Chapter Five

NOTES RECEIVABLE

Having completed the audit of the Cash account, the next account to be taken up is Notes Receivable. Notes are easily convertible into cash, consequently should be audited on the same day that the Cash account is audited.

1. ACCOUNTING THEORY.

There are two methods of recording notes and drafts receivable. The first method is to record them in the general journal and to keep a record in an auxiliary notes receivable book. Under this plan the notes receivable book contains a memorandum record only and does not constitute a posting medium. The notes receivable book should show the date received, drawer or endorser, maker or drawee, payee, where payable, due date, amount, rate of interest, and when paid.

The second method is to record notes and drafts in a notes receivable book from which posting is to be done. In other words, when this method is followed, the notes receivable book is considered a book of original entry and no auxiliary record is kept. This book differs from other subdivisions of the journal in that it provides for considerably more information. All the information provided for in the auxiliary notes receivable book explained above, is also provided for under this plan, and in addition, columns are provided to enable the bookkeeper to post the totals to the proper accounts in the ledger. The exact arrangement of the columns will depend upon the system of accounts in use. The notes receivable book will usually provide for a Notes Receivable debit, Interest debit, Interest credit, Sales Ledger credit, General Ledger debit and General Ledger credit columns. The important thing is to understand the two different methods of recording notes and drafts. If recorded in the general journal, then the entries should be supported by memorandum entries in an auxiliary notes receivable book. If a special division of the journal is to be used for recording transactions involving notes receivable, then all necessary information may be recorded in it and posting may be done direct from it.

Notes Receivable Account. If the first method explained above is followed, then the Notes Receivable account will show the individual debits and credits for each note receivable recorded in the books of account. If the second method is pursued, then the Notes Receivable account will be in the nature

of a summary or controlling account. For instance, the Notes Receivable account will be debited only for the total of the notes receivable debit column in the notes receivable book and may be credited for the total of the notes receivable column in the cash book, depending upon whether or not a special column for notes is provided on the debit side of the cash book.

Terminology. The term "bills receivable," is frequently used instead of "notes receivable", but it is practically universal in practice to records, notes and bills or drafts in the same account. Some bookkeepers call the account "bills receivable" while others call it "notes receivable". The term "bills" comes from the use of drafts and bills of exchange. There is no real object in attempting to separate drafts and notes in the books of account and, to do so, will only lead to confusion. A draft accepted by a customer is a "promise to pay" just as much as a promissory note would be. Seymour Walton, * C. P. A., says: "While the term 'bills receivable' is almost universally understood, it would perhaps be better if it could be replaced by the more accurately descriptive term 'notes receivable', on the ground that in this country, when a person gives his written promise to pay a given amount, the document is invariably referred to as his note, while a bill is the creditor's statement in writing, specifying the amount and character of his claim in detail".

Trade acceptances are becoming quite popular with business men. The question often arises as to whether or not a separate account should be kept with trade acceptances. In other words, should they be separated in the books of account from notes receivable. There can be no real reason for separating them in the ordinary business except where the volume of trade acceptances is large and it is desired to show trade acceptances as a separate item in the statements. In this event, separate accounts can be kept with trade acceptances and they may be recorded in the general journal, or a special journal may be provided.

Notes Receivable Discounted. A question arises as to the best method of recording notes receivable discounted. With a great number of bookkeepers, it is common practice to credit the Notes Receivable account at the time of discounting a note. This has been criticised by accountants because of the fact that before a note can be discounted it must be endorsed, and in case the maker fails to pay the note at maturity, the endorser becomes liable, consequently, accountants hold that this liability must appear in the statements. It is considered better practice to keep a separate account with Notes Receivable Discounted, crediting the account for the face value of each note or draft when discounted at the bank and debiting it with the *From his text on "Auditing", published by the Alexander Hamilton Institute.

face value of each note or draft discounted, when paid or dishonored by the maker or payee. Of course, when the Notes Receivable Discounted account is debited, the Notes Receivable account would be credited. In order to verify the amount of notes receivable on hand, it is necessary to deduct the balance of the Notes Receivable Discounted account from the balance of the Notes Receivable account.

Contingent Liability. Notes receivable discounted are a contingent liability and this fact should be indicated in the Balance Sheet. Kester says:

"For this reason, whenever a business house transfers a note by any method of endorsement (except the qualified), it incurs a contingent liability, which might become a real liability in case the maker of the note should fail to meet the obligation at maturity. Since it is the function of good accounting to present all the facts. bearing on the welfare of the business, it is evident that this fact that of incurring a contingent liabilityshould be entered in the books of account. Very frequently, however, the importance of this matter is practically ignored, with the result that the contingent liability item is lost sight of altogether."

2. AUDITING THEORY

It is important that the notes be counted on the same day that the cash is counted for the reason that, like cash, they may move on account of their being readily convertible. Analysis paper is usually used for preparing a list of notes receivable, on account of the amount of information desired.

Listing the Notes Receivable

(NOTE-Since this comprises a Balance Sheet audit for credit purposes, we will quote freely from the Federal Reserve Bulletin of April 1917. That Bulletin was termed "Uniform Accounting" and was intended as a tentative proposal to be adopted by manufacturing and merchandising concerns).

Quoting from the Federal Reserve Bulletin:

"A list of notes receivable outstanding at the end of the fiscal period should be prepared, showing the dates the notes are made, the customers' names, the date due, the amounts of the notes and the interest, if any, contained in the notes. If discounted, the name of the discounting bank should be noted and verification obtained from the bank.

"The outstanding notes must be carefully examined with the notes receivable book, and with the list prepared by or produced to the auditor, the due dates and the dates of making the notes being carefully checked, and when notes have been renewed the original dates

should be recorded. When notes have been paid since
the close of the fiscal year, the cash should be traced into
the books of the company, and, when they are in the
hands of attorneys or bankers for collection, certificates
should be obtained from the depositaries.

"When notes receivable are discounted by banks,
the company has a liability therefor which should appear
on the Balance Sheet. Lists of discounted notes not
matured at the date of the audit should be obtained from
the banks as verification and their totals entered under
secured liabilities if the cash therefor is shown as an
asset.

"The value of collateral, if any, held for notes should be ascertained, as it frequently happens that the notes are worth no more than the collateral.

"Notes due by officials and employees must always be stated separately from customers' notes, as must also notes received for other than trade transactions.

"Notes due from affiliated concerns must not be included as customers' notes, even though received as a result of trading transactions. Affiliated companies' notes should be shown as a separate item of current assets or as other assets as the circumstances warrant. They may be fairly included in current assets if the debtor company has ample margin of quick assets over its liabilities, including such notes."

3. AUDITING PROCEDURE

While one of the juniors counted the cash, the other junior prepared a list of the notes receivable owned by the Blank Manufacturing Company as at December 31, 1918. The Federal Reserve Bulletin stipulates that only a list should be made of the notes receivable outstanding at the end of the fiscal period, but it is believed to be better practice to make a complete list of all the notes receivable, whether on hand or outstanding for the reason that the information will be of value later on when calculating the accrued interest and in case any discrepancies are noted. Reference to the illustration on page 69 will show the junior's working sheet on which he prepared a list of the notes receivable.

Reference to page 51 will show that the management had estimated that 2% of the notes receivable will prove worthless. Investigation shows that this estimate is based on previous experience. However, a reserve of this kind would not be a permissible deduction on an income tax return, only actual losses within the year being allowed. Where experience and investigation show that beyond a doubt there will be a certain per cent of notes prove worthless, then it is sound accounting to set up a reserve. This will be discussed further in a later chapter.

(1A-Working Sheet, J. I. King, junior accountant.)