During the course of trade a seller supplies goods or services to a buyer. If the transaction is carried out on credit terms, in which the seller gives the buyer a term of credit in which to settle their outstanding account, bills of exchange can be used to signify that the buyer has agreed to make a payment to the seller on a predetermined date.
Bills of exchange are simply documents which signify the agreement between the seller and the buyer. The seller draws up the bill of exchange requiring the buyer to pay the amount outstanding to the seller, or to a person nominated by the seller, on a particular date. The bill of exchange is sent to the buyer, and the buyer signs and accepts the bill, and returns it to the seller. The seller now has a transferable document which is legal proof that the buyer has agreed to pay the amount on a particular date.
Bills of Exchange Terminology
In the description above the terms seller and buyer were used to signify the parties to the agreement. In general the following terms are used when discussing bills of exchange. By way of explanation the terms seller and buyer are indicated in brackets.
The drawer is the person who draws up the bills of exchange. (Seller)
The drawee is the person on who the bills of exchange are drawn. (Buyer)
The acceptor is the person who accepts the bill of exchange. (Buyer)
The payee is the person to who the bill of exchange is to be paid at the maturity date. (Seller)
The maturity date is the date on which the bill of exchange matures. (Payment date or due date)
Bills receivable represent amounts receivable under bills of exchange. The bills receivable are an asset shown in the accounting records of the person entitled to payment under the bills of exchange. In the above case the seller has bills receivable for the amount due from the buyer.
Bills payable represent amounts payable under bills of exchange. The bills payable are a liability shown in the accounting records of the person responsible for making payment under the bills of exchange. In the above case the buyer has bills payable for the amount due to the seller.
It should be noted that in this particular case, the seller is both the drawer and the payee, and the buyer is the drawee, and the acceptor of the bill of exchange.
Using Bills of Exchange
Bills of exchange can be transferred between different parties. In the above discussion there was a simply arrangement between a drawer (seller) and a drawee (buyer). The drawer however is under no obligation to retain the bills of exchange, they have a number of options.
1. Hold Until Maturity
The drawer (seller) can hold the bill of exchange until its maturity date, and simply present the bill to the acceptor (buyer) for payment to be made. This process is shown in the diagram below.
2. Discounting Bills of Exchange
Alternatively, the drawer (seller) can discount the bill of exchange with a bank (discounter). The drawer transfers the right to collect payment on the bill to the bank in return for a cash payment less a discount representing the banks fee. The discount charged by the bank is the interest on the amount of the bill for the period from the date of discounting until the date of maturity.
The bank who is now the payee, holds the bill of exchange until the maturity date at which point it presents the bill to the acceptor (buyer) for payment. This process is shown in the diagram below.
3. Negotiation of Bills of Exchange
Finally, the drawer (seller) can negotiate the bill of exchange with a third party in return for a payment. The drawer endorses the bill to the third party (endorsee and payee) who then holds the bill until maturity and presents it to the acceptor (buyer) for payment. Alternatively, the third party could further negotiate the bill with another third party and so on until the person who holds the bill at its maturity date presents it to the acceptor (buyer) for payment. This process is shown in the diagram below.
Dishonored Bills of Exchange
If the acceptor (buyer) fails to make the payment required under the bill of exchange on the maturity date, the bill is said to have been dishonored.
When a discounted or negotiated bill is dishonored, the drawer of the bill (seller) becomes liable to compensate the bank, or in the case of a negotiated bill the endorsee, for the amount due. The drawer has legal recourse to the acceptor of the bill.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.