Accounting For Bills Of Exchange

Accounting for Bills of Exchange: A Comprehensive Guide

Bills of exchange, also known as drafts, are negotiable instruments that represent a written unconditional order from one party (the drawer) to another (the drawee) to pay a specified sum of money to a third party (the payee) on a certain date. Understanding how to account for these instruments is crucial for businesses involved in international trade and other financial transactions. This comprehensive guide will cover all aspects of accounting for bills of exchange, from their creation and acceptance to their discounting and dishonor.

Introduction to Bills of Exchange

A bill of exchange typically involves three parties:

• Drawer: The party who initiates the bill and orders the payment.
• Drawee: The party who is ordered to pay the sum of money. This party usually accepts the bill, making it a legally binding promise to pay.
• Payee: The party who is entitled to receive the payment. This is often the drawer, but it can be a different party.

Bills of exchange are used for various purposes, including:

• Financing international trade: Exporters often use bills of exchange to receive payment from importers.
• Short-term financing: Businesses can use bills of exchange to obtain short-term credit.
• Debt settlement: Bills of exchange can be used to settle debts between parties.

There are several types of bills of exchange, including:

• Trade bills: These are used in international trade to finance the sale of goods.
• Finance bills: These are used to obtain short-term financing, often for speculative purposes.
• Accommodation bills: These are drawn without underlying commercial transactions, usually to help a party obtain credit.

Stages in Accounting for Bills of Exchange

The accounting treatment of bills of exchange varies depending on the stage of the transaction. Let's break down the key stages:

1. Drawing of the Bill

When a drawer creates a bill of exchange, they are essentially ordering the drawee to pay a specific sum. From the drawer's perspective, no immediate accounting entry is required until the bill is accepted.

2. Acceptance of the Bill

Once the drawee accepts the bill, they are legally obligated to pay the sum on the due date. This acceptance transforms the bill into a legally binding promise. The accounting implications depend on whether the drawee is the drawer's debtor or a third party:

• Drawee is a Debtor: The drawer will debit their Accounts Receivable and credit Bills Receivable. This reflects the conversion of a trade debt into a bill.

• Drawee is a Third Party: No immediate entry is necessary from the drawer's perspective until the bill is negotiated or matures. The drawee, however, will debit Bills Payable and credit the relevant account (e.g., creditor's account) upon accepting the bill.

3. Negotiation/Discounting of the Bill

The payee (often the drawer) can negotiate or discount the bill before the maturity date. This involves selling the bill to a bank or other financial institution at a discounted rate. The discount represents the interest charged for the early payment.

• For the Drawer (if they are negotiating): The drawer will debit Cash (or Bank) and credit Bills Receivable for the proceeds received. The discount is recognized as a finance cost. The journal entry would include a debit to Finance Cost and a credit to Discount on Bills Receivable.

• For the Bank/Discounting Institution: The bank will debit Bills Receivable and credit Cash (or Bank) for the amount paid to the payee. They will also debit Discount Received and credit Interest Income.

4. Maturity and Payment

On the maturity date, the drawee pays the face value of the bill to the holder (the party who owns the bill at that time).

• For the Drawee: The drawee will debit Bills Payable and credit Cash (or Bank).

• For the Holder: If the holder is the drawer, they will debit Cash (or Bank) and credit Bills Receivable. If the holder is a bank or a third party, they will debit Cash (or Bank) and credit Bills Receivable.

5. Dishonor of the Bill

If the drawee fails to pay the bill on the maturity date, the bill is dishonored. This has significant accounting implications:

• For the Holder: The holder will debit Accounts Receivable (or the drawee's account) and credit Bills Receivable. The amount due becomes a trade debt. The holder may incur further costs related to recovering the payment. These costs are debited to expense accounts.

• For the Drawer (if they are the holder or indorser): If the drawer is still liable, they will debit Accounts Receivable and credit Bills Receivable. Any protest fees or other collection costs are debited to expense accounts.

• For the Drawer (if they are not the holder): The drawer is still potentially liable depending on the terms of the bill. If they pay, they will debit Bills Payable and credit Cash.

Detailed Journal Entries: Example Scenarios

Let's illustrate the accounting entries with two example scenarios:

Scenario 1: Drawer negotiates the bill before maturity

• April 1: X Ltd. draws a bill of exchange on Y Ltd. for $10,000 payable after 3 months.

  • No entry required for X Ltd.

• April 1: Y Ltd. accepts the bill.

  • Y Ltd.: Dr. Bills Payable $10,000; Cr. X Ltd. $10,000

• May 1: X Ltd. discounts the bill with the bank at a discount rate of 10% per annum. The proceeds received are $9,750.

  • X Ltd.: Dr. Cash $9,750; Dr. Discount on Bills Receivable $250; Cr. Bills Receivable $10,000

• July 1: The bill matures and Y Ltd. pays the bank.

  • Y Ltd.: Dr. Bills Payable $10,000; Cr. Cash $10,000

Scenario 2: Bill is dishonored

• June 1: A Ltd. draws a bill of exchange on B Ltd. for $5,000 payable after 2 months.

  • No entry required for A Ltd.

• June 1: B Ltd. accepts the bill.

  • B Ltd.: Dr. Bills Payable $5,000; Cr. A Ltd. $5,000

• August 1: The bill matures, and B Ltd. dishonors the bill. Protest fees of $50 are incurred.

  • A Ltd.: Dr. Accounts Receivable (B Ltd.) $5,000; Dr. Bank Charges $50; Cr. Bills Receivable $5,050

Accounting Standards and Best Practices

Accounting for bills of exchange is governed by generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS). Key considerations include:

• Accurate recording: All transactions related to bills of exchange should be recorded accurately and timely.
• Proper classification: Bills receivable and payable should be classified correctly on the balance sheet.
• Disclosure: Any significant information about bills of exchange should be disclosed in the financial statements.
• Provision for potential losses: If there is a risk of dishonor, the holder may need to recognize a provision for bad debts.

Frequently Asked Questions (FAQ)

• What is the difference between a bill of exchange and a promissory note? A bill of exchange involves three parties (drawer, drawee, payee), while a promissory note involves only two (maker and payee). A promissory note is a promise to pay, while a bill of exchange is an order to pay.

• How are contingent liabilities related to bills of exchange accounted for? If a company has accepted a bill of exchange on behalf of another party, it should disclose this as a contingent liability in the financial statements, as it could be liable for the amount if the drawer defaults.

• What is the impact of discounting a bill of exchange on the financial statements? Discounting a bill will reduce the amount of cash received compared to the face value of the bill. The discount is recognized as a finance cost, impacting the profit or loss statement.

Conclusion

Accounting for bills of exchange is a complex but crucial aspect of financial reporting for businesses that utilize this financial instrument. Understanding the various stages involved, from drawing and acceptance to negotiation, maturity, and potential dishonor, is essential for accurate and compliant financial reporting. By adhering to GAAP and IFRS, and implementing sound accounting practices, businesses can effectively manage their exposure to bills of exchange and ensure the integrity of their financial statements. Always consult with qualified accounting professionals for specific guidance related to your business circumstances and transactions. The information provided in this article should serve as a general guide, and not as financial or legal advice.