Bills of Exchange and Promissory Notes: Complete Guide for CA Foundation (Accounting)

Bills of Exchange and Promissory Notes are negotiable instruments that facilitate credit transactions in business. For CA Foundation students, understanding the legal framework, the roles of various parties (Drawer, Drawee, Payee), and the accounting treatment for various scenarios like discounting, endorsement, and dishonour is critical for scoring well in Accounting.

In India, these are governed by the Negotiable Instruments Act, 1881.

Quick Answer for Featured Snippets:
A Bill of Exchange is an unconditional order in writing, signed by the maker, directing a certain person to pay a certain sum of money. A Promissory Note is an unconditional undertaking in writing, signed by the maker, to pay a certain sum of money. Both are negotiable instruments used to settle debts.

Introduction to Negotiable Instruments

Negotiable instruments are documents that guarantee the payment of a specific amount of money, either on demand or at a set time, with the payer named on the document.

Characteristics:

• Easy transferability (by delivery or endorsement)
• The holder in due course gets a better title than the transferor
• Right to sue in one's own name
• Presumption of consideration (it is assumed the instrument was issued for value)

Primary Types:

• Promissory Notes (Section 4)
• Bills of Exchange (Section 5)
• Cheques (Section 6)

Promissory Notes vs. Bills of Exchange

Key Terminology & Concepts

• Drawer: The person who creates/writes the bill (the creditor).
• Drawee: The person on whom the bill is drawn (the debtor).
• Payee: The person to whom the amount is payable.
• Acceptance: The drawee's assent to the bill, signified by writing 'Accepted' and signing it. This turns the drawee into the 'Acceptor'.
• Endorsement: The act of signing the back of the instrument to transfer the rights to another person.
• Dishonour: Failure of the drawee to make payment on the due date.

Accounting Treatment & Journal Entries

The accounting for bills depends on whether you are recording from the perspective of the Drawer (Seller/Creditor) or the Drawee (Buyer/Debtor).

Due Date Calculation:
$\text{Due Date} = \text{Date of Drawing} + \text{Tenure} + 3 \text{ Days of Grace}$

Standard Journal Entries:

Scenario: Drawer accepts a bill from Drawee

[In Drawer's Books]
Dr. Bills Receivable A/c
Cr. Drawee's A/c

[In Drawee's Books]
Dr. Drawer's A/c
Cr. Bills Payable A/c

CA Exam Tip: Always calculate the 'Due Date' by adding 3 days of grace. If the question mentions 'Days of Grace', include them; if not, standard practice is to add them.

Special Scenarios: Discounting, Endorsement & Dishonour

1. Discounting of Bills

The holder (Drawer) sells the bill to a bank before the due date. The bank charges a fee called 'Discounting Charges'.

$\text{Discounting Charges} = \text{Face Value} \times \text{Rate} \times \frac{\text{Period}}{365\text{ or }12\text{ months}}$

Journal Entry (Drawer):
Dr. Bank A/c
Dr. Discount A/c
Cr. Bills Receivable A/c

2. Endorsement of Bills

The holder transfers the bill to a third party (Endorsee).

Journal Entry (Drawer/Endorser):
Dr. Endorsee A/c
Cr. Bills Receivable A/c

3. Dishonour of Bills

If the bill is dishonoured, the original debtor becomes liable again.

Journal Entry (Drawer):
Dr. Drawee A/c
Cr. Bills Receivable A/c

Note: If the bill was endorsed or discounted, the Drawer must also account for the liability to the Endorsee or Bank.

4. Renewal of Bills

Occurs when the Drawee cannot pay on the due date and requests more time. This requires: 1. Cancellation of old bill, 2. Payment of interest for the extended period, 3. Drawing of a new bill.

Practice Questions

Short Form Questions

Q1. Distinguish between a Bill of Exchange and a Promissory Note.
Model Answer: 1. Nature: A Bill of Exchange is an 'Order' to pay, whereas a Promissory Note is a 'Promise' to pay. 2. Parties: A Bill requires three parties (Drawer, Drawee, Payee), while a Note requires two (Maker, Payee). 3. Acceptance: A Bill must be accepted by the Drawee to become valid, whereas a Note is valid upon signing by the Maker.

Q2. A bill for ₹5,000 is drawn on 1st March for 2 months. Calculate the due date.
Model Answer: Date of drawing: 1st March. Tenure: 2 months. Maturity date: 1st May. Adding 3 days of grace: Due Date = 4th May.

Q3. Define 'Days of Grace'.
Model Answer: Days of grace are three additional days added to the period of the bill to determine the final maturity date. This is a customary practice in negotiable instruments to provide a small buffer for payment.

Case Studies

Case Study 1: Comprehensive Bill Transaction
Scenario: On 1st Jan 2024, X sells goods to Y for ₹20,000. X draws a bill on Y for 3 months. Y accepts the bill. On 15th Jan, X endorses the bill to Z. On 1st Feb, X discounts the bill with the bank at 12% p.a. On the due date, the bill is dishonoured.

Requirements:

1. Pass journal entries in the books of X (Drawer).
2. Calculate the amount received from the bank.
3. Pass journal entries for the dishonour in X's books.

Model Solution Summary:
Due Date: 4th April.
Discounting Period: 1st Feb to 4th April (approx 63 days).
Discount = $20,000 \times 12\% \times \frac{63}{365}$.

X's entries include: 1. B/R Dr to Y, 2. Z Dr to B/R, 3. Bank Dr, Discount Dr to B/R, 4. Y Dr to Bank (on dishonour).

Case Study 2: Renewal of Bill with Interest
Scenario: A debtor, B, owes A ₹10,000 via a bill due on 1st May. B requests a renewal for 3 months with interest @ 10% p.a. A agrees. B pays interest immediately in cash.

Requirements:

1. Pass journal entries in the books of A for the cancellation of the old bill and the creation of the new bill.
2. Calculate the interest amount.

Model Solution Summary:
Interest = $10,000 \times 10\% \times \frac{3}{12} = ₹250$.
Entries: 1. Cash Dr to Interest Income, 2. B Dr to Bill Receivable (old), 3. B Dr to Interest Income, 4. New B/R Dr to B.

Common Mistakes & CA Exam Tips

• Forgetting Grace Days: Always add 3 days to the maturity date.
• Confusion of Parties: Ensure you know if you are recording for the Drawer or Drawee.
• Dishonour Complexity: If a bill was endorsed, the Drawer's entry for dishonour must involve the Endorsee.
• Practice Tip: Solve past ICAI RTPs/MTPs on Kartavvya to master the complex journal entries for renewal and retirement.

Key Takeaways

• Bills of Exchange are orders; Promissory Notes are promises.
• The due date always includes 3 days of grace.
• Discounting involves a bank and a charge; Endorsement involves a third party.
• Dishonour reverts the liability to the original debtor.

Ready to master this topic?
Practice hundreds of MCQs, past-year questions, and get personalized weak-area analytics with adaptive study plans on Kartavvya – your AI-powered CA prep companion. [Start Free Trial / Join Now]