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:
- Cash
- Interest Cost
- Notes Receivable
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:
- Cash
- Interest Cost
- Notes Receivable Discounted
and at maturity when the note is paid by the maker:
- Notes Receivable Discounted
- Notes Receivable
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.