The books of original entry, i.e., the journals, having been explained, the attention of the student will be directed next to the sources of information on which the entries in the various journals depend. Accordingly, some of the important papers and methods used in business will be discussed, after which further accounting principles and methods will be given adequate treatment.

Use of the Note Receivable.—The purpose of sales is the ultimate conversion of stock-in-trade into cash to provide for the payment of services and for the purchase of commodities for future sale. This conversion of stock-in-trade into money may be immediate, as when goods are sold for cash, or deferred, as when goods are sold on account. In the latter case the conversion is indirect, because the charge against the customer must be collected before conversion is complete.

Frequently the “note receivable” acts as an intermediate step in the process of converting stock-in-trade into cash. It is an instrument in which the customer formally promises to pay his debt at a fixed time in the future. The kind of claim represented by a note receivable is, legally, different from the open account claim; generally speaking, a note is considered a better claim than an open account. This is because the note implies a prima facie acknowledgment of the correctness of the original charge, and in event of suit relieves the holder from proving the original items of the claim.

Accordingly, when a promissory note is received from a customer, the open account claim against him ceases to exist and a different kind of claim evidenced by his promissory note is acquired. Therefore the open account is credited to show cancellation of the original charge, and Notes Receivable is debited to show the new claim. It may be well to remark here that the same instrument which is a note receivable to the vendor is a note payable to the customer.

In some businesses, it is the policy to encourage customers to give notes. In such cases it is often advantageous, particularly for the credit information shown, to set up the note transactions with each customer under individual names, e.g., “John Doe, Notes Receivable.” Such a title plainly indicates the nature of the items listed under it; viz., claims against John Doe, witnessed by his promissory notes. As a general rule, however, the notes received from any one customer or all customers are usually relatively small in number and for this reason they are for the most part brought together under one class title, Notes Receivable.

Negotiable Instruments—Their Use and Requisites.—Notes receivable belong to a class of business papers termed negotiable instruments, the distinctive feature of which is that in many ways and for many purposes they take the place of money. The negotiable instrument, usually of small size but often representing a large sum of money, is used in the commerce of the world as a medium of exchange, in place of heavy and bulky coin or valuable bank notes which when lost or stolen can be passed as currency.

From a legal standpoint a negotiable instrument is one which gives a bona fide holder an absolute right to it, whether the preceding holder had acquired it lawfully or not. It is in this respect distinguished from other objects of value, as a horse, for example, the present possessor of which is the legal owner only if he acquired it in good faith from one who in turn had acquired it lawfully.

To be negotiable, an instrument must have the following requisites:

Negotiable Instruments—Kinds and Definitions.—Any formal or informal written promise to pay possessing these essentials is a negotiable instrument. Examples are: promissory notes—notes receivable and notes payable—drafts, checks, money orders and, with certain restrictions, warehouse receipts.

A promissory note may be defined as an unconditional promise to pay a specified sum of money at a certain time. It usually has a form similar to the following:

The Draft.—A draft is a written order by one party on a second party to pay to a third party the amount of money named. To be negotiable, it must be so drawn as to meet the requirements of negotiability named above. A draft may have a form similar to the following:

It will be noticed that there are three parties to a draft—the drawer, the drawee, and the payee. The drawer is the person who draws the draft and whose signature appears at the lower right-hand corner of the draft. The drawee is the person on whom the draft is drawn, George S. Perkins, above. He is sometimes called the payer. The payee is the person who is to receive the payment ordered, James Stanley Jackson & Co.

To understand the use of the draft as an instrument of business, suppose the following relations exist between the three parties named above:

The problem will be discussed from the standpoint of Bert V. Robbins. From the above data it is clear that Robbins has a claim against Perkins for $175 and owes $125.75 to Jackson & Co. Instead of collecting the claim against the former and paying his debt to the latter, he writes out a draft for $125.75 on Perkins, with Jackson & Co. as payee, thereby requesting (or ordering) Perkins to pay $125.75 to Jackson & Co. This draft he sends to Jackson & Co. and they present it through their bankers to Perkins. Under ordinary circumstances Perkins acknowledges the correctness of the draft and writes his acceptance on the face of it, thereby promising to pay the amount when due. Acceptances are usually worded in the following manner:

Accepted, Oct. 6, 19—
Payable at First National Bank
of Providence
George S. Perkins

It should be said that the three-party draft is not usually made use of without the consent of the drawee previously obtained, as in the case of a bank check, which is a draft on the bank drawn by the depositor. Very often in ordinary drafts, particularly when drawn against an export of goods, the drawer makes out the draft in favor of himself and indorses it in blank, thus making it transferable to bearer.

The Accepted Draft.—When accepted, the draft becomes, to all intents and purposes, an ordinary promissory note—Perkins’ promise to pay Jackson & Co. $125.75. Until the draft is accepted by Perkins, it simply constitutes a request from Robbins to Perkins to pay the amount named and the draft as such does not bind Perkins in any way. Hence, no entry is made on the books of account of any of the three parties until acceptance. Of course, a memorandum is kept of all drafts drawn.

Illustrative Entries.—Upon acceptance by Perkins, the following entries are made:

1. On the books of Jackson & Co., the payee:

Perkins’ acceptance, in possession of Jackson & Co., constitutes a claim against Perkins, and Jackson & Co. therefore debit Notes Receivable. They credit Robbins because this draft was sent to them by Robbins in payment of Jackson’s open claim against Robbins for $125.75.

2. On the books of Perkins, the drawee:

This entry cancels Perkins’ liability on open account to Robbins, and shows as a substitution therefor the amount of his acceptance in favor of Jackson & Co. at Robbins’ request.

3. On the books of Robbins, the drawer:

From the point of view of Bert V. Robbins, the acceptance by Perkins means two things: (1) the cancellation of a part of Robbins’ claim against Perkins, and for this reason Robbins credits Perkins with $125.75; (2) the cancellation of Robbins’ debt to Jackson & Co., hence Jackson & Co. is debited on Robbins’ books for $125.75.

It is important to note here that in case Perkins fails to pay the note at maturity, Robbins becomes liable to Jackson & Co. Robbins may therefore be considered the first indorser of the accepted draft. The discussion of the manner of booking Robbins’ liability contingent upon Perkins’ failure to pay is deferred to Chapter XLIII.

Entries After Payment of the Draft.—Upon payment by Perkins, the following entries are made:

Draft and Cash Compared as Instruments of Payment.—The following two diagrams may further illustrate the utility of the draft as an instrument of trade.

1. Showing the settlement of the several claims in cash—in case Robbins had collected $125.75 from Perkins and had paid $125.75 to Jackson & Co., the payments being made independently in each case:

2. Showing a settlement by draft—a clearing house method:

The commercial, three-party draft is little used now. With the larger function of banks in the conduct of modern business, other kinds of drafts as discussed below have come into use. The three-party relationship is the basis of all draft transactions, however, and must therefore be thoroughly understood.

Classification of Drafts.—There are several kinds of drafts, which may be either sight or time instruments. A draft drawn “at sight” is a request on the drawee to pay at sight, i.e., immediately upon presentation to him. The use of the sight draft in making collections is quite common. A delinquent customer is drawn on at sight and collection is attempted through the bank. The method is oftentimes effective because refusal to pay may reflect on the drawee’s credit with his own bank. Usually no formal book entry is made of such drafts until paid. A draft drawn, say, “at 60 days’ (or 30 days’) sight” is a request to pay 60 (or 30) days after presentation. Hence, the dating of the acceptance of such a draft is of prime importance. Such a draft is, of course, a time draft.

A draft drawn “60 (or other number) days after date” is called a date draft and is payable 60 days from the date of the instrument—not, as in the first case, 60 days after presentation or acceptance. It also is a time draft. It is not necessary, although customary, to present time drafts for acceptance.

Drafts may be “commercial” or “bank” according as the drawee is a merchant or a bank, respectively. B. V. Robbins’ draft on Perkins shown above is a merchant’s draft. A bank draft is a request by one bank on a correspondent bank to pay a given amount of money to a named payee. A customary method of remitting money is by the purchase and remittance of a bank draft, for the issuing of which banks usually charge a fraction of a per cent. To illustrate its use, take the following situation:

L. W. Roberts of Denver owes Field & Co. of Chicago $210 on account. Roberts goes to his Denver banker and buys a bank draft which may read as follows:

Before sending this draft to Field & Co., Roberts indorses it in favor of Field & Co., who upon its receipt deposit it with their own bank and through it secure its collection from the Second National Bank. Roberts pays his bank for the draft $210 plus exchange.

Drafts may be foreign or domestic. They are domestic when they are drawn and payable within the same state or country; otherwise they are foreign. According to the present usage, the term “draft” is used whenever the parties concerned live within the United States, although they may reside in different states, and the term “bill of exchange” is applied to all such instruments where some of the parties live abroad.

The Trade Acceptance.—The Federal Reserve Board defines a trade acceptance as “a bill of exchange drawn by the seller on the purchaser of goods sold and accepted by such purchaser.” The chief characteristic of this document as contrasted with the ordinary draft is the showing on its face of the origin of the transaction giving rise to the draft, usually by means of the following statement: “The obligation of the acceptor hereof arises out of the purchase of goods from the drawer.” The following requirements to make a trade acceptance eligible for rediscount by the federal reserve banks have been laid down by the Federal Reserve Board:

Trade acceptances are promissory notes just as are any other accepted drafts. Because they comprise a very liquid asset, it is not unusual to record them in an account, Trade Acceptances, and so distinguish them from other notes and drafts. If they are few in number, they are more usually recorded as Notes Receivable.

Checks.—A check is a draft on a depositary bank. It is an individual’s order to his bank of deposit to pay a named or designated payee a certain sum of money. Two illustrations are given below, somewhat different in form but identical in nature. In the first, likeness of the check to a draft is very evident.

The certified check is usually an individual’s or firm’s check bearing the certification of the bank’s cashier that the check is good. This certification is evidenced by writing across the face of the check these or similar words:

Good
when properly indorsed
First National Bank
F. G. Moffitt, Cashier

Such a certification makes the bank responsible for its payment.

A cashier’s check is a bank’s own check drawn on itself in favor of a third party and signed by its cashier. As a medium of exchange it ranks higher than the check of a private person, due to the superior credit of the bank and to the fact that the bank is usually more generally known in a community.

Other Negotiable Instruments.—Express and postal money orders are drafts payable at sight, drawn respectively by one express agent on another and by one postmaster on another.

A warehouse receipt is a receipt from a warehouse, elevator, or other storage concern acknowledging the receipt of goods or property. Such a receipt usually contains the contract agreements entered into by the parties, covering the conditions according to which the goods are accepted for storage. The warehouse receipt is usually negotiable, or partially so, in that title to the property may pass with its transfer.

Principles Governing the Writing of Commercial Paper.—Ordinary prudence requires commercial paper to be drawn in a way that will make forgery difficult if not impossible. To this end the following two rules should be observed:

Kinds of Indorsement.—An indorsement is usually for the purpose of transferring title. There are several kinds of indorsement, as follows: