What is Bill of Exchange?

Bill of Exchange Definition

A bill of exchange is a written, unconditional order by one party (the drawer) to another (the drawee) to pay a certain sum of money to a third party (the payee) or the bearer of the document. It is a negotiable instrument, which means it is legally transferable from one party to another. Bill of exchange is used primarily in international trade for transactions involving the sale and purchase of goods across borders, providing a secure mechanism for payment.

Purpose of Bill of Exchange

Bill of Exchange facilitates trade and finance by providing a reliable and formal method for transacting payments across different parties and, often, international borders. It ensures that sellers receive payment for goods or services immediately or at a predetermined date. The bill of exchange provides the flexibility to manage cash flow and fulfill payment obligations without an immediate cash exchange. 

A bill of exchange acts as a legally binding commitment that the drawee will pay the specified amount, reducing non-payment risk for the seller. A versatile tool for financing and credit management, this financial instrument supports debt obligations transferability as it can be endorsed to another party. Its role in confirming and formalizing payment terms between parties in trade transactions streamlines and secures commercial operations globally.

Key Features of Bill of Exchange

Bill of exchange offers various features, widely accepted and used in domestic and international trade for providing a secure and standardized method of payment and credit. The key features of a bill of exchange, which make it a distinctive financial instrument, include:

• Written Document: It must be in writing, clearly stating the terms and conditions of the payment obligation.
• Unconditional Order: The document contains an unconditional order to pay a specific sum, indicating that the drawee must pay the specified amount without any conditions.
• Specified Amount: The amount to be paid is fixed and specified within the document. This amount does not change, making the obligation clear and straightforward.
• Parties Involved: The parties involved in the bill of exchange include the drawer, drawee, and the payee. The drawer creates and signs the bill, directing the drawee to pay the money. the drawee is ordered to pay the amount specified in the bill. Upon acceptance of the bill, the drawee becomes responsible for paying. The payee is the individual or entity to whom the payment is made. The drawer can also be the payee, or the bill can be payable to the bearer or another party if endorsed.
• Payment to Order or Bearer: The bill specifies to whom the payment is to be made, which can be a named person (order bill) or the holder of the document (bearer bill).
• Maturity Date: The payment or maturity date is mentioned and may be on demand or at a specified future date.
• Acceptance: Before a bill becomes binding on the drawee, it must be accepted by the drawee. Acceptance is indicated by the drawee's signature on the document.
• Transferability: A Bill of exchange can be transferred from one party to another, allowing the holder to endorse the bill to another party before maturity.
• Legal Document: It is a legally binding document. If the drawee fails to make the payment, the holder has the legal right to take action against the drawee and any endorsers.

Bill of Exchange in Accounting

In accounting, a bill of exchange represents a written promise or obligation to pay a specific sum of money at a future date. It is used in international trade and finance transactions. The accounting for bill of exchange ensures that both assets and liabilities are accurately reflected in the financial statements, providing clarity on the financial position and performance related to these instruments.

When it comes to accounting for bill of exchange, there are several points to consider:

Recognition

A bill of exchange is recognized in the financial statements when issued or accepted. For the issuer (drawer), it may represent a receivable if they are expecting to receive payment. For the acceptor (drawee), it represents a payable, as they have a future obligation to pay.

Measurement

Initially, a bill of exchange is measured at its face value—the amount stated on the bill that the drawee has agreed to pay at maturity. Over time, if the bill is held until maturity, it may be discounted or interest may be accrued, affecting its carrying amount on the balance sheet.

Presentation

• For the Drawer: If the drawer holds the bill (has not endorsed or sold it), it appears on the balance sheet as a receivable under current assets if its maturity is within one year. If it’s a long-term bill (maturity beyond one year), it could be classified under non-current assets.
• For the Drawee: The obligation to pay the bill is recorded as a liability. It's categorized as a current liability if the bill is due within one year and as a non-current liability if it's due in more than one year.

Endorsement or Discounting

If the bill holder (usually the drawer) endorses it to another party or discounts it with a bank before maturity, the transaction must be accounted for. The new holder records the bill as a receivable, while the endorser might recognize a gain or loss based on the difference between the bill’s face value and the amount received.

Settlement

Both parties adjust their accounts when the bill matures, and the drawee makes the payment. The payee (or current holder) will debit cash and credit receivables to reflect the receipt of money, while the drawee will debit their liability account for the bill payable and credit their cash account to show the payment.

Impairment

If the bill of exchange cannot be fully recoverable due to reasons like financial difficulties of the drawee, then the holder must recognize an impairment loss in the income statement. This reduces the carrying amount of the bill to its recoverable amount.

Types of Bill of Exchange

Bills of exchange come in various types, each tailored to meet specific requirements of the exchange transaction and the parties involved. Each type addresses different aspects of financial transactions, from immediate payment to credit facilitation and government financing, reflecting the versatility and importance of the bill of exchange in the financial world. Understanding these types helps in selecting the most appropriate form for a given financial or trade scenario.

• Sight Bill (Demand Bill): This type of bill requires the drawee to pay the specified amount upon presentation or sight. It does not have a fixed maturity date.
• Time Bill: A time bill specifies a future date for payment, allowing the drawee a certain period to settle the payment. This period can vary depending on the agreement between the parties.
• Trade Bill: A Trade bill is issued in the context of an exchange transaction for the goods sale and purchase. They are typically used in domestic and international trade.
• Accommodation Bill: This bill does not stem from an actual goods or services sale but is drawn to provide financial assistance or credit to one of the parties.
• Treasury Bill (T-Bill): While not a traditional bill of exchange, a T-Bill is a short-term government security issued at a discount from its face value and is a way for governments to raise funds.
• Foreign Bill: Specifically used in international trade, a foreign bill is drawn in one country but payable in another, involving currency exchange and additional legal considerations.

FAQs

1. What is the difference between a Bill of Exchange and a Promissory Note?

A bill of exchange and a promissory note are financial instruments used for making payments, but they differ in their structure and the parties involved. A bill of exchange involves three parties, the drawer, the drawee, and the payee. It is an order made by the drawer to the drawee to pay a certain sum to the payee. On the other hand, a promissory note is a two-party instrument where the maker (or issuer) promises to pay a certain amount to a payee. A bill of exchange is an order to pay, while a promissory note is a promise to pay. This distinction highlights the different roles and obligations that each instrument carries in financial transactions.

2. What is the difference Between a Bill of Exchange and a Letter of Credit?

A bill of exchange and a letter of credit are both financial tools used in international trade, but they serve different purposes and involve different processes. A bill of exchange is an order from one party to another to pay a specified sum to a third party at a predetermined date. It focuses on the obligation to pay, with the payment typically being between buyers and sellers directly. In contrast, a letter of credit is a guarantee from a bank that the seller will receive payment as long as the terms and conditions stated in the letter are met. The letter of credit provides security to the seller that they will be paid, with the bank standing behind the buyer's obligation. Thus, while a bill of exchange directly involves the trading parties for payment, a letter of credit involves a bank's guarantee to facilitate and secure the payment process.

3. What is the Bill of Exchange Law?

The bill of exchange law refers to the legal framework that governs the creation, endorsement, acceptance, and settlement of a bill of exchange. This body of law establishes the rights and obligations of the parties involved in a bill of exchange, including the drawer, the drawee, and the payee. It specifies how a bill of exchange should be written, how it can be transferred from one party to another, and what happens if a bill is not honored (i.e. if payment is refused or cannot be made). These laws ensure that the bill of exchange is recognized as a binding legal document across jurisdictions. It facilitates international trade by providing a standard, secure method for parties to extend and receive credit. The most well-known international codification of these laws is the "Uniform Rules for Collections" and "Uniform Customs and Practice for Documentary Credits" provided by the International Chamber of Commerce (ICC).