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Accounting is a subject that rarely gets discussed in the note investing world. But in my opinion its one of the most important areas of the business you need to understand well. Last week I talked about putting together JV reports. One aspect of those reports is how the principal and interest portion of payments recieved are split out. It’s an area where I get the most questions from JV’s. When I’m doing ROI calculations I just look at the total P&I payment, but from an accounting perspective on the backend principal and interest need to be treated differently.

For starters, portions of interest payments that are paid out to JV’s will get a 1099. The principal won’t because its technically a return of capital. This is the mean reason why they have to be treated differently. Eventually at the end of the deal those principal portions will show up as profit.

Now I’ll talk about how I actually treat them. Within Quickbooks I have a few different accounts set up for each note. There is a class for each note, but then 4 different accounts:

• Account 1, the note
  • This shows the purchase price of the note
  • As payments come in, the principal portions get applied to this account and reduce the balance over time
• Account 2, holding costs
  • This is where all of the expenses related to the note are captured.
  • Its not actually relevent to this P vs I discussion but I am including it here for completeness
• Account 3, liability to the JV
  • This account starts with the portion of the JV funding that was used for the purchase of the note. 
  • As payments come in, half of the interest portion of the payment is applied here, growing the balance over time.
• Account 4, liability to the JV for the reserve funding
  • Like the holding costs account, this one isn’t really relevant to this discussion. 
  • This account captures the portion of the JV funding provided for expenses. It could be combined with account 3, but I like having them broken out. This makes it easy for me to compare the funding for expenses to what has been spent so far (account 2).

So when a payment comes in it gets applied like this:

1. Principal portion – to account 1 for the note
2. 1/2 the interest portion – to account 3 which becomes a liability to the JV (meaning I owe them this money)
3. 1/2 the interest portion – applied as interest income to Fusion Notes
   1. There isn’t a separate interest income account for each note, although the transaction does get tagged to the class of the note

I’m not sure if this makes things more clear or more confusing. I’ll cover additional accounting and JV examples in the coming weeks, including how and when the principal and interest portions due to the JV get paid out, and how profits are calculated at the end of a deal.