HOW A BILL OF EXCHANGE WORKS?

How a bill of exchange operates, is illustrated in Figure 1 and Figure 2, but first we should read the following points.

(1) A person, who wants to purchase goods but has no money, may agree to accept a bill of exchange drawn upon him at some future date for the value of the goods he wants to purchase. For example, Mr. B (a retail trader) wishes to purchase furniture from a furniture manufacturer (Mr. A) but has no money. Mr. A is agreed to sell furniture for a 90 days credit worth Rs. l 0,000."

(2) The drawer (Mr. A) draws a bill for Rs. 10,000 on the customer (Mr. B), the drawee, who accepts it (thus becoming the acceptor of the bill) and returns it to the drawer. The drawer delivers the furniture and has a 90 days bill for Rs. 10,000.

(3) He can keep the bill till due date and present it on the due date before the acceptor.

(4) When a drawee (the acceptor) acknowledges the obligation in the bill he is bound by law to honour the bill on the due date. If he is a reputable person the bill is as good as money, and any bank will discount it. There are special kinds of banks which do this job and they are called discount houses. What do the discount houses do? They cash the bill by giving the drawer the present value of the bill.

Present value = Face value of the bill - interest at an agreed rate for the number of days the bank has to wait.

So the drawer who discounts the bill with the bank gets less than the face value.
On the due date the bank will present the bill to the acceptor, who honors it by paying the full value. The bank has earned the amount of interest it deducted when it discounted the bill.
Where does the acceptor get the money to honor the bill? The answer is that he was given 90 days to sell the goods at profit, and therefore, he is liable to honor the bill.

Now it is hoped that the students will be able to follow what is happening in Figure No. 1 and No. 2.

You can understand the Figure 1 given above with the help of the following notes:

(1) Business activities cannot proceed because the retail trader (Mr. B) has nothing to sell and has no money to buy goods.

(2) We need a system by which the retailer can purchase goods without paying for them at the moment and which enables the manufacturer (Mr. A) to be paid immediately.

(3) Since a Bill of Exchange from a reputable trader is almost as good as money, it will be acceptable to banks. They have plenty of money to lend out to reliable customers so, they will advance money to the holder of Bills of Exchange.
Now, look at Figure 2.

Business activity under the influence of a bill of exchange

The result is that a Bill of Exchange is a useful instrument to increase business  activities, and is beneficial to all the parties involved.

Further Reading : Further Study Material from this Topic .

• Accounting for Bills of Exchange, Definition, Explanation & Parties
• How a Bills of Exchange Works?
• Types of Bills of Exchange
• ACCEPTANCE OF A BILL OF EXCHANGE
• HOW TRANSACTIONS RELATING TO BILLS OF EXCHANGE ARE RECORDED?
• ACCOUNTING TREATMENT FOR BILLS RECEIVABLE AND BILLS PAYABLE