Accounting: The Language of Business (Part 48)

“There’s no accounting for the mysteries of the human heart.” —Susan Elizabeth Phillips

Receivables (Part G)

by

Charles Lamson

Discounting Notes Receivable

Although it is not a common transaction, a company may endorse its notes receivable and transfer them to a bank. The bank transfers cash (the proceeds) to the company after deducting a discount (interest) that is computed on the maturity value of the note for the discount period. The discount period is the time that the bank must hold the note before it becomes due.

To illustrate, assume that a 90-day, 12%, $1,800 note receivable from Pryor & Co., dated April 8, is discounted at the payee's bank on March 3 at the rate of 14%. The data used in determining the effect of the transaction are as follows:

The endorser records as interest revenue the excess of the proceeds from discounting the note, $1,807.13, over its face value, $1,800, as follows:

What if the proceeds from discounting a note receivable are less than the face value? When this situation occurs, the endorser records the excess of the face value over the proceeds as interest expense. The length of the discount period and the difference between the interest rate and the discount rate determine whether an interest expense or interest revenue will result from discounting.

Without a statement limiting responsibility, the endorser of a note is committed to paying the note if the maker defaults. This potential liability is called a contingent liability. Thus, the endorser of a note that has been discounted has a contingent liability until the due date. If the maker pays the promised amount at maturity, the contingent liability is removed without any action on the part of the endorser. If, on the other hand, the maker dishonors the note and the endorser is notified according to legal requirements, the endorser's liability becomes an actual one.

When a discounted note receivable is dishonored, the bank notifies the endorser and asks for payment. In some cases, the bank may charge a protest fee for notifying the endorser that a note has been dishonored. The entire amount paid to the bank by the endorser, including the interest and protest fee, should be debited to the account receivable of the maker. For example, assume that the $1,800, 90-day, 12% note discounted on May 3 is dishonored at maturity by the maker, Pryor & Co. The bank charges a protest fee of $12. The endorser's entry to record the payment to the bank is as follows: 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST. ED., PP. 332-333*

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