Accounting theory and practice, Volume 1 (of 3)

by Roy B. Kester

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.