 Hello! In this presentation we will discuss the discussion question of why don't we record interest at the inception of a loan? Another way this essay question could be asked is just simply what is interest? What is interest expense? In order to answer this question we need to consider you know how does interest expense happen? How does it accumulate? How is interest used within the recording? And then of course how do we record that interest expense and what is going to be the effect on the financial statements? Why this question is a bit of a problem is because the idea of interest one can be a bit abstract and when we first see interest within the recording of a problem especially within a comprehensive problem or even when with a short answer question we often see something like a loan we're going to take the loan out it's going to be a ten thousand dollar loan we're going to make so many payments and the interest rate is going to be five percent or something like that and when we record the payment then it's very easy for us to start getting confused on the recording of the loan and think that we have to do something with that five percent interest at the point in time that we are recording the loan instead of just doing what the actual transaction is when we first record the loan which would just be a debit to the cash if we got cash for the loan if we took if we got a ten thousand loan for cash and then a credit to the loan payable increasing the cash we got increasing the liability and increasing the payable meaning we are increasing the amount we owe the question then is well what do we do with this five percent interest that a problem inevitably gave us within the problem it's just kind of confusing things I know it's important I know we're going to have a five percent interest somewhere why isn't it something I need to deal with at the point in time that I do the question and if I don't need to deal with it why did the question give us that information there'll be a couple answers to that one is that of course in real life if we had a loan agreement and in real life with many different things it's it's often the case that we have more information than we need in book problems especially with multiple choice questions the reverse is often the case meaning a book problem often tests our knowledge by limiting the amount of information they give us in order to achieve a certain goal or objective and that can really test conceptual concepts well but in practice it's often the opposite it's often that we've got this giant loan agreement with all this stuff on it and we need to pick and choose those things that are relevant to what we need to deal with and in that sense this type of question is good if they're gonna because it's kind of related to real life if if the question is going to give us the full loan terms at the inception of the loan in order to record a journal entry we don't really need some of the information given we don't really even need to know at that point in time what the interest rate is the fact that interest rate is five percent versus six percent versus ten percent at the inception of the loan the journal entry we record when we start the loan process doesn't make a difference now then just to think about what interest is or why that's the case we got to think about what interest is now i would consider i would think of interest kind of as similar to something like rent it's going to be a rent it's going to be very clear people have a good idea of what rent is if we have an office building and we live in it first or you know we work in it basically live in it we're working in an old time for a certain period of time then we're going to have to pay rent on the office building as we consume it as we use it so if a month has passed we pay whatever is due for that month that has passed in accordance to an agreement that we have agreed upon for the rents amount over a period of time the concept of interest is really the same thing except that we were borrowing something that i guess is kind of more intangible more abstract in nature we're borrowing money so rather than having the use of something very tangible very visible very obvious that we're using such as a building we're going to be using something that i guess is less obvious is that's going to be the use of the money if we got ten thousand dollars and we're using that in order to help us run our business just like us consuming the use of a space we're consuming the use of that purchasing power so we have we're getting that purchasing power and that's worth something we're getting the purchasing power today in order to help generate revenue and we're paying the rent in order to allow us that purchasing power that rent is just the interest so just like if we were going to pay so much a month for for the rent on a building we're going to pay so much on the rent for the money now of course the rent on money can be a bit more difficult for us to calculate we might not just say we're just going to pay the the interest at you know a hundred dollars or a thousand dollars a month we're going to base it somehow on the principal and those terms of rents could be confusing meaning we might pay some of the principal and interest back for if we most of us think of like a mortgage or a car payment in which case we pay some of the interest and some of the principal at a monthly time period and in that type of setup it can actually be a little bit confusing what interest is versus what principal is because we're paying off a little bit of each as we go the purest sense or the most easy comparison to say a rental property would be that i'm going to borrow the ten thousand dollars we're going to pay back the ten thousand dollars at the end of say five years and within that time period we're going to pay the rent monthly or pay the interest monthly meaning we're going to pay five percent monthly and not to pay any of the principal back we're going to return the entire principal just like we would return the office building at the end of the time period at the end of five years in that case it would be a very straightforward comparison and we can say okay we're just paying for the use of that ten thousand dollars so the complexity of different loan agreements which which could have a good purpose and they're not complex just to confuse people but you know there's a good reasons why we might want to pay off some of the principal at the same time but the idea of paying off the principal and that the vast ways that we can structure a loan agreement and the way the interest is going to be paid back and how the principal is going to be paid back really can kind of muddy the waters it kind of confuse us in terms of what you know what actually interest is so when considering what interest is it's going to be basically the rent on the money when we record the interest then we're just going to record the interest over time why then doesn't it happen at at the point in time that we take out the loan why at the inception of the loan don't we have to deal with interest well it's going to be the same thing as the inception of a lease agreement when we when we go and say we're gonna we're gonna pay you you know a thousand dollars a month for the next five years in order to use the office building we don't typically write the check for that month in the first day unless we prepay for the office building or we're putting down a deposit because why because we haven't used it yet we're gonna we can't record the expense under the matching principle the matching principle or the expense recognition principle saying that we don't recognize an expense until it has been incurred in order to help us generate revenue uh so in in this case in the case of just making agreement if we just signed a lease with a with somebody we haven't yet incurred an expense because we haven't consumed anything we haven't used the office bill then used the space in order to achieve the goal of revenue generation when we first take out a loan the same case if we got ten thousand dollars today then i haven't i don't have any interest even though i know the interest rate the interest rate is five percent haven't used it though so even though i'm gonna pay five percent just like i know i'm going to pay a thousand dollars on the property i haven't yet consumed that five percent because time has not passed so it's going to take time to pass in order for that interest to accumulate over time and as it does as we consume the use of that ten thousand dollars that purchasing power over time in order to help us generate revenue in accordance with the matching principle that's when the interest will take place so when we take out the loan the you know the transaction doesn't matter what the interest rate if whether it's you know five percent ten percent a hundred percent hopefully not you know twenty percent it's going to be we're going to record the loan is just a debit to cash and a credit to the loan balance that we got the loan payable then over time we're going to have to record that interest as it is incurred in accordance with whatever policy we have it might be that we just pay the interest only on the loan it might be that we pay some of the interest and some of the principal but the interest portion of it the interest portion of any payment just represents the use the consumption of that money at the agreed upon price that agreed upon price being reflected in terms of a rate some type of interest rate that we will have to calculate so if asked the question why don't record why don't we record interest at the inception of the loan or just a simple question as what is interest I would then break it down in in that format in terms of defining you know what is interest how do we use interest and why is it used we have interest basically to record the expense related to the consumption of the value of money in a similar way as to the when we consume or rent the value of a property we don't record it at the inception of the loan because we have not yet consumed the value of the money that we have received just as we have not consumed the value of a rental property at the signing of the lease we record the interest expense reflecting the consumption of the use or purchasing value of that money as it has been used or purchased as time passes where we are consuming that that purchasing power in the future recording interest expense in the point in time that it has been incurred in order to help us generate revenue in accordance with the matching or expense recognition principle