 Hello and welcome to the session in which you would look at long-term notes. What is the big idea with long-term notes? Simply put, we are looking at long-term debt, long-term loans. Why is that important? Well, I'm sure you know that all companies at some point they have to borrow money from the banks. Whatever company you work for, you're gonna have to deal with borrowing of money, interest costs, how to compute it, how to present loans on the balance sheet, how to prepare amortization schedule. Also, companies might buy assets by issuing a note. For example, they could buy a truck, a warehouse, a machine issuing a note. So it's very important to understand the different type of notes. Now, we do have different types of notes. One, we have what's called interest-bearing notes. Interest-bearing notes means the interest is stated or interest-bearing or stated. Now, we also have non-interest-bearing or sometime it's called zero interest-bearing note. There is no such thing as zero interest-bearing note and we'll talk about this later on. In other words, there is a rate. There is no zero interest-bearing note and within zero interest-bearing notes, sometime we're gonna have to compute the imputed interest and we'll talk about this later on. It's very important when the interest is not reasonable or it's not stated. We have to impute the interest. Also, when we have a loan you could only make payment, you could make payment for interest only. So you could have a loan and they will ask you to make only interest payment then at the end of the life of the loan you make the principal amount. Or the most common loans that we are all familiar with, you make interest plus principal. And this is what we are mostly familiar with. But it doesn't mean that you may not have a loan where you only pay the interest and you pay the principal all at once. Now, how do we compute the interest? Usually, we use the effective method, which is basically the carrying balance of the loan times the market rate. Now, if you don't know what the carrying balance you should know from the prior session, I will talk about that later. Also, the straight line could be acceptable, could be acceptable if on the exam they told you to use the straight line then use the straight line. But I'm gonna show you the effective rate method, which is the method that companies use, the CPA exam, examiner use for the exam. We're gonna value the loan at present value. And this is important. Why? Well, the present value of what? The present value of a future interest and principal cash flow. Simply put, this is what a loan looks like. So if you have a loan, if you borrow money, here's what you're gonna have to do. You're gonna have to make payments. So each one of those dashes is a payment. So let's assume you're gonna have to make payment of $10,000. So each ax is $10,000. And at the end of the life of the loan, you're gonna have to make maybe a payment of the principal, $1,000,000, just for the sake of the figures. So what we have to do when we record the loan, when we record the loan today, we record the loan at the present value. If these payments are all the same, we treat this as an annuity and the face value or the principal amount will be discounted at a single factor, present value of a single amount. Just like what we did with bonds, just like what we're gonna do in leases, long-term notes receivable as well. In accounting, when we have future cash payments or future cash receipts, here we're dealing with future cash payments, we discount them to the present value. And this is what we do with loans and we're gonna work several examples. So the point I'm trying to make here before I proceed is, guess what? If you are not comfortable or familiar with the time value of money, stop. Go to the time value of money, charter, get comfortable, come back and work with notes. But I think you should be able to, because if you're dealing with long-term notes, it means you already dealt with short-term notes, you already learned about the time value of money. I'm just saying, if that's the case, go to my website to learn about time value of money. The best way to illustrate all these concepts is to work series of examples. Illustrating interest-bearing versus non-interest-bearing, imputed rate, how to compute the interest, how to state the interest, how to present the loans, how to find the carrying value, so on and so forth. Starting with a simple example. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's gonna help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Myles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. No obligation, no credit card required. Adam issues a 103-year note, 10% at face value to Ryan. The note was issued at face value, so it means the market rate and the stated rate are the same. Adam to make interest payments only. So the deal is Adam will borrow $100,000 today. Adam will debit cash, credit notes payable Ryan, borrowed the money from Ryan. Then at the end of every year, Adam will debit interest expense, credit cash for $10,000 or a year later. We're gonna assume for the sake of this example, the loans start at January 1st. Therefore, December 31st or January 1st, you book the interest expense for three years. Then at the end of year three, Adam will pay Ryan back the note. The note is gone. We paid off the note. So this is basically, this is first of all, this is an interest bearing note, and this is interest only loan. Why interest only? Because Adam was paying only the interest and Adam paid in year three the full amount all at once. Zero interest bearing note. There's no such thing as no interest. And we're going to emphasize this later on when we talk about the imputed interest. Zero interest bearing, it means the rate is not stated, but we can find out what the rate is. Okay. So the borrower will receive less cash today than the face amount. So when does that happen? When is it a zero interest bearing note? Well, there's a difference between what you have to pay and what you're getting today. So for example, today you will get $9,500 and you'll have to pay us back $10,000. There's no interest rate, but the difference between those two is the amount of interest, which is $500. So the difference between the face amount, $10,000 and the present value the cash received is the discount of $500. And basically what is a discount? Discount is a contra liability and discount is a future interest. Therefore, it's going to be amortized to interest expense. Well, again, we saw this when we dealt with bonds. Don't worry, we're going to deal with this again today. Let's take a look at this example. Adam company issued three year 100,000 zero interest bearing note to Ryan. The implicit rate is 5%. So what would Ryan do? Ryan would want to earn 5%. So Ryan would go to the time value of money table of a single amount because Adam will have to pay this 100,000 all at once. We'll go to three period, 5%, and Ryan will multiply the 100,000 by .86384. And Ryan would give Adam today 86,383 and Adam is responsible for paying back 100,000. The difference between the cash and the discount is the cash and the face value. Remember the cash and the face value. The cash is the present value of the 100,000 is the discount. And this is what I was discussing. This is what the discount is. We record it as a discount and we're going to have to amortize the discount over the life of the loan. So let's go ahead and look at an amortization schedule and to determine the journal entries and to determine the what's going to happen to the book value of the loan. So this is the carrying value of the loan when we started and the carrying value is the face value of the loan minus any an amortized discount. Just like bonds, it's an it's a discount minus any an amortized discount. Therefore, we're going to start with the carrying value of 86,383. Let's try to derive the journal, the journal entries from this table. Again, the carrying value starting carrying value 86,683. Well, this is a zero interest bearing note. We, it's at, we, we implied it's at 5%. Adam will make no payment. Then what's going to happen is this, although we're not making payment. We still have to record the interest. How do we compute the interest expense? Well, the interest expense is the carrying value of the note at the beginning of the period, which happens to be 86,383 times the interest rate that we are imputing 5%. So the interest is 4,319. We're going to debit interest expense 4,319 credit discount on notes 4,319. So here's what's happening to the discount. We have this discount amount here. We started at 13,600 debit. We started at 13,617. And now we credited this amount 4,319. So what we're doing is we are transferring this discount into expense. So we are reducing the discount and increasing the expense. As we reduce the discount, hopefully you remember from the bonds chapter, the carrying value of the bond goes up. So as we reduce the discount, the discount goes from 13,617 minus 4,319. The discount now is 9,298. This is the discount that we have unamortized. Now the carrying value becomes, the carrying value becomes nine, I'm sorry. This is the amount of the discount. The carrying value becomes 90,000, 90,702. The carrying value becomes this. So now we have 100,000 minus the remaining unamortized discount. And notice what's going to happen. For year two, the interest expense would repeat itself 4,535, 4,535. And again, the bond carrying value will go up. And notice interest expense is going up because the bond carrying value goes up. And for year three, interest is 4,763. And we amortize up the discount 4,763. So notice what's happening to the discount. The full amount is eventually amortized. It's basically the full amount of the discount is eventually amortized. That went from discount to interest expense. Now it's also important to know how to present the note on the financial statement. So on the financial statements, which is specifically the balance sheet, we still show the note at face value 100,000, then we subtract the discount. Then the note net of the discount is 90,702. So at the end of year one, because on the CPA exam, they ask you these questions a lot. What is shown on the balance sheet? This is how we show the note. Sometime we just show it net of discount and we'll show only the amount. We don't show the discount. We may show it in the notes of the financial statements. Let's take a look at another example. And now it's an interest-varying note. Assume that Adam issued for cash 100,003 year note bearing in bearing 4%. So the note itself is bearing 4%. The market rate of interest is 5%. So Adam is paying four, but the true rate should be five. So what's going to happen is this, Ryan knows this. So what's Ryan's going to do? Ryan's going to tell Adam, look, I'm willing to give you the money. I'm willing to give you the money now. You'll pay me 4%, but I cannot give you the full amount because the prevailing interest rate is 5%. So for me to lend you the money, I have to discount this note at 5%, but you're going to pay me 4% in interest. How do we discount a note? Basically here we're going to look at the present value, basically a review of the present value of money. Well, again, the note is composed of two things, of payments. So Adam will make a payments throughout the loan. Then they will make large payment at the end as the face value. So Ryan will, this is the face value. This is 100,000. So Ryan will discount the 100,000 at 5% for three periods. And I'm sorry, this is the annuity table. This is the present value of a single amount. Three periods, 5%, and they will discount it at 0.86384. So they will take this 100,000 and it's worth the day, 0.86384. Then Adam, I'm sorry, then Ryan will discount the payments. And the payments are three payments of how much? What's the payment? The payment is $4,000 because Adam will be paying 4%. Ryan will take this payment, $4,000 will go to the annuity table. Make sure you're going to the proper table. Three payments at 5% and the factor is 2.7235. It's worth 10,000, 10,893. Just like a bond. Now we add those two figures together and we find out that the loan is the loan that Ryan's going to give out today, 97277 in cash, but Ryan would receive 100,000. Let's go ahead and look at the journal entry. Adam would receive 92,277 in cash. However, Adam is responsible for paying back in total $100,000 as notes payable. The difference between the cash and the notes payable, you guessed it. It's the discount, discount on notes payable. Remember, discount on notes payable is a counter-liability. Therefore it takes a debit balance. Now also bear in mind this is an interest bearing note. It means Adam will be making a payment of $4,000. So here's the table that we're going to be working with. So Adam's going to make $4,000 payment. The starting value of the note is 100,000 face value minus 2,723, which will give us 97277. Now we're going to start to take a look at the end of year one. Okay. So we looked at the carrying value, 97277. At the end of year one, we're going to take the face value of the note times 5%. And that's going to give us interest expense of $4,864. Adam is paying only $4,000. Now we're starting to amortize the note. So Adam will pay $4,000 in cash and Adam would record an additional $864. Why the $864? Because the total interest expense should be $4,864. This is the total interest expense. $4,000 of this amount is cash. $4,000, let me do it below here. So the interest expense is $4,864. I'm going to break it down into two entries. $4,000 is cash and $864 is discount. So the cash is $4,000, the $864 is the discount. Or I can combine those two entries. So basically I would say, and this is what I'm saying, this entry is the same as those two entries. Okay, just combine them. I just wanted to show you that the interest expense here is composed of two things. What Adam pays in cash plus the discount that we're amortizing. Remember, we have a discount of $2,723 that we're going to discount. And as we discount, as we discounted $864, the carrying value of the note, look what's going to happen. We went from 2000 for the an amortized discount. We were at $2,723. And after the first payment, and after the first payment, the discount went down to $1589. Now the carrying value is $100,000 minus $1859. The new carrying value is $98,142. And again, at the end of the life of the loan, the whole discount is amortized. The note goes back to the face value. The note will go back to the face value. Let's take a look at what we called imputed interest. What is imputed interest? Imputed interest is needed when we have an exchange and there is no interest rate or the interest rate is unreasonable. So we assume that there is no interest-free loan. Once there is a loan interest is involved. Okay. So in a company exchange, a note for an asset, we assume that the stated rate, that the stated rate that they have in the deal is reasonable. Unless there is no stated rate. If there is no stated rate, we have to find out what the implied or imputed rate is, or if the stated rate is unreasonable. So basically they give you either a very high or very low. It's unreasonable. Or if we find that there's a large discrepancy between the note face value and the asset. So you're buying, you are buying a machinery and the cost of the machinery is $10,000 and we have a loan for $35,000. Well, that's unreasonable. Okay. That's unreasonable. A loan for that machine of $35,000. Something's not right. So there's a large discrepancy between the two. And on the CPA exam, they give you those hints when you have to use the implied. Implied when you have to use the implied rate. Now what, what rate do you use? So if, if, if that's the case, if there's no interest rate, the stated rate is unreasonable, or there's a large discrepancy between the asset and the loan, what do we have to do? Well, what do you have to do is determine the true value of the, of the goods and services? Well, let's go back to that machine. If the machine is, if the machine is worth $10,000 and the loan is $12,000, well, we can imply that there's an interest of $2,000, or if the, or if the loan is $10,000 and the machine is worth $8,000 or the machine is worth $9,000, we imply it's $1,000. So once we know the value of the goods and the service, the difference between that and the face value should be interest and hopefully it's reasonable. Or if we don't know the fair value of the asset or the service or the goods that we are purchasing, we'll try to find the fair value of the note. If we don't know the fair value of one in two, then we have to impute a rate that's, that's similar to some, to similar instrument with what we are dealing with. Simply put, we ask ourselves, if this buyer of the asset, if this issuer of the note goes to the bank today and wants to borrow money, how much will the bank charge them? Well, if that's how much they charge them, 10, 8, 7, 6, that's the prevailing interest rate for that loan. So it doesn't matter what they state. If it's unreasonable, we have to assume what would happen if they went to the bank to borrow money. The best way to illustrate this is to actually look at an example. On December 31, X1, Adam issued a promissory note to Ryan Consulting Services for services provided during X1. The note has a face value of 80,000. So Adam will have to pay 80,000. A due date of December 31, December 31, year X3. So this is year, so it's going to be year two and year three, two years. And bears a stated interest rate of 1%. Well, payable at the end of each year. Well, we're going to determine that 1% is not a reasonable rate, okay? So Adam cannot determine the fair value of the consulting service for Ryan. So that's what they agreed on. But really, so if this is 80,000, how much is really interest and how much is really for consulting services? We don't know. So because we don't know how much is consulting services, we're going to assume we cannot determine the value. Also, we cannot determine the, if we want to sell this note, we can, there's no market for that note. Also, what we know, if Adam needs to borrow the money from the bank to pay Ryan, Adam will be charged 10% based on his credit rating and the absence of collateral. So what we know though, if Adam needs to pay Ryan, an amount of money today, let's assume 60, 70, 80,000 goes to the bank, the bank will charge Adam 10%. Well, what do we know then? What do we do? We assume that the rate is 10% because we don't know the fair value of the goods or the services. The note itself, there is no value for the note. And if one and two are not known, we impute a rate that's, that's prevailing rate, the similar instrument. The most similar instrument is what happened if Adam goes to the bank and tried to borrow money? The bank will charge you 10%. Therefore, if this is an 80,000 dollar loan, we will discount this at 10% for two years and will separate the interest component from the principal component. Then we work with the loan, we work with the previous loan. Now this situation is very common in the real world. I'll tell you how when, when you have owners of companies borrowing or lending money from their company, and this happens a lot, this happens a lot in the real world. When you have small, small or medium sized businesses where the owner takes a loan out of their company, they have to charge themselves interest or they lend the company money. Then they have interest revenue and the company will have an interest expense. So this is very common in the real world. This reminds me of tax time when I was in practice. This happens a lot.