Introduction to Negotiable Instruments: Bills of Exchange and Promissory Notes

In the world of business and finance, transactions often involve the transfer of money not immediately but at a future date. To facilitate such transactions smoothly, special written documents called negotiable instruments are used. These instruments promise or order the payment of a certain sum of money, making them legally enforceable and widely accepted in trade.

Two of the most important negotiable instruments are bills of exchange and promissory notes. They play a crucial role in credit transactions, helping businesses manage payments, credit, and cash flow efficiently. Understanding these instruments is vital for anyone preparing for competitive exams in Accountancy, as they form a fundamental part of accounting and financial management.

This section will explain what bills of exchange and promissory notes are, their features, the parties involved, how they differ, and their accounting treatment. We will also work through practical examples to help you master these concepts.

Bills of Exchange

A bill of exchange is a written, unconditional order by one party to another to pay a specified sum of money either immediately or on a fixed future date. It involves three parties and is commonly used in business transactions where goods or services are sold on credit.

To understand this better, let's define the parties involved:

• Drawer: The person who creates and signs the bill, ordering payment.
• Drawee: The person on whom the bill is drawn and who is ordered to pay.
• Payee: The person who is entitled to receive the payment. The payee can be the drawer or a third party.

When the drawee accepts the bill by signing it, they become liable to pay the amount on the due date. This acceptance is crucial as it confirms the drawee's commitment to pay.

graph TD    Drawer[Drawer creates Bill of Exchange]    Drawer -->|Orders payment| Drawee[Drawee]    Drawee -->|Accepts Bill| BillAccepted[Bill Accepted]    BillAccepted -->|Pays on maturity| Payee[Payee receives payment]

Key Features of a Bill of Exchange:

• It is an unconditional written order to pay.
• Involves three parties: drawer, drawee, and payee.
• The drawee must accept the bill to become liable.
• It is transferable by endorsement.
• Payment is made on demand or at a fixed future date.

Promissory Notes

A promissory note is a written, unconditional promise made by one party to pay a certain sum of money to another party either on demand or at a fixed future date. Unlike a bill of exchange, it involves only two parties.

The parties involved are:

• Maker: The person who makes the promise to pay and signs the note.
• Payee: The person to whom the payment is promised.

Since the maker promises to pay, there is no need for acceptance by another party, which is a key difference from a bill of exchange.

Accounting Treatment of Bills of Exchange and Promissory Notes

In accounting, bills of exchange and promissory notes are treated as negotiable instruments and recorded in the books to reflect the credit transactions accurately. The accounting entries depend on whether the instrument is received or issued, accepted, discounted, dishonoured, or retired.

Here is a simplified flowchart showing the accounting process for these instruments:

graph TD    Receipt[Receipt of Bill/Note] --> Acceptance[Acceptance by Drawee/Maker]    Acceptance -->|If discounted| Discounting[Discounting with Bank]    Acceptance -->|If held till maturity| Maturity[Payment on Maturity]    Discounting -->|If dishonoured| Dishonour[Dishonour of Bill/Note]    Maturity -->|If dishonoured| Dishonour    Dishonour --> Recovery[Recovery of Amount]

Each stage involves specific journal entries, which we will explore through worked examples.

Worked Examples