You must be aware of the fact that in the modern business scenario, most of the business transactions are made on credit. Customers are lured with the facility of enjoying credit for enhancing the volume of sales. In case of a cash purchase, it is settled immediately by payment of cash. However, for settlement of a credit transactions, bills of exchange or promissory notes are used. These instruments used for the settlement of debts are known as Negotiable Instruments. In this article we will have a formal introduction to Bills of Exchange.
If you are conversant with the Hindi Language then you can watch this video for detailed explanation of the topics discussed below or you can continue reading below.
What are Bills of Exchange?
A Bill of Exchange is an instrument used for settlement of debts. It is drawn (prepared) by the creditor (i.e the person who is entitled to receive the money) on a debtor (i.e the person who is liable to pay the money).
It is a written order to pay a certain sum of money to a certain person. Also, it is a legal document which confirms a debt.
Section 5 of the Negotiable Instruments Act, 1881 defines a Bill of Exchange as:
A Bill of Exchange is an instrument in writing containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to, or to the order of, a certain person or to the bearer of the instrument.
I have purposely highlighted the important words in the above definition so that proper stress is given while reading it. This might give you an understanding of the features of a bill of exchange which we will discuss in detail below.
Features of Bills of Exchange
- It is an instrument in writing.
- It contains an unconditional order to pay. It means that no conditions can be attached for making the payment.
- It mainly involves three parties: Drawer, Drawee and Payee. In most of the cases, the Drawer and Payee are the same person as the Drawer draws the bill in his/her own favour. However it must be remembered that the Drawer and Drawee cannot be same person (Its very stupid of me to mention it but I have noticed that it helps in better understanding).
- The Parties to bills of exchange must be certain.
- The Drawer (a.k.a the Maker) must sign the bill.
- The amount of money to be paid must be certain.
Parties to Bills of Exchange
1. Drawer or Maker
Drawer is the person who draws (or makes) the Bill. He is the person who is entitled to receive the money (i.e the Creditor). He is required to sign the bill and send it to the drawee for acceptance.
Drawee is the person on whom the bill is drawn. He is the person who owes the money.
The Drawee has to accept the bill of exchange drawn by the drawer. Acceptance is done by signing his name across the face of the bill. Acceptance of the bill denotes that the drawee has agreed to pay the amount mentioned in the bill on the maturity of the bill or on demand, as the case may be.
Payee is the person to whom the money is payable. In most cases the drawer of the bill is himself the payee.
4. Drawee in case of need
If the drawer has a doubt that the original drawee will not accept or dishonour the bill, he may write the name of another person for accepting the bill in case the original drawee does not accept it (You may think him to be a backup for the drawee).
If the bill is not honoured by the original drawee, the bill must be presented to the drawee in case of need.
Mr C is a trader of cosmetics. He sells goods to Mr D worth Rs 30,000 on credit. Mr G is the mutual friend of Mr C and Mr D and he has assured Mr C that Mr D has a good creditworthiness. Upon his assurance Mr C made the sale on credit with a credit period of two months.
After making the sale, Mr C draws a bill on Mr D for Rs 30000 payable after 2 months from the date of the bill.
Below you can see the specimen of the Bill drawn by Mr C.
In the above example:
- Mr C is the creditor and drawer of the bill
- Mr D is the debtor and drawee of the bill
- Tenure of Bill is two months
- A certain amount i.e Rs 30000 is to be paid by the drawee
- Mr C is the payee here. The words “or his order” after Mr C in the bill denotes that Mr C can endorse the bill in favour of someone who will, upon such endorsement, become the payee of the bill.
Now assume that Mr C has also written the name of Mr G (the mutual friend who assured the creditworthiness of Mr D) on the bill as Drawee in case of need. In such case, if the bill is not accepted or dishonoured by Mr D (original drawee) then it would be presented to Mr G for acceptance and payment. If Mr G also refuses to accept or pay then the bill will be considered as dishonoured.
Types of Bills of Exchange
As shown in the above image, Bills of Exchange are normally of two types:
1. Bills of Exchange Payable at Sight
These types of bills are payable on demand and the drawee has to pay the amount when the bill is presented to him for payment.
2. Bills of Exchange Payable After a Certain Period of Time
These bills become payable after a certain period of time.
In the example we took above, the bill was payable after two months and so it will fall in this category. These types of bills are also called Term Bills.
Date of Maturity/ Due Date of a Bill of Exchange
The date on which the amount of a bill becomes payable is called its due date or maturity date. The following points must be kept in mind in relation to the due date or maturity date:
1. A Bill ‘Payable at Sight’ becomes due immediately when it is presented for payment.
2. THREE DAYS OF GRACE are added to the date on which the term of the bill ends. This is a done as a custom. Three days of grace are not available for a bill payable on demand.
In the example taken above, the date on which the bill was drawn is 6th October, 2017 and the tenure is 2 months. So the due date would be 6th December, 2017 + 3 days of grace which comes to 9th December, 2017.
3. When the tenure of the bill is mentioned in days, the calculation of due date must be made on the basis of days.
4. When the tenure of the bill is mentioned in months, the calculation of the due date should be made monthwise ignoring the actual number of days in a month.
So a bill drawn on 1st January for 3 months will mature on 1st April + 3 days of grace i.e on 4th April. Please note that here we are ignoring the actual number of days in the month and counting 1st Jan to 1st Feb as one month and so on.
5. If the due date turns out to be a public holiday, the due date shall be considered to be the preceding day. However if the preceding day is also a public holiday then the working day preceding the previous day would be considered the day of maturity.
6. After Date & After Sight: Go to the above image of the bill of exchange and notice the words “Two months after date“. The words after date mean that the bill will mature after two months from the date on which the bill is drawn.
In case the bill mentions the words “after sight” instead of “after date” then the period (i.e tenure) of the bill shall be counted from the date on which the bill was accepted by the drawee.
Is a Cheque a Bill of Exchange?
You must have heard of a Cheque which is drawn on a bank by a person who wants to make payment using funds in his bank account.
Do you think that a Cheque is also a Bill of Exchange? If your answer is Yes then you are on the right track.
According to Section 6 of the Negotiable Instruments Act, 1881
A “cheque” is a bill of exchange drawn on a specified banker and not expressed to be payable otherwise than on demand and it includes the electronic image of a truncated cheque and a cheque in the electronic form.
Thus a Cheque is Bill of Exchange with the following restrictions:
- it is always drawn on a banker; and
- it becomes payable only on demand.
What are your impressions on this article? Was this article able to provide you with a good understanding of the Bills of Exchange? Please comment below if you have any feedback or suggestions. Thanks a lot for reading! Also visit our YouTube channel for tutorial videos on accountancy.