Entries in the Account.—The elementary discussion of entries to the note accounts in Chapter XIV will be reviewed and amplified here.
Where the Notes Receivable account in the ledger shows each note separately rather than the totals of the items, good practice countenances the recording of the credits in this account in non-chronologic order. Thus, when a customer settles his promissory note and the document is returned to him, the credit to Notes Receivable should be entered directly opposite the original debit item. This brings each complete note transaction on a single line and shows at a glance which notes are outstanding, as evidenced by the blank lines on the credit side of the account.
When, however, the credit items are entered in chronological order, the same purpose may be accomplished by the use of an index figure for the original debit and the corresponding credit item.
What has been said above applies equally to notes payable.
The Discounted Note.—In the booking of notes receivable discounted and accepted drafts, a problem arises because of the legal right accorded the holders of notes, in case of non-payment by the maker, to look for payment to any or all of the indorsers, provided certain formal requirements are complied with. Whenever a business house transfers a note by any method of indorsement (except the qualified), it incurs a contingent liability, which may become a real liability if the maker of the note fails to meet the obligation at maturity. Since it is the function of good accounting to present all the financial facts bearing on the business, it is evident that whenever a contingent liability is incurred, it should be entered in the books of account. Very frequently, however, this liability is ignored, with the result that it is eventually lost sight of altogether.
The usual, though incorrect, method of journalizing a note discounted transaction is as follows:
Usually when an asset is sold, a credit to the account of the asset sold is correct, but not so in the case of notes sold, i.e., of notes discounted. For the purpose of showing the complete facts, the entry at the time of discount should be made as follows:
and at maturity when the note is paid by the maker:
The effect of the first entry is to set up a suspense account, Notes Receivable Discounted, representing the contingent liability on the discounted note. The effect of the second entry is, first, to cancel the credit of the Notes Receivable Discounted account, because upon payment of the note by the maker the contingent liability ceases; and second, to cancel the original debit to the Notes Receivable account which was made at the time the promissory note was received but which remained unchanged when the note was discounted, because it was still needed to record the contingent asset which would become a real asset in case the contingent liability became a real liability.
It has been argued that the above treatment of discounted notes stretches the theory of debit and credit nearly to the breaking point. It must be observed, however, that unless accounting records are so kept as to give the necessary information, they are not serving the purpose which justifies their existence. Any theory which prevents the proper functioning of the records must be changed; there is no place for it.
It would be incorrect, however, to regard Notes Receivable Discounted as an independent liability account, because it only represents a contingent liability. The two accounts, Notes Receivable and Notes Receivable Discounted, must be considered together, the latter account being set up merely for the purpose of keeping notes discounted under review until their final status is determined. The purpose of the Notes Receivable Discounted account is in a way similar to that of the valuation accounts of depreciating assets. The asset account is held at its original figure, and in order to determine the present value of the asset, the valuation account must be referred to. Similarly, the asset account, Notes Receivable, is held at its original figure, even though some or all of the notes are discounted, and in order to know the amount of notes receivable actually on hand, the credit of the Notes Discounted account must be subtracted from the debit of the Notes Receivable account. In the balance sheet, Notes Receivable Discounted is not shown as a liability item, but appears as a deduction from Notes Receivable, only the difference, representing the amount of notes actually in possession, being extended among the assets. It should be noted, however, that this contingent liability is oftentimes shown on the liability side of the balance sheet, the corresponding asset, Notes Receivable, then being separated into two items, “Notes on Hand,” and “Notes under Discount per contra.” Banks uniformly follow this practice in showing these and similar items.
At maturity of the note the final entry (Notes Receivable Discounted debit and Notes Receivable credit) is placed upon the books as illustrated above. Usually no formal notice is received by the indorser that the note has been paid by the maker. In case the note is dishonored, prompt notice would be sent, and failure to receive such notice implies that the note has been duly paid.
What has been said above concerning notes applies equally to accepted drafts, the legal character of which is identical with that of notes, the status of the drawer of an accepted draft being the same as that of the first indorser of a promissory note. The contingent liability arising from the transfer of all negotiable instruments should usually be shown.
In some instances, however, there may be good practical reasons for not adhering to the above principle. When, for instance, a large number of notes and acceptances are handled and the experience of the business shows that few of them are ever dishonored, or if the matter is under constant review by the financial manager, it might be considered an unnecessary requirement to make use of a separate Notes Receivable Discounted account. It must be left to the judgment of the accountant to decide which method is preferable in connection with the needs of the business. However, if no current account is kept to show the contingent liability, at the end of the period the balance sheet must be made to show the amount of discounted notes still outstanding as of the closing date of the period.
The Dishonored Note.—A note is dishonored either when the maker refuses payment upon its legal presentation at maturity or when there is sufficient evidence that he intends to refuse. When a note is dishonored, a formal protest is required in order to hold the indorsers. The payee appears before a notary public or some other officer with notarial powers, and makes oath that legal presentment of the note has been made and that the payment was refused. The notary then takes the note and personally presents it for payment to the maker. If payment is still refused, the notary makes a certificate of protest and mails notices of the protest to all indorsers desired to be held. Such notice is sufficient basis for action to recover from the party or parties thus notified.
In making the accounting record of a dishonored note, a number of problems may arise. These problems deal with these two situations: (1) when the note is dishonored in the hands of the named payee; and (2) when the note has been discounted by him and is charged back on account of dishonor. To illustrate the entries required, take the following two cases:
Problem. Case 1. Promissory note made by P. Canning for $100. Payee, D. Johnson. Due December 15. At maturity Johnson presents the note for payment, but payment is refused.
Case 2. Promissory note for $250 made by P. Canning. Payee, D. Johnson. Due December 15. Note was discounted by Johnson. Final holder is A. Andrews who presents the note for payment on December 15, but payment is refused.
The questions arising in connection with these two cases may be stated as follows: What record should be made on December 15—
(a) D. Johnson, at the time he received the note from Canning, made the following entry:
| Notes Receivable | 100.00 | ||
| P. Canning | 100.00 | ||
and on December 15, in order to show that the note is dishonored, he may make either of the following two entries:
| (1) P. Canning | 100.00 | ||
| Notes Receivable | 100.00 | ||
| or | |||
| (2) Notes Receivable Dishonored | 100.00 | ||
| Notes Receivable | 100.00 | ||
Entry (1) takes the charge out of the note account and sets it up again as a claim on Canning’s open account. Entry (2) transfers the charge to a Notes Receivable Dishonored account. Entry (2) is theoretically a better entry than entry (1), because from the latter it might be inferred that the nature of the claim has changed from a note claim to an open account claim. Such change has not taken place, however; Johnson’s claim against Canning is still on the note. Therefore, entry (1) is not true to the facts.
On the other hand, entry (1) has an important advantage over entry (2), because by posting entry (1) Canning’s personal account in the ledger is made to show the fact that one of his promissory notes was dishonored. This is a matter of very great importance, especially if Canning should again apply for an extension of credit.
If the second method is adopted, it is clear that the posting of the entry will not show the dishonor of the note on Canning’s account. It is essential, therefore, that the bookkeeper should make a special memo of the fact in that account. If the bookkeeper could be depended upon to make such memorandum entry, the desired purpose of making Canning’s account show a complete record of all dealings with him would be accomplished. Any treatment consistent with accounting principles and securing a complete history in one place of all dealings with the same individual satisfies all requirements.
(b) A. Andrews, who is the last indorsee of the note, should make the following entry at the time the note is dishonored:
| Notes Receivable Dishonored | 250.00 | ||
| Notes Receivable | 250.00 | ||
The Notes Receivable Dishonored account represents Andrews’ claim against any or all the indorsers whom he wishes to hold responsible. Instead of this, an entry might be made corresponding to entry (1) discussed above.
(c) In case the note should be charged back to Johnson, either by Andrews or by one of the other indorsers, he should make the following entries:
| Notes Receivable Discounted | 250.00 | ||
| Cash | 250.00 | ||
| P. Canning (or Notes Receivable Dishonored) | 250.00 | ||
| Notes Receivable | 250.00 | ||
It will be noticed that these two entries completely reverse the two original entries made by Johnson, viz.:
| Notes Receivable | 250.00 | ||
| P. Canning | 250.00 | ||
at the time he received the promissory note from Canning, and
| Cash | 250.00 | ||
| Notes Receivable Discounted | 250.00 | ||
when he transferred the note by indorsement.
It is to be understood that all expenses in connection with the dishonored note should be charged either to the personal account of the maker or to the Notes Receivable Dishonored account, as the case may be.
Where the Notes Receivable Dishonored account is used, it secures a good analysis of the claims against customers from the standpoint of probable realization and gives a relatively better basis for the bad debts estimate than that offered by the other manner of treatment. Of course, the use of such an account is limited to the ledger; it never appears as such on the balance sheet, being included there in the customers’ accounts with ample reserve for uncollectible items.
The Classification of Notes.—The Notes Receivable account should carry only the short-time notes of customers, and thus be a truly current asset. Long-time notes and those secured by mortgage should be booked under separate account titles. For a similar reason, the notes receivable given by officers, employees, or stockholders of the corporation should have separate booking, as these notes are given for the purpose of making formal record and acknowledgment of indebtedness, usually without regard to time of payment. Such notes do not constitute easily convertible assets, and therefore should not be recorded under the same account with short-time customers’ notes.
Notes Receivable Out as Collateral.—Notes receivable are sometimes given as collateral security for a loan. When they are so used, no bookkeeping problem is involved—though a memorandum to show their use as such should appear in the note account, and in case a balance sheet is drawn up, a cross-reference or a footnote should indicate the liability secured by the notes. However, the sale of the notes to satisfy the loan constitutes a regular business transaction, which should be recorded in the proper manner.
Note Renewals and Partial Payments.—The renewal of notes and partial payments are other features met in the accounting for notes. The renewal of a note is rather a question of business policy than of accounting procedure. When a note is renewed, it is usually better to deliver up the old note and secure a new one in its stead. The accounts should reflect the transaction by showing cancellation of the old and receipt of the new note. If the old note is extended, a memorandum of that fact should be entered in the ledger account.
From the financial standpoint, if neither note is interest-bearing, the amount of the renewal note should be larger than that of the old note, to cover the cost of deferring payment to a future date. For example, if the old note amounts to $1,000 and is renewed two months later, the amount of the new note should be fixed at $1,000 plus 1% interest, or $1,010.
In accounting for partial payments, no new accounting principle is involved. When such payments are numerous, additional space in the note journal and in the ledger should be provided for the purpose of facilitating the actual work of making the book record.