Today, most trade happens on a credit basis – cash rarely exchanges hands without a bill of exchange. Most, if not all trade in the world balances on promises – the buyer promising to pay the seller at a later date.
A bill of exchange is the written form of this promise – and one of the most important instruments in both international and domestic trade. Let’s understand how a bill of exchange works, and more.
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What is a Bill of Exchange?
A bill of exchange is a written order from a drawer instructing a drawee to pay a specified amount of money at a specific date. Simply put, a bill of exchange is a note that tells someone to pay a certain amount of money at a later date.
They are similar to promissory notes and letters of credit – but of course, the three have subtle differences which we will discuss in a later section. First, how do bills of exchange actually work?
How does a Bill of Exchange work?
A bill of exchange can be drawn between two or three parties.
- Drawee: the party required to pay the money
- Drawer: the maker of the bill of exchange
- Payee: the party that receives the money
Why is there a distinction between the party making the bill of exchange and the party receiving the money? In some cases, the party that drew up the bill might transfer the bill of exchange to a third party, in a transaction called an endorsement.
Otherwise, the drawer and the payee are the same party – the party that drew up the bill of exchange and stands to receive the money from the drawee.
Sample Bill of Exchange
Here’s a sample bill of exchange drawn up for the sum of Rs 20 lakhs on the 15th of August. This bill of exchange matures three months after the 15th of August – on the 15th of November, 2023.
Format of Bill of Exchange
Here is the information that a bill of exchange should have:
- Name and address of drawer
- Name and address of drawee
- Amount of money to be paid
- Date of transaction
- Date of maturity
- Signatures of both parties to authorize the transaction
Features of Bill of Exchange
It is a legally binding document that orders one party to pay a fixed sum of money to another party. It can be drawn in any currency and is usually settled in the currency of the country in which it was issued.
It is transferable and can be endorsed to another party. It also serves as a guarantee of payment and is usually accompanied by a promissory note.
If it is not paid on the due date, the holder can take legal action to enforce the payment.
Bill of Exchange in International Trade
The terms of transactions in international trade can be quite complicated since there are multiple currencies and multiple parties involved – not to mention differences in legal regulations and time zones.
In these cases, a bill of exchange becomes very important. The exporter or the seller writes a bill of exchange to the importer, or the buyer. The bill can then be guaranteed by a bank, which becomes a third-party payee.
If the importer dishonours the bill and fails to make the payment on the due date, the payee is then liable to make the payment to the exporter.
Learn more: How to bring foreign capital to India with RazorpayX Forex
Endorsement of Bill of Exchange
Bills of exchange are transferable between parties. This process is called endorsement and helps reduce risk to both parties in case of failure of payment.
Endorsement of a bill of exchange is the process by which the drawer of the bill transfers their rights to receive payment under the bill to another party. This endorsement is a critical aspect of negotiability for bills of exchange, allowing them to function as a form of payment and credit instrument in business transactions.
Promissory Note vs Letter of Credit vs Bill of Exchange
| Feature | Promissory Note | Letter of Credit | Bill of Exchange |
|---|---|---|---|
| Definition | A written promise by one party (maker) to pay a specified amount to another party (payee) on a specific date or on demand. | A financial document issued by a bank on behalf of a buyer to a seller, guaranteeing payment to the seller upon meeting conditions specified in the document. | An unconditional order in writing, issued by a seller (drawer) to a buyer (drawee) to pay a specified amount to a payee (seller) on a future date or on demand. |
| Parties Involved | Maker (borrower) and Payee (lender) | Buyer, Seller, and Issuing Bank | Drawer (seller), Drawee (buyer), and Payee (seller) |
| Payment Assurance | Based on trust and relationship between parties. | Ensures payment to seller if terms met; minimizes buyer’s risk. | Payment may or may not be assured depending on acceptance and financial standing. |
| Payment Date | Specified maturity date or on-demand. | Payment due upon meeting conditions. | Specified due date or on-demand. |
| Usage | Often used in informal lending situations. | Commonly used in international trade to facilitate secure transactions. | Widely used in domestic and international trade for payment. |
| Negotiability | Can be negotiable or non-negotiable, depending on terms. | Non-negotiable, only parties involved can use it. | Can be negotiable or non-negotiable, depending on terms. |
Types of Bill of Exchange
- Sight Bill of Exchange: This is payable on demand or on a set date after the bill is presented.
- Time Bill of Exchange: This is payable on a set date and not on demand.
- Usance Bill of Exchange: This is payable after a set period of time, typically several months.
- Trade Acceptance Bill of Exchange: This is used in international trade and is generally accepted by the seller of goods to the purchaser.
- Accommodation Bill of Exchange: This is created for the purpose of providing financial accommodation to a third party such as a family member or friend.
Bill of Exchange Terms
Let’s have a look at the important bill of exchange terms.
- Drawer: The person who issues or creates the bill of exchange.
- Drawee: The person or entity who is ordered to pay the amount specified in the bill of exchange.
- Payee: The person or entity to whom the payment is to be made.
- Acceptance: The act by the drawee of agreeing to pay the amount specified in the bill of exchange.
- Endorsement: The act of transferring the ownership of the bill of exchange to another person or entity.
- Due date: The date on which the payment is due to the payee.
- Maturity date: The date on which the payment becomes due and payable.
- Discounting: The process of selling the bill of exchange to a bank or financial institution at a discounted price.
- Bill of exchange amount: The amount of money specified in the bill of exchange.
- Noting: The act of recording any protest or dishonour of the bill of exchange by the drawee or payee.
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Frequently Asked Questions
What is a bill of exchange?
A bill of exchange is a written order from one person (the drawer) to another person (the drawee) to pay a specified sum of money to a third person (the payee) at a specified date or on demand.
What are the parties involved in a bill of exchange?
The parties involved in a bill of exchange are the drawer (the issuer), the drawee (the person/entity to whom the bill is addressed), and the payee (the person/entity to whom the payment is to be made).
What are the different types of bills of exchange?
The different types of bills of exchange are demand bills, sight bills, time bills, usance bills and acceptance bills.
What are the legal implications of bills of exchange?
The legal implications of bills of exchange depend on the jurisdiction in which the bill is issued and the laws governing it. Generally, a bill of exchange creates a legally binding obligation between the parties involved, and the drawee is obligated to make the payment to the payee as specified in the bill.
What is an acceptance bill?
An acceptance bill is a type of bill of exchange in which the drawee acknowledges the payment obligation and agrees to pay the bill at a specified date.
