Conditions Precedent to the Present Use of Notes and Bills.—During the twelfth and thirteenth centuries there was much bad money in circulation in Europe because of the widespread practice of coin-shaving and the entire lack of standards of purity of the coins. If a monarch needed funds for war or government purposes, his easiest way of getting them was to increase the amount of base alloy in the coins of the country or to increase the rate of seigniorage. As the former method might be resorted to several times during the reign of one sovereign, the weight and relative purity of metallic coins had no relation to the denominated value of the coins, and they fell under general suspicion. Consequently, only the money dealers, who could determine the actual value of coins by assaying them, were willing to trade for coins. These men gradually became the custodians of moneys for merchants, who were given receipts showing the assay value of the coins deposited. Because the receipt represented tested and proven value, it was a more acceptable medium of exchange than the coins themselves.

Medieval trade was subject to many perils, chief of which was that from robbers. Any safeguards placed about the transportation of money from one place to another, or any method devised for settling debts without the transportation of coin and bullion, were more than welcome. Out of these conditions arose the method of settling debts by means of drafts. The draft, not countenanced by law at first, had standing, however, under the “law merchant,” the code of rules recognized by merchants as governing commercial relations. This code was later incorporated by statute into the law of the country.

These two kinds of paper, the one a receipt for coin which was in the nature of a demand promise to pay, the other a counterpart of the modern draft, were the forerunners of our promissory notes and bills of exchange of the present day. The law with regard to the bill or draft became settled as the result of the practice of merchants sooner than that relating to notes.

The Titles “Notes” and “Bills.”—In this way, the word “bill” became an established term. The titles “bills receivable” and “bills payable” still cling to both classes of items. Inasmuch as the accepted bill is practically identical with the promissory note, and the title “bill” is so often used interchangeably with the word “invoice,” it is advisable to use the terms notes receivable and notes payable instead of bills receivable and bills payable. Some advocate the use of the title “acceptances” in order to distinguish accepted bills from promissory notes. Unless these two classes of paper are large enough in volume to justify it, little advantage is secured by this separation of their bookkeeping record. However, in the case of trade acceptances, i.e., acceptances based on particular sales of goods and therefore evidencing bona fide commercial transactions as the basis for the extension of credit, it is advisable, because of their superior rating in the money markets, to segregate this class of acceptances from notes and other acceptances.

Relation of the Note to the Open Account.—In the preliminary discussion of the relation of the note to the open account in Chapter XXI, it was pointed out that both the note and account are claims against the person liable for payment; and that the one is carried under a class title “notes receivable,” because the number of such notes is usually small, while each account receivable is carried under a separate title which designates the person liable for payment. The essential difference between the two kinds of claims is that the note is an acknowledgment of the justice of the claim and the correctness of the amount, whereas the claim under the open account may be disputed and in case of dispute requires outside proof; besides, the open account may always be offset by counterclaims and sometimes by a return of all or a part of the goods bought.

Any defenses of value under the contract for which the note was given are good defenses as between the original parties to a note; but not so as between the maker and a third party who is an innocent purchaser for value. To him the maker is liable according to the exact terms and tenor of the note. Only so could the element of negotiability be insured and the note pass from hand to hand as money. In no other sense is the note a preferred claim over the open account.

In case of bankruptcy a claim against the bankrupt under an open account and a claim under a promissory note or an acceptance made by the bankrupt before his insolvency, rank alike, both sharing pro rata in the net assets available for the satisfaction of the total claim of unsecured creditors.

Relative Liquidity of the Note and Open Account.—Compared with the liquidity of open accounts, promissory notes have a slight advantage in that they can more readily be turned into cash and at a better rate. Although an assignment of open accounts is possible by hypothecating them with a third party, the cost of such assignment is almost prohibitive and is resorted to only where the customary sources of credit are not available.

The legitimacy and the low cost of discounting notes greatly increase their liquidity. Oftentimes the question of risk, i.e., the degree of certainty of their payment when due, enters into the determination of the relative liquidity as between open accounts and promissory notes, but from this standpoint there is little, if any, difference between the two claims. Occasionally a firm, which refuses to pay its debts on open account, will meet its notes and acceptances in an effort to bolster its credit at the local banks. This phase of the question does not usually enter into the discounting operation, where the credit of the discounter is the determining factor in raising money. Of course, this may be only a temporary expedient if the note is dishonored and charged back to the bank. In some lines of business it is very common practice to secure notes for overdue accounts. If the Notes Receivable account contains many such items, its liquidity is seriously to be doubted. However, the note is usually classed as a more liquid asset than the open account.

Method of Recording Notes.—As to the accounting phase, a record is made of each note received or given, entry being to Notes Receivable or Payable, as the case may be. If the note transactions are few in number, the general journal is used for their record. Ample explanation must be given as to the essential facts of date, maker, for what received, rate of interest, due date, etc. Notes receivable must be watched carefully, as failure to present them when due releases all indorsers. There is nothing unusual in the entry when made in the general journal, its debit and credit being determined as indicated in Chapter XI.

The Note Journals.—Because the general journal does not lend itself to an easy record of the essential data pertaining to note transactions, a separate book is oftentimes kept for this purpose. This special book may be used merely as a memorandum record for carrying the detailed explanation of the Journal entry; or it may become a special journal that is used as an integral part of the accounting system, and, when so used, posting to the ledgers is made direct therefrom. The use of this special journal is always advisable when note transactions are numerous. A bills or notes receivable journal may be ruled as shown on Form 41. The notes payable journal differs but slightly from the notes receivable journal.

If the bill book is for memorandum use only, the “Amounts Credited” columns may be omitted. If it is a real note journal, its debit and credit equilibrium is shown through summary entry at posting time. The total debit is to Notes Receivable for the amount of that column’s total. If it were not for the fact that sometimes notes are received in whose face amount is included not only the credit to the customer but an interest item as well, there would be no need of credit columns. The note journal would then be operated just as is any simple special journal, with a debit to Notes Receivable and the same amount credited to the customer; but when interest is included, the note is best recorded in an additional column, separating the credit to Customers from that to Interest. If notes are numerous, a distributive column in the cash book should be used for receipts from notes, in order to secure a total posting to the credit of Notes Receivable account.

Referring to the left-hand page of the illustrated ruling (Form 41), the face amount of the note receivable is entered in the Notes Receivable column, and the due date in one of the narrow columns headed “When Due,” each of these columns representing a separate month. In this way it is easy to find the total of all the notes due in a given month and the amount of cash to be expected from their payment. For this purpose, however, it is best to use a note journal arranged by months of maturity on the principle of a “tickler.” In such a journal one page is reserved for each month, and the notes are entered, not on the page for the month when received, but on that for the month when due. Thus a note received in January and due in March should be entered on the March page. To secure a summary of all notes received during each month for posting to Notes Receivable account at the end of each month, the various month pages are totaled and “recapped” on a special page. On this “recap” page, at the end of January, say, will be entered the total of the January page, giving the notes received in and maturing during January; the total of the February page, giving the notes received in January but maturing in February; etc., for each month during the year. The grand total is the amount to be posted to the general ledger, representing all notes received during January.

This type of journal gives easy control over maturities, and forecasts for a given month the amount of cash receipts from notes.

Notes Entered at Face Value Always.—Some notes are interest-bearing from their date of issue; others only after their due date when not paid. Even on non-interest-bearing notes, the law allows the charging of interest for their overdue period. From the standpoint of strict accuracy, a note payable at a future time is not worth its face value at the time of entry, unless it is interest-bearing from date at approximately as high a rate as the current discount rate. Its present value is such an amount as when placed on interest will equal the face at its due date. That value increases day by day until it reaches par or face on the due date. Because of the practical difficulties encountered in the numerous adjustments necessary under any other method of entry, universal practice countenances the bringing of the note onto the books at a slightly inflated value, i.e., face value, at the time of entry. Face value is the amount of the credit to the customer’s account; it shows the amount to be collected on account of the note; and if interest-bearing, the amount on which the interest is based. Accordingly, the note transaction is entered at its face value. Where the note is interest-bearing and the face plus the interest is paid at maturity, credit is in two items, one to Notes Receivable for the face, and the other to Interest Income for the amount received as interest.

Occasionally, the interest for the period the note is to run is added to the amount of the debt, and the sum is made the face of a non-interest-bearing note. The purpose of such procedure is to secure a compounding of interest for the first period if the note is not paid at maturity. The entry of the note on the books is a debit to Notes Receivable for its face, and credits to the customer for the amount of the debt and to Interest Income for the amount of the interest. Only a credit to Notes Receivable is made when the note is paid. The credit to Interest Income, before the interest is actually earned and received, is necessitated by its pre-estimate and inclusion in the face of the note. Were a balance sheet drawn up on that date, the entire amount of this interest would be shown as deferred income.

The Interest Accounts.—As explained in Chapter XV, when interest items are numerous two interest accounts are usually carried on the ledger, one for Interest Income and one for Interest Cost. Sometimes, however, only the one account, Interest and Discount, is carried, and if it is desirable to separate the two classes of interest, it may be done by entering the debit and credit totals of the Interest and Discount account—instead of simply the balance—when the trial balance is taken. Needless to say, bank discount—interest paid in advance—is the only kind of discount recorded under this account title; it must not be confused with discounts on sales and purchases, which receive different accounting treatment.