What Happens When a Note Receivable Is Dishonored?

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Businesses occasionally lose money to customers who cannot pay their debts.
Businesses occasionally lose money to customers who cannot pay their debts. (Image: Hemera Technologies/AbleStock.com/Getty Images)

A debtor can choose to pay a debt with a promissory note. Promissory notes serve as promises to pay a certain amount of money when conditions are met. They are not IOUs, which are informal promises to pay a debt. The maker of a promissory note sometimes fails to pay the note. Then the note is designated as dishonored, and the debtor can no longer negotiate over the note receivable.

Accounting

When the promissory note is not honored, the accountant debits the accounts receivable, credits the notes receivable and credits the interest income or interest receivable. The bank lets the endorser know about the non-payment of the note receivable and the endorser is charged protest fees for legal fees.

Debt is Written Off

If the debtor will not likely pay the debt, such as when the debtor declares bankruptcy, disappears or has debts that are beyond the statute of limitations, the crediting company generally writes the debt off as operating expenses.

Back to Accounts Receivable

When the note is dishonored, the business can either have the customer sign a new note or send the note back to Accounts Receivable. When transferred back to Accounts Receivable, the customer not only owes the amount of the note, but also owes interest. The note is considered reclassified, but the debt is not canceled.

Interest

The amount of time that it takes the customer to pay the note affects how much interest the customer will owe. The business must calculate the number of days from the maturity of the debt to the payment date, calculate the interest income, record the total payment into the account receivable, record the additional interest income and enter the cash received. The promissory note sometimes has provisions regarding the business’s rights when the customer fails to pay the promissory note. For example, the customer might agree to foreclose her assets in the event of not paying.

Legal Action

Notes receivable do not guarantee payment to the business. Instead, the note lets the business get the loan in writing, which allows the business to use the note in court to order the customer to pay the debt. Businesses could choose to turn over delinquent debt to a debt-collection agency, a lawyer or a company that buys delinquent debt and then tries to collect the debt. The creditor or debt collector can sue the debtor. The court judgment states how much money the debtor owes and lets the creditor or collector get garnishment orders, allowing a third party -- like an employer or the bank – to turn over funds to pay the debt.

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