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—