 Hello and welcome to the session. This is Professor Fahad in the session. In this session, we would look at notes receivable. Notes receivable sounds very much like account receivable, which it is, but it's a little bit different. We need to talk about this topic. This topic is typically covered in introductory accounting course, also covered on the CPA exam far section. As always, I would like to remind you to connect with me on LinkedIn. If you haven't done so, YouTube is where you would need to subscribe. I have 1,600 plus accounting, finance and tax lectures. This is a list of all the courses that I cover. If you like my recording, please click on the like button, share them. If they benefit you, it means they might benefit other people, especially these days with the coronavirus, many students are going online. So please share this knowledge. Also connect with me on Instagram. On my website, farhatlectures.com, you will find additional resources if you are studying for your CPA exam, or if you would like to supplement your accounting education. So it's the big idea with notes receivable. It's very similar to account receivable, except you are financing a transaction. Think about providing a loan. So when you give a loan to someone, rather than calling it an account receivable, it's a notes receivable. Think of giving someone a loan for $10,000. Well, if you do so, for example, banks give loans all the time, the bank will credit cash, $10,000, and they will debit notes receivable, $10,000. So one use of note is when you lend money. Simply put, you lend money. Another way to create a note is when you sell goods and services, let's assume you're selling a car, but what you do, you finance the transaction. So you sell the car, but you tell the buyer to sign a note. Basically, the dealer is financing the transaction. Here, we have a loan. So in this situation, we have a loan. Simply put, you gave them money. Here, you made a sale. So what's gonna happen, let's assume you sold this car for $15,000. You debit notes receivable, $15,000. You credit sales, $15,000. So simply put, you make a sale, but you make the customer sign a note. Now, what's the difference between notes then and accounts receivable? Here, you're gonna be charging them interest. So that's the main difference, is you're gonna be charging them interest. Notes receivable would involve the interest component, would involve an interest component. So that's the second use of a notes receivable. Third use, let's assume you sold someone 5,000 worth of merchandise on credit. Then you tell them to pay later. Therefore, you debited account receivable, $5,000. And you credited sales, $5,000. And that's called this customer ABC customer, ABC. So you debited account receivable, $5,000. And you credited sales, $5,000. And you gave them 30 days to pay. Now, after 30 days, they cannot pay the bill. After 30 days, they cannot pay the bill. What you do is, you'll tell them, look, I'm willing to give you more time since your account is past due. What's gonna happen? I'm gonna transfer the account receivable into a notes receivable. So simply for going forward, I'm gonna give you more time, but I'm gonna be charging you interest. Therefore, what we do is we credit the account receivable of ABC company, $5,000. And we replace it with a notes receivable, ABC company, $5,000. So this is the third use of a notes receivable, basically a form of refinancing for the client, replacing the account with the note. Now, in the real world, sometime this is called due from, an account that's called due from, but we're gonna be using the term notes receivable. So those are basically the three usage of notes receivable, either a loan, a sale, or you are refinancing or giving extending time for an account receivable. Now let's take a look at an actual note and look at officially, what's the definition of a notes receivable? It's a promissory note, it's a promise to pay, it's a written promissory note, like account receivable, it doesn't have to be written. Usually it's an oral, you trust the client here, it's written, it's more formal, to pay a specified amount of money, usually with interest, not usually, it's with interest. That's the main difference between notes and account, either on demand or at a specified future date. So the note sometime is on demand, it means as soon as I ask you for the money, you have to pay for it or at a future date. Future date is, we agreed on a future date to pay that note, to pay that note. So let's take a look at an actual note and see what it looks like. So this is an actual note or the elements of an actual note. An actual note might include five pages, 10 pages, 50 pages, it might include many details, but here are the elements, the elements of a note. First, we're gonna have to have somebody who's gonna be making the note, the maker of the note. This is the maker of the note, Julia Brown. Julia Brown is making the note. Julia Brown is promising to pay someone, that someone is the payee, the payee is TechCom. So Julia, it's the maker of the note, promising TechCom company, which is in LA, a payee to pay a principal amount of $1,000. Julia made the note, July 10th, 2019. That's the date of the note. The note will have a date. The note will have a due date. The due date is either explicitly stated or expressed in terms of days. 90 days after July 10th, Julia promised to pay TechCom, and we have obviously to have the amount we said $1,000, and we have to have interest, 12%. So notice the players, not the players, the elements. You have to have a maker. Julia Brown is making this promise to the payee to pay a principal amount, and the date is not explicitly stated, but we're gonna find out the date. You need to learn how to find the date. So those are the basic element of a note. Now, this note could be for a sale. This note could be for cash. So if TechCom gave Julia cash, we will debit notes receivable, NR, we will debit notes receivable, and we credit cash for $1,000. If TechCom made the sale to Julia and Julia promised to pay, we will debit notes receivable $1,000, credit sales $1,000, because that's what we provided. We gave them a sale. So depending, we're not told here what the situation is, but the point is Julia promised to pay $1,000. Now let's find out what's the maturity date, computing the maturity date. The maturity date is an important date because that's the date when Julia will have to pay back the note plus interest. When you pay back the note, you'll pay it plus interest. So we need to know what date on what date you will need to pay off the note. Here's how we compute this. The maturity date, the maturity date of the note is the day that the note, which is the principal plus interest must be repaid. That's important, important to re-notice the maturity date of a note. How do we compute the maturity date? Here's how we do it. On July 10th, TechCom received a $1,000 90 day, 12% promise to re-note as a result of a sale. Now we are told that this transaction was a sale. So Julia promised to pay for the sale. When would Julia have to pay back? Here's what we do. The date the note is signed is not counted. So here we go. We're gonna count 90 days. July 10th is when the note is signed. What we do, we don't count the day the note was signed. So minus July 10th, we have 31 days in July, minus 10. We have 21 days in July. We have 31 days in August, 30 days in September, and we need eight days to complete the 90 days in October. Therefore, the maturity date is October the 8th. Just remember, the date the note is signed is not counted. So if it's signed in July 15th, you will say you will take 31 minus 15. You don't count the 15th day. So you'll have 16 days in July, then you count the other days. So remember, the date the note is signed, it's not counted. Now how do we compute the interest? That's also important. How do we compute the interest? The formula for the interest is PIT. I call it PIT. It's principle times interest times, and I'm gonna put the time in a different color, times time. So this is how we compute the interest, because the note will involve interest. So you have to pay back the note plus interest. The principle is the amount of the note, which is obviously, for our purpose, is $1,000. The annual interest rate is 12%. This is the annual interest rate from the note that was stated on the note. Now we have to be careful when it comes to time. The time for the note, if it's a fraction of a year, 90 days is less than a year. If it's less than a year, we have to prorate the time. We have to express the date differently. What do I mean by this? For the purpose of this course, you will use 360 days in a year, not 365. Don't worry about why, why not? Just obviously, you know that there are 365 days in a year, but for the purpose of our textbook, they use 360 because it gives you a rounding number. So for the date, we're gonna take 90 days divided by 360. Why did we do so? Why did we use 360, not 365, just for rounding purposes? You don't have to worry about this. And when you are completing the work, when you are completing the homework, they will tell you to use 360 to input the answers as 360, use 360. So remember, the time is a fraction of a year because it's less than a year. Therefore, we have to make sure we compute the date properly, okay? This is called the banker's rule. Don't worry about it, okay? Therefore, how much interest it's gonna be will accrue, well, 1,000 times 12% times nine divided by 360. Now, if you're doing the math on your calculator, make sure to compute the ratio first, which is 0.25 of a year times 12% times 1,000. The interest that Julia will have to pay is $30. So Julia will not only have to pay 1,000, will have to pay the 1,000 plus $30. So let's take a look at the transaction and see the actual journal entry. So notes receivable are usually recorded in a single notes accounts receivable to simplify bookkeeping. Or you could have many notes, but usually you add them all up and you will have on the general ledger one note. The original notes are kept on file, including information on the maker, rate, interest, and due date. Obviously, you will have a list of all your notes with their names, addresses, social security, when do they have to pay, so on and so forth. So to illustrate this concept, we're gonna go back to the Julia Brown. She purchased from Techcom 1,000 worth of goods. She promised to pay 90 days plus 12%. So the entry we make is debit notes receivable, credit sales. Now we're gonna emit cost of goods sold for simplicity. Now, when Julia pay this note later, when Julia pays the note, how much would Julia will have to pay? So when we fast forward till October the eighth, when we fast forward till October the eighth, the cash that we would receive, from Julia 1,030 dollars. We will credit the notes receivable for Julia. She owes us exactly 1,000. Then the 30 dollars that's left is interest revenue of 30 dollars. So this is the entry that we make on October the eighth. Now, so this is one use of the note we make a sale. Now the same concept would have been if we gave Julia rather than make a sale. If we gave Julia cash, the entry will be the same when we receive the money. She'll have to pay us the cash back plus 30 dollars and the 30 dollars is interest for us, okay? Now, let's take a look at another scenario. Let's take a look in another scenario, okay? A seller may accept a note receivable from an account receivable customer to allow an extension to pay pass-due account receivable. I told you this, if we have a customer and that customer cannot pay their bill, they owe us money and they cannot pay their bill, what can we do? We tell the customer, look, we're gonna give you more time since you cannot pay your bill today. However, we are going to charge you interest. So it's not interest-free anymore. It's not an account receivable. Now it's a note receivable. So let's take a look at this transaction and see how do we process such transactions. So to illustrate, assume Techcom company agreed to accept $232 in cash. That's good. We're gonna debit cash to 32. Along with $600, 60-day 15% note from Joe Cook to settle her 832 pass-due account. So simply put, Jay Cook owes us $832. They paid in cash immediately. They paid in cash immediately. They said, we have $232. We'll take the cash. The remainder is, we're gonna accept a note, note receivable for the remainder, which is $600. And what we do is we remove the account receivable receivable for the full amount, which is 832. So we remove the receivable, we replace it with a note, and we accepted the cash. So what did we do here? We accepted a note in lieu, instead of billing the customer for an account receivable. Now we're gonna be charging the customer for the $600. We're gonna be charging the customer, obviously, interest on that money. Why? Because we gave them some time to pay. They could not pay. We're willing to refine it. We're willing to give them more time, but we're gonna be charging them interest. So this is another use of a note receivable. Let's look at recording an honored note. What is an honored note? An honored note means the person that issued the note honored it. Honored it means they paid it, okay? So the principal and the interest of the note are due on its maturity and the person paid it. So let's go back to Jay Cook. You remember Jay Cook signed the note for $600, wanted to pay in 60 days, and they accept to pay 15% interest. Well, first we have to compute the interest, so we have to know how much they have to pay in interest, 600 times, 15% times, remember, 60 divided by 360. On your calculator, finish the fraction first, and that's gonna give us $15 of interest. So we're gonna receive from Jay Cook, $615. $600 is the note, 15 is the interest. We're gonna remove the note, and we're gonna record $15 of interest revenue. Now, what happened if the note is dishonored? Dishonored means you remember Jay Cook, they promised to pay $600, but for the note, we gave them additional time, but they end up not paying us. The act of dishonoring the note does not relief the maker of the obligation to repay the principle and the interest. Although they did not pay it, it doesn't mean they're off the hook, they're still responsible for the principle, and now they're responsible for the interest. So remember that Jay Cook, $600, 60 day, 15% note. December 4th came in, Jay Cook did not pay the money. What do we have to do? Well, we know what we have to do if they paid. If they paid, we accept the cash. If they don't pay, everything else the same, except rather than cash, we are going to debit their account receivable. So we're gonna build them again, $615. So here's what's gonna happen. So the only difference between honoring and not honoring, rather than debiting cash, we're gonna debit account receivable for Jay Cook, and we're gonna build them for the $615. We are still going to record $15 of interest revenue because we did earn that revenue. We held that note, and now they owe us the money, $15, okay? Now, another thing we have to be aware of when it comes to notes receivable is what we called end-of-the-period interest adjustment. What is the idea of this? Let's assume we have two periods, year one and year two. And let's assume we accept the note on December 1st, that's due January 15th. So we accepted the note, and we're not gonna receive any payment till January 15th. From December 1st till December 31st, we are going to earn some interest on that note. What do we have to do with that interest? We have to accrue the interest, although we will not be receiving the cash till January, but we have to accrue the interest. So this is what we mean by end-of-the-year interest adjustment. The best way to illustrate this is to work a complete example. On December 16th, that come accept 3,060-day 12% note from a customer in granting an extension on a pass due account. So simply put someone owes us $3,000, they did not have money to pay. So what we did is we replaced the account with the note. So therefore we debited notes receivable 3,000, and we credited their account receivable 3,000. This was on December the 16th, okay? Now what happened? From December the 16th till December the 31st, we have 15 days. Why? Because the interest was accruing during that period. So we're gonna take the principal amount times the interest rate, times the time. Remember the time is a fraction, and we earned $15 worth of interest. So simply put, in period one, there is $15 worth of interest. Now they're not gonna pay us this money until 45 days later. Remember the payment is, we have another 45 days because it's 460 days. But we did earn $15 worth of interest. What do we have to do? We're gonna have to record this interest as revenue. So we debit interest receivable. We say we earned, we are expecting to be paid $15, and that $15 is interest revenue as of December 31st. So now what we did is we did a year-end adjustment. Now, let's fast forward until the payment date. When is the payment date? Let's find out the payment date. 31 days in December minus 16th, 15 days. We already know that 15 days in December, plus 31 days in January, plus 14 days in February will make 60 days. So the note is due February the 14th, Valentine's Day. What happened on Valentine's Day? They're gonna have to pay us the principal, which is $3,000 plus the interest. So how much is the interest? Well, $3,000 times 12% times 60 divided by 360. Why 60? Now we are computing the cash. So the cash that they have to pay us is $60, interest cash. So here's what's gonna happen. We debit cash 3,060. Why 3,060? 3,000 is the original note and $60 in cash. Now, on February the 14th, what we do is we credit the interest receivable. Remember this interest receivable that we accrued on December 31st. We accrued and we recorded it as revenue. So of that $60, 15 was already revenue from December 31st. What remained is $45 of revenue and that $45 is from January 1st. So this $45, the interest revenue is from January 1st till February the 14th, till Valentine's Day. And this is the entry that we make. And simply put, I'm not exaggerating if I said this is as difficult as it gets when it comes to notes. It's basically when you have a year-end adjustment, that's the most difficult thing, but it's not difficult, but this is as difficult as it gets. Now, as always, I would like to remind you, if you are studying for your CPA exam or if you'd like to supplement your accounting education, please check out my website, like my lectures if you like them, subscribe, share them with other. In the next session, we would look at disposal of receivable. When you have a receivable and you don't, you want to get rid of it, what can you do? In the next session, also we would look at the ratio for receivable. Stay motivated, stay safe, and study hard for your CPA exam. Good.