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Home Accounting for Bills of Exchange Definition and Explanation of Bill of Exchange

Definition and Explanation of Bill of Exchange:

No business wants to sell goods on credit to his customers who may prove unable or unwilling to pay their debts. Today, however, in every field of retail trade it appears that sales and profits can be increased by selling goods on credit basis. The manufacturers and the wholesalers sell goods mostly on credit. Credit is a very powerful instrument to promote sales, so most of the business transactions, in most business concerns, are carried on credit basis. A bill of exchange is a method of payment used between businessmen which has certain advantages over other methods of payment.


Definition and Explanation of Bill of Exchange:

"An unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed or determinable future time a sum certain in money  to or to the order of a specified person, or to the bearer".

You should keep in mind the following points to understand the definition:

  1. The person who writes out the order to pay is called the drawer.

  2. The person upon whom the bill of exchange is drawn (who is ordered to pay) is called the drawee.

  3. The drawee may "accept" the bill. This is a special use of the word accept because it means that he accepts to pay the amount payable expressed in the bill, i.e. if he accepts the obligation to pay he writes "accepted" across the face of the bill and signs it. From that time on he is know as the "acceptor" of the bill and has absolute liability to honor the bill on the due date.

  4. The amount of money must be mentioned clearly. For example, I cannot make out a bill requiring someone to pay the value of my car or house. That is an uncertain sum. It must say "five thousand dollars or ten thousand dollars" etc.

  5. The time must be fixed or at least be determinable. For example, "sixty days after date" is quite easily determinable. If the bill is made out on first July, it will be 29th august.

  6. The person who is entitled to receive the money from the acceptor is called the "payee". It is usually the drawer who is supplying goods to the value of the bill, and wants to be paid for them. If the drawer decides, the bill can be made payable to someone else by endorsing it. That is why the definition says, to pay..... to, or the the order of, a specified person.

  7. A bill can be made payable to a bearer, but it is risky, since any finder of the bill or any thief, can claim the money from the acceptor.

Format of Bill of Exchange:

Now read the definition again and see the format of the bill of exchange below:

bill of exchange format

Important Points:

  1. This bill is drawn by the peter & Co., so the drawer of the bill is peter & Co.

  2. The bill is drawn upon William & Co., so they are drawee of the bill. They have not yet accepted the bill, and so are not liable to pay it at maturity.

  3. The bill is an unconditional order in writing. It says "pay ten thousand dollars to Peter & Co." it does not say "provided you are in funds". It just says "pay!".

  4. It is addressed by one person (Peter & Co.) to another (William & Co.) and is signed by the person giving it (Peter & Co.).

  5. The date is easily determinable it is 90 days after first July, which is 29 September, 20....

  6. The sum of money is very certain, ten thousand US dollars.

  7. The bill is payable to, or to the order of, Peter & Co.

How a Bill of Exchange Works?

  1. A person who wants to purchase goods but has no money, may agree to accept a bill of exchange drawn upon him at some future date for the value of the goods he wants to purchase. For example, Mr. B (a retail trader) wishes to purchase furniture from a furniture manufacturer (Mr. A) but has no money. Mr. A is agreed to sell furniture for a 90 days credit worth $10,000.

  2. The drawer (Mr. A) draws a bill for $10,000 on the customer (Mr. B), the drawee, who accepts it (thus becoming the acceptor of the bill) and returns it to the drawer. The drawer delivers the furniture and has a 90 days bill for $10,000.

  3. He can keep the bill till due date and present it on the due date before the acceptor.

  4. When a drawee (the acceptor) acknowledges the obligation in the bill he is bound by law to honor the bill on the due date. If he is a reputable person the bill is as good as money, and any bank will discount it. There are special kinds of banks which do this job and they are called discount houses. What do the discount houses do? They cash the bill by giving the drawer the present value of the bill.

    Present Value = Face value of the bill  -  Interest at agreed rate for the time the bank has to wait
    So the drawer who discounts the bill with the bank gets less than the face value.

  5. On the due date the bank will present the bill to the acceptor, who honors it by paying the full value. The bank has earned the amount of interest it deducted when it discounted the bill.

Where does the acceptor get the money to honor the bill? The answer is that he was given 90 days to sell the goods at profit, and therefore, he is liable to honor the bill. Now it is hoped that you will be able to follow what is happening in the following diagrams:

You can understand the figure above with the help of the following notes:

  1. Business activities cannot proceed because the retail trader (Mr. B) has nothing to sell and has no money to buy goods.
  2. We need a system by which retailer can purchase goods without paying for them at the moment and which enables the manufacturer (Mr. A) to be paid immediately.
  3. Since a bill of exchange from a reputable trader is almost as good as money, it will be acceptable to banks. They have plenty of money to lend out to reliable customers so, they will advance money to the holder of bills of exchange.

Now look at the following figure and note how bill of exchange can increase the business activities.

The result is that a bill of exchange is a useful instrument to increase business activities, and is beneficial to all the parties.

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More study material from this topic:

Definition and explanation of bill of exchange
Types and classification of bill of exchange
Accounting treatment of bill of exchange
Discounting of a bill of exchange
Endorsement of bill of exchange
Bill of exchange sent to bank for collection
Dishonor of bill of exchange
Renewal of bill of exchange
Insolvency of one party
Retiring a bill of exchange under rebate
Accommodation bills of exchange
Bills receivable and bills payable books
Promissory note
Questions and answers



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