finance it. We don't want to finance the transaction interest free. Also, notes receivable could be used to replace an account receivable. So we might sold someone on credit, gave them 30 days, they could not pay us. Now we ask them, well, we would remove the account, we would replace it with the note. So these are, these are all could be potential credit cash, sales revenue, account receivable. And sometimes what we do is we replace an, a notes receivable with another notes receivable. So somebody promised to pay us, we have a notice notes receivable against them, they can't pay it anymore. So we would replace the old note with a new note. That's fine. And a note would look something like this. So a note basically, it's a promise. So you have a maker that promise on a certain date, there's an issue date. The maker promises to pay certain amount of money, $1,000. Here's two months after two months to the, to Wilma company, this is the paid, whoever's going to be getting the money. And Calhoun company is the maker that's making the note. And this note is bearing interest because the interest is explicitly stated on, on it, on it. You're most likely, you most likely sign a note when you took out student loan, or if you have a credit card, you are dealing with, with a note or if you have a loan without even knowing, but this is what it looks like. Note is a negotiable instrument. And we will have a different recording about this where you can sell it, discount it, sell it, sell it to another party. Notes receivable could be interest bearing as you just saw this note, 12% or zero interest bearing. It doesn't mean it doesn't have interest, but the interest is not stated automatically, it's not stated directly on the note. Notes receivable could be short term when it's short term, we usually report it at face value, or it could be long term. Well, under those circumstances, we have to find the present value of the payment. And this is why I told you one of the issues with notes receivable is students don't understand the time value of money. Therefore, when it comes to notes, they find difficulty understanding notes. And it's also subject to allowance valuation, just like an account receivable, or you have an allowance for doubtful account, you have to write them off, so on and so forth. So you have to be familiar with the account receivable, then you are familiar with the notes. The best way to understand notes is to actually look at an actual example. We're going to work two or three examples to illustrate the various types of notes that we can have. On January 1st, 2nd local bank lent Adam $10,000 in exchange for a $10,000 three year note bearing, it means the interest rate is there 10% annually. The market rate for interest of similar risk is 10%. So what we are saying Adam lent borrowed $10,000 from the bank, the bank gave them the money, they said, we're going to charge you 10% and the ongoing interest rate for similar loan is 10%. Now, why are we saying the ongoing interest rate? Because whoever discount, whoever find the price of the note, here's what's going to happen. Here's what the bank is technically doing. The bank is saying, we're going to give you the money today. You're going to give us $1,000, $1,000, then another $1,000, then you're going to give us back our money, $10,000. Well, what does this looks like? Well, it looks like the point of it is an annuity. So we have an annuity, three payments of $1,000. Then we have a single sum. It looks like what we learn about a bond, which we'd learn about later. It looks like also a bond. So what does that mean? Well, what we have to do is we have to find the present value of these payments. We have an annuity and we have a single payment. So the bank will have to discount everything, as I told you, in the time value of money. When you go to the discounting, you would use the market rate because you want to use the market. Therefore, what's going to happen is we're going to go to the time value table. First, we're going to discount the $10,000 because this is a single payment. So you want to make sure you are dealing with the present value of a single payment and equal to 3, 3 periods, i equal to 10%. We use the market rate. 10% happens to be the same as the the market rate happens to be the same as the note rate, which means the note will be discounted for the face value. Don't worry about this. We'll talk about this later on when we talk about the loans. So we're going to take $10,000 times 0.75132. And that's going to give us for the for the face value $7,513.20. So we discounted the $10,000. Now we need to discount we need to discount also the annuity. The annuity, which is three payments, we have this. Now we're going to go to the present value table, present value table of an annuity. Make sure you are at the present value table of an annuity. Your textbook, your CPA review course could, you know, it could be some other place. Make sure it's the present value of an ordinary annuity as well. So n equal to 3, i equal to 10. The factor is 2.48. So we're going to take the $1,000. Now where do you get the $1,000 from? Well, the interest rate is 10% times $1,000 times 10,000 is $1,000. So 1,000 times 2.486.685. And this should be $2,486. And rounding, I'm going to make it 80 cents. So if we add the present value of the face value, if you add the present value of the face value, the present value of the note, it's going to give us $10,000. Therefore, the note, it's going to be recorded at $10,000. So what's going to happen is we're going to debit notes receivable from Adam, $10,000. So the bank will debit notes receivable. Let me clear. So where did the $10,000 came from? Once again, the present value of the face value, the present value of the payment, the present value of the face value, the present value of the payment. Now if you are lost, go back to my time value and specifically how to compute the price of the bond, which is an application of the time value of similar example. So they will debit the notes receivable, we credit cash $10,000. Now every year for the next three years, Adam will have to pay $1,000 and the bank will be receiving $1,000. So we're looking from the issuer, from the bank's perspective. So the bank would receive $1,000 and they will credit interest revenue of $1,000. Once again, where is the $1,000 coming from? $10,000 times 10% and it's this 10%, not this 10%. Because although they're both the same, although they're both 10%, this is the 10%. I'm going to show it in a different color. This 10% that I'm just, this 10%, give me one second please. This 10% here is the market rate. This is when we do the discount and this 10% is the one that we will compute the interest revenue for. So every year we would receive $1,000. Then in year three, Adam will pay back the note, we will debit cash and remove the note that Adam issued and life is good. We're done with this note. So this is basically an interest bearing note that was issued at face value. We borrowed, we lent $10,000. It was issued at $10,000. So let's take a look at an example with a zero interest bearing note. Adam receives three year, 10% zero interest bearing note for lending money to Ryan. That's fine. Here's the deal. Ryan says I'm going to pay you $10,000 three years from now. One, two, three, three years from now. They did not specify what interest rate, they did not specify what interest rate they're going to pay Adam. That's all what the deal is. I'm going to pay you $10,000. Now Adam would want to know how much would I give Ryan today? How much would I give Ryan today? So I will earn 10% because I'm going to be getting $10,000, but I'm not going to give Ryan $10,000. I'm going to give him less than $10,000. So I'm going to discount the $10,000 to the present value. Remember, I'm receiving the money once. I will go to the present value of a single payment. Be careful to be using dry table. This is one of the problem with students with this, with these type of issues. N equal to three, three years we would receiving the money. Adam thinks, not Adam thinks the ongoing grade is 9%. We find the factor. So the factor is 0.77218. Therefore, Adam would give, would pay for this investment today $7,721.80. But Adam is promised to receive how much? $10,000. So you will debit notes receivable against Ryan $10,000 and he's only going to give cash of $7,721.80. Well, the difference between them is a discount on notes, not payable notes receivable, sorry. The difference is a discount on notes receivable. What is the discount on notes receivable? The discount on notes receivable is the future, is the future interest revenue. So this is how much interest because the difference between $10,000, the difference between what Adam's receive in three years from now and what Adam is given up now is $2,278. That's the amount of interest. The difference is interest, but Adam cannot record this as interest revenue today because you have to wait until time goes by. So what we do is we say this is discount on notes receivable. And what's going to happen is we're going to earn this as time goes by. We're going to reduce the in, we're going to reduce the note, a discount on notes receivable and increase the interest revenue as time goes by. So simply put, if I ask you what is the value of the note, the value of the note, the carrying value is $10,000 minus $2,278.20. The difference is $7,721.80. So this is the carrying value of the note. So simply put, the discount is a contra notes receivable. Now what's going to happen? Although Adam will not be receiving any payments until three years from now, but interest is accruing every year. So every year, Adam will have to earn interest on that note. Although they're not receiving the money, but interest is being earned. How do we compute the interest? Well, we're going to take this amount, 77.21.80 times 77.21.80 times the discount rate times the rate that we that we agreed to lend to lend the implied rate was 9%. So if we take 77.21.81.80, it doesn't matter times 0.09. We're going to earn $694.96. So every year, our interest revenue will go up and the discount will go down. So the entry will be every year for year one, specifically, again, on notes receivable. Sorry, not notes payable. We would start to reduce discount on notes receivable. So this, this account here is starting to go down and we increase interest revenue. So on year one, we would report revenue of $694.96, although we did not receive any penny yet. When are we going to be receiving the full amount in year three? So by the end of year two, what's going to happen? The value of the care, the carrying value goes up because a year later, we have less discount. Therefore, the carrying value will go up too. So basically, if we take 77.21.80 plus what we amortized, it's going to give us 84.16. This is the new carrying value or we can take 10,000 minus the unamortized amount will give us 84.16, which is what's the unamortized amount because look, look what's going to happen to the discount. I want to show you this because it's, it's, it's important that you see it. So the discount on the notes receivable, it starts at 2278.20 and year one, it went down by 694.96, year two went down by 757.51 and year three, it's going to go down by 825.73. So what's happening to the discount, it's leaving the discount and going to revenue. So this, those are the debits, the credits are to interest revenue. So it's leaving the discount going to interest revenue and as a result, it's increasing the value of the note. So by year three, Adam would receive the $10,000. Within that $10,000, Adam already accounted for the interest revenue throughout the years. Every year, they will make this payment year one, 694. And notice for year two, the interest is higher. Why? Because the value of the note, the both value went up and in year three, the interest is higher because the value of the note went up again. Okay. So this is the life of a zero interest bearing note. We started by discounting the note, finding the discount on the note's receivable. Although we don't make any payments, although we don't make any payments, we would still account for the revenue. We are earning the revenue. Okay. Let's take a look at this example. Adam company loan, loan to Ryan and receive an exchange, a three year $10,000 note bearing interest of 10% annually. Okay. So here's the deal. It's annually one, two, three. So one, two, three. So 10% times a thousand. So every year, Ryan will have to pay $1,000. Then Ryan will have to pay back the loan of 10,000. The market rate of interest for note of similar risk is 12%. Hold on a second. So Adam gave them the loan. They only charged them 10%. But in reality, they can earn 12%. Okay. So basically it's the note, it's going to be discounted at 12% because Adam can earn 12% easily because that's what they want to earn. They want to earn 12%. So what's going to happen is to make up that 12%, they're going to give Ryan less than 10,000 today to make up, to make up the difference in the note, in the note interest rate. Okay. So when we discount, we're going to discount using 12%. Let's do that. So first, we're going to discount the payment and equal to three, I equal to 12. So we're going to take 1000 times 2.40183. So let's do the computation here. So 1000 times 2.40183. And that's equal to 2,400. And I'm going to spend around 2,402. Then Adam would discount the $10,000. Again, and equal to three, I equal to 12. And that's 0.71178. So we're going to take 10,000 times 0.71178. It's going to be $10,000 10,000 times 0.71178. And that's $7,118. $7,118. And it's going to round in $18. So we're going to find the value of the note, the cash we're going to be giving out, plus 24.02. That's going to be 9,500. I'm going to round to 20, 9,520. So this is how much we're going to be giving Ryan. Why? Because if Ryan goes somewhere else, they're going to have to pay 12%. So since we're giving Ryan only 10% interest rate, we're not going to give them the full amount. Otherwise, why would we do that? Then we would lend our money to someone at 12%. Therefore, we will discount the note. Therefore, we debit notes receivable Ryan for 10,000. This is how much Ryan will have to pay us. We will only give Ryan 9,520. And the difference is discount on notes receivable. So difference is additional interest revenue. It's our right. What do I mean? It's our right in quote. Our right in a sense that we're giving him a loan for 10%. But really, the same loan, if he goes somewhere else, it's at 12%. Therefore, we have extra revenue that we have to account for. Now, what's going to happen is we're going to have a note starting date of the issue at carrying value 9,520. Again, what's the, how do we find the carrying value? It's the face value minus the unamortized discount, which has happened to be 480. Therefore, when we started the value of the loan is 9520. Again, what's going to happen to this notes on discount on notes? It's a future interest. So as we start to receive the cash payment from Ryan, we're going to start to account for this additional $480 over a period of three years. Let's take a look at the first year. After at the end of the first year, we're going to be paid $1,000 in cash from Ryan. That's easy. That's how much he's going to pay us. The revenue we are going to compute, it's going to be the carrying value of the note from the prior period, which is 9,520 times 12%. And our interest revenue is 1142. Our interest revenue is higher than the cash. Why? Because upfront, we gave Ryan less than 10,000. So we have $480. So the difference between what we received in cash and the interest revenue is the amount of discount we are going to amortize. As we amortize the discount, as the discount is no longer an amortize, it's going to be added to the 9,520 and the face value will become 9,662. Now also you can look at it as this 10,000 minus, now the 480 lost 142. So I'm going to reduce the 480 by 142. So $338, $338. What's remaining is $338. 10,000 minus $10,000 minus $338 will give us 9,662. So this went from 480 went down to $338 because we reduced the discount by 142. Okay? Or I can take the 142, the amount that I amortize and add it to the prior value if I have the prior value. So here's the entry that I make. I debit cash only 1,000. I debit discount on notes receivable. So I'm starting to reduce this discount because eventually I'm going to bring it down to zero and my interest revenue is 1,142. So simply put my interest revenue, 1,000 of it is cash and $142 of it is coming from the discount and this count is this coming from the original entry when I gave Ryan less money and as a result it means I made more revenue. I made more interest revenue up front but I could not record that revenue up front because interest is earned over time and this is the time. For year two again I will take now to compute my, the first thing is you do is you compute your interest revenue. It's your prior balance 96, 62 times 12% will give you $1,159. You pay the $1,000 and cash the difference between them is what you amortize. So this $1,59 gets added to the prior value. The new value is $9,821. So for year two the cash would still be $1,000. This will be $1,59 and this will be $11,159 my interest revenue. Year three I will take my prior carrying value $9,821 times 12% to come up with $1,179 for the interest revenue. My cash is always the same. Ryan is paying me 10% of $1,000. The difference between them is $179. So my entry will be cash is $10,000. My discount is $179 and my interest revenue is $11,179. My interest revenue is $11,179. And notice what happened at the end of the three years all the discount. This is rounding it's $481. It's gone and my interest revenue is the cash plus the $480 that I again it surrounded $480 that I receive upfront. So this is the story of notes receivable. You want to make sure you are comfortable with the amortization schedule how to compute the present value of the note. At the end of this recording once again as usual I'm going to invite you to take a look at my website farhatlectures.com. Again I don't replace your CPA review course. I'm a useful addition. I can give you more information. I can explain the material in details which in turn will help you add 10 to 15 points on your exam. Your risk is is one month of subscription. You give it a try. You like it. You keep it. You don't. You cancel. 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