Accounting for Bills of Exchange

Meaning

A Bill of Exchange is a "formalized promise." In the business world, people don't always pay cash immediately when they buy goods. Instead, they use documents to manage credit.

Definitions

• Negotiable Instruments Act: "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."
• General Accounting: A formal document used in credit transactions where the seller instructs the buyer to pay the amount after a specific period.

Simple Explanation

Imagine you own a furniture shop. A customer buys a dining table worth 20,000 but says, "I cannot pay today, please give me two months." Instead of just taking his word, you write a document saying, "Pay me 20,000 on December 1st." He signs it. Now, you have a legal paper in your hand. That paper is the Bill of Exchange.

Key Points

• It must be in writing.
• The order to pay must be unconditional (no "if" or "but").
• The amount must be certain.
• The parties must be certain.
• It must be signed by the person making it.

Examples

• A supplier sends an invoice to a retailer and requests a signed bill to be returned, ensuring payment in 60 days.
• A manufacturer issues a bill to a distributor to formalize a credit sale of raw materials.

Common Misconceptions

• Misconception: A Bill of Exchange is the same as a Promissory Note.
  Correction: A Bill is an order to pay (I tell you to pay), whereas a Promissory Note is a promise to pay (I promise to pay you).
• Misconception: The amount can be "approximately 5,000."
  Correction: The amount must be exact and certain.

Every bill has three main characters. Getting these names right ensures your journal entries are correct.

Note: In bank discounting, a Bank may become an Endorsee.

A. Based on Timing

• Bills at Sight: Payable immediately when presented to the drawee.
• Time Bills: Payable after a certain period (e.g., 3 months after date).

B. Based on Nature of Transaction

• Trade Bills: Drawn for actual sale of goods.
• Accommodation Bills: Drawn to help parties raise funds (liquidity) rather than for actual trade.

Comparison: Trade Bills vs. Accommodation Bills

BILL OF EXCHANGE

Amount: 50,000
Date: October 1, 2023

Three months after date, pay to [Payee Name] or order, 
the sum of fifty thousand only, for value received.

To,
[Drawee Name]
[Drawee Address]

(Signed)
[Drawer's Signature]
        

A. Renewal of Bills

If the Drawee cannot pay, they request to "renew" the bill. The old bill is cancelled, and a new one is drawn with interest.

B. Dishonour of Bills

Happens when the Drawee fails to pay on the due date. The Drawer can claim "Noting Charges" from a Notary Public to provide legal proof.

C. Insolvency

If the Drawee is legally unable to pay debts, the Drawer receives only a "dividend" (small portion) from the official receiver.

Comparison: Renewal vs. Dishonour

Rule: Debit what comes in/receivable, Credit what goes out/receivable decreases.

In the Books of the Drawer (Seller)

• When Bill is drawn/accepted:
  Bills Receivable A/c ... Dr
      To Drawee's A/c
• When discounted with Bank:
  Bank A/c ... Dr
  Discounting Charges A/c ... Dr
      To Bills Receivable A/c
• On Dishonour:
  Drawee's A/c ... Dr
      To Bills Receivable A/c

In the Books of the Drawee (Buyer)

• When accepting the Bill:
  Drawer's A/c ... Dr
      To Bills Payable A/c
• On Dishonour:
  Bills Payable A/c ... Dr
      To Drawer's A/c

Problem: On Jan 1, 2023, Alpha Traders sold goods to Beta Ltd for 40,000 on credit. Beta Ltd accepted a 3-month bill. Alpha Traders discounted the bill at 12% p.a. On the due date, the bill was dishonoured.

Step-by-Step Solution:

1. Calculate Discount: 40,000 * (12/100) * (3/12) = 1,200
2. Net Amount Received: 40,000 - 1,200 = 38,800

Journal Entries (Alpha Traders - Drawer)

*Due date: Jan 1 + 3 months + 3 days grace = April 4.

1. The person who makes the bill is called the:
   A) Drawee | B) Payee | C) Drawer | D) Endorsee
   Answer: C. The Drawer is the one who creates/writes the instrument.


2. A bill drawn to help a friend raise money is a/an:
   A) Trade Bill | B) Accommodation Bill | C) Sight Bill | D) Inland Bill
   Answer: B. Accommodation bills are for mutual financial assistance.


3. The period of grace added to the maturity date is:
   A) 1 day | B) 3 days | C) 7 days | D) 30 days
   Answer: B. 3 days of grace are standard.

1. Explain the importance of the "Unconditional Order" in a Bill of Exchange.
   Answer: If the order is conditional (e.g., "Pay if goods arrive"), it loses its character as a Negotiable Instrument. The law requires certainty for trading/discounting.


2. Distinguish between a Drawer and a Drawee.
   Answer: The Drawer is the creditor who issues the order, while the Drawee is the debtor who receives and accepts it.


3. How is the maturity date calculated?
   Answer: Maturity date = Date of drawing + Period of bill + 3 days of grace.

• Parties Mnemonic: Remember "D-D-P" $\rightarrow$ Drawer (Giver), Drawee (Taker), Payee (Receiver).
• Dishonour Logic: When a bill "breaks" (dishonours), the Drawee becomes a "debtor" again. To make someone a debtor, you Debit them.
• Discount vs. Interest: Discount is deducted upfront from face value; Interest is usually added later (e.g., during renewal).