Bill of Exchange Definition: A Quick and Easy Guide

The bill of exchange dates back to at least the 8th century A.D., when a similar concept was used by Arab merchants to guarantee payment for goods. The modern bill of exchange gained popularity in 13th-century Italy, where it was used to conduct foreign commerce.

But what, exactly, is a bill of exchange, and are these antique accounting tools still in use today?

Currently, bills of exchange aren't as common as they once were, especially for domestic transactions. Still, they're heavily utilized in international trade. Businesses involved in specific types of supply chains — and anyone in the import or export processes — should understand bills of exchange.

Read on to get a more detailed bill of exchange definition. Then, discover how Orderful's EDI services can help you drive cost-effective cloud solutions for payments and other accounting considerations.

What is a bill of exchange?

A bill of exchange is a financial instrument that creates a purchasing agreement. It's a short-term, negotiable instrument. That means:

• The agreement is usually for an immediate, on-demand, or future payment that’s not too far off.
• The seller of the goods (the original payee on the bill) can sell the bill to someone else, in which case the sum to be paid is now owed to the new holder.

To better understand what a bill of exchange is, let's look at a bill of exchange example scenario:

• A business in the United States wishes to purchase goods from a business in India.
• The cost of the goods is $20,000 total (or around 1,650,000 Indian Rupees).
• The Indian business creates a bill of exchange stating that the U.S. business agrees to pay $20,000 within 30 days of the order’s shipment.
• The authorized person with the U.S. company signs the bill of exchange, committing the business to the payment.

What information does a bill of exchange include?

‍

There is a somewhat specific bill of exchange format. This type of document must include the following information:

• Title. The document is titled "Bill of Exchange" to indicate its purpose.
• Amount of money to be paid. Typically, this is written out in words as well as numerically, similar to how a check is written.
• As of. This is the technical term for the component that indicates the payment’s due date. It may list a specific date or a timeline that depends on another factor (e.g., 30 days after goods are shipped or received).
• Identification number. Every bill of exchange should come with a unique identification number. This is essential for tracking the document and related payments in accounting systems or electronic data interchange processes.
• Payee. This is the person or entity that should receive the payment at the agreed-upon time. The bill of exchange may also include the payee’s contact information, such as their address.
• Signature. A bill of exchange is binding once signed by an authorized person qualified to agree to the payment.

Parties involved in a bill of exchange

Commonly, two or three parties are involved in every bill of exchange scenario.

• Drawer: The drawer is the person or business that draws up (creates or initiates) the bill of exchange. They are the entity that requires the drawee to pay the payee.
• Drawee: The drawee is the person or business agreeing to pay. The payment will be drawn from their account.
• Payee: The payee is the person or business set to receive the payment. Sometimes, the drawer and the payee are the same entity, but this isn’t always true.

Types of bills of exchange

Bills of exchange come in many varieties. The overall format is similar, but the context surrounding the different types of bills of exchange is unique. Here are some of the most common varieties:

• Documentary bill. This type of bill comes with backup documents demonstrating that the transaction (the sale) associated with the bill of exchange was legitimate and genuine. This is typically preferred for transactions between an exporter and an importer.
• Clean bill. This is the opposite of a documentary bill. Because it's not backed by documents, a clean bill may come with a higher interest rate to protect the drawer.
• Inland bill. This bill of exchange is drawn and payable in one country.
• Foreign bill. These bills of exchange can be drawn and payable in different countries, making them typical in international trade.
• Demand bill. A demand bill is a bill of exchange that doesn’t specify a payment date or specifies that payment is due upon demand. The drawee must pay the payee when the bill is presented for payment.
• Time-bound bill, also called a usance bill. Unlike a demand bill, this gives the drawee a specific future date by which payment must be made.

This list is not comprehensive. You might note that a bill of exchange can be several types at once. A demand bill is a bill of exchange that doesn’t specify a payment date or specifies that payment is due upon demand.

3 bill of exchange benefits you should know

Although bills of exchange may not be the go-to tool for accounting and payment agreements today, they offer a few considerable benefits:

• They're legal and binding documents. Bills of exchange are recognized legal documents in many nations around the world. They provide security for all parties involved. The payee has a legally binding agreement ensuring they get paid, and the drawee knows precisely how much they owe and the timeframe for their payment.
• They're transferrable. Bills of exchange are more than promises to pay; they're negotiable financial assets that can be transferred from the drawer or payee to different parties. That means they can be used as an asset to negotiate or satisfy debts.
• They support discounting. The drawer/payee can choose to discount the bill and receive immediate payment for a smaller amount of money — often by transferring the bill to someone else or a bank. This can be a way to fund an urgent business need or support cash flow.

Bill of exchange vs. promissory note vs. check

In many ways, a bill of exchange is similar to a promissory note, bank draft, or check. However, there are some significant differences between these financial and payment tools. Here’s the rundown:

What is a check?

A check is a document used by one person or entity to tell their bank to transfer funds from one of their specific accounts to another person's account.

Checks are similar to bills of exchange in that they are negotiable instruments. If Sam writes a check payable to Mike, Mike can sign the check over to Paul. Paul can then cash or deposit the check or sign it over to someone else in payment for something.

Checks are different in that they are originated by the drawee — not the drawer or payee. They are also typically payable upon demand.

A check might be used to make the payment agreed to in a bill of exchange or promissory note.

What is a promissory note?

A promissory note is a promise to pay. Like a bill of exchange, it may dictate the terms of the payment — when it must be made. In some cases, promissory notes are also negotiable. Unlike a bill of exchange, they only include the payer and the payee.

Like checks, promissory notes are typically originated by the payer — the person agreeing to pay. However, there are cases where the payee writes or creates the promissory note and the payee agrees to its terms by signing it.

What is a bank draft?

A bank draft is another negotiable financial instrument that guarantees payment from a specific bank account. One fundamental difference between a bank draft and a check is that a bank draft guarantees the funds are available to cover the payment, whereas a check can bounce if there aren’t adequate funds when it’s presented for payment.

A bank draft is another potential method for paying the amount agreed to in a bill of exchange.

Standardize payment data with Orderful for more efficient operations

The bill of exchange was initially created to provide a standardized, legal method for guaranteeing payment for goods. When everyone uses a streamlined format for financial and accounting matters, it makes conducting business easier.

The same is still true today, which is why EDI formats are so important. Speak to an expert at Orderful today to learn how EDI can help you standardize and share payment data — and how a 3PL partner can help.