Majority of business transactions today operate on credit basis. This means that the transaction or exchange of goods and services takes place on a certain date, whereas the payment settlement for the same takes place at a future subsequent date. This time lag between consumption of goods or services and payment is referred to as credit period. In order to secure interests of the seller in such transactions, negotiable instruments are used. These are legally binding documents to guarantee or secure payment of specified sum on a specified date to the payee or the holder of the instrument.
This article looks at meaning of and differences between two types of negotiable instruments – bill of exchange and promissory note.
Definitions and meanings
Bill of exchange:
A bill of exchange is a negotiable instrument that is drawn by a creditor on his debtor, that contains an order to pay him a specified sum on demand or on a specified date. Essentially, a bill of exchange is a legally binding document that once accepted creates a payable obligation in favor of the holder of the bill.
The typical steps that occur in the cycle of a bill of exchange include:
- The bill of exchange is prepared by the creditor and sent to his debtor specifying the amount and date of payment
- The debtor must accept the bill of exchange for it to be valid. After acceptance, the bill becomes bill receivable for the creditor and bill payable for the debtor.
- The creditor can now:
- hold the bill till maturity present the same to the debtor for payment.
- discount the bill with the bank to avail an early payment. Once discounted, the bank becomes the holder of the bill.
- transfer this bill in favor of any of his creditors to settle a liability. Upon exercising this option, the transferee becomes the holder of the bill who then waits for the date of maturity.
- On the maturity date, the holder of the bill will present it to the debtor or drawee for payment.
- If the drawee honors the bill, the holder will receive payment against it.
- If the drawee fails to make payment, the bill of exchange will stand dishonored.
Example: Sale and purchase transactions are generally the underlying transactions that give a rise to raising of a bill of exchange.
A bill of exchange thus generally involves three parties:
This is the creditor or seller who draws the bill.
This is the debtor or buyer on whom the bill is drawn and who is obligated to honor the bill.
The payee is the person who is entitled to receive the amount specified in the bill. The payee is typically the holder of the bill who can be the original drawer, the bank with whom the bill has been discounted or any person in whose favor the bill has been endorsed or transferred.
A promissory note is a negotiable instrument that is drawn by the debtor (drawer) in favor of his creditor (drawee) and that contains a commitment/promise to pay, on a specific date, the sum specified therein to the creditor.
It is a signed legal document wherein the drawer undertakes to make payment in favor of the drawee. It thus does not require any acceptance to become valid as it is the debtor himself who is making a commitment to honor a payment.
The parties to a promissory note include:
This is the debtor or the buyer or the borrower who makes a promise to pay by drawing up a promissory note.
This is the creditor or seller or lender to whom the promise is made and who will be entitled to receive the payment on date specified in the promissory note.
Example: Mr. A approaches a lending agency for a loan. The agency agrees to give him a loan of $50,000. In return Mr. A is required to draw, sign and issue a promissory note in favor of the bank for payment of the amount of $50,000 after 2 years.
Difference between bill of exchange and promissory note
The key points of difference between bill of exchange and promissory note are as follows:
- A bill of exchange is a negotiable instrument drawn by a creditor requiring his debtor to pay a specified amount on demand or on a specified date.
- A promissory note is a legally binding document drawn by a debtor in favor of his creditor committing to make payment of a specified amount on a specified date.
- A bill of exchange is an order to pay.
- A promissory note is a promise to pay.
- The drawer or maker in case of a bill of exchange is the creditor or seller who is entitled to receive a payment.
- The drawer or maker in case of a promissory note is a debtor, buyer or borrower who is obligated to make a payment at some specific future date.
- The drawee in case of a bill of exchange is the debtor who has a liability to pay.
- The drawee in case of a promissory note is the creditor who has an outstanding receivable balance with the drawer.
5. Need for acceptance
- A bill of exchange must be accepted by the drawee to get legal validity. A unilateral act of making the bill of exchange by the creditor without acceptance by the debtor creates no legal obligation.
- A promissory note does not require any acceptance to become valid. As the note is drawn by the payer himself, it becomes legally binding once it is drawn up and signed by the drawer.
6. Action on dishonor
- If a bill of exchange is dishonored by the drawee, the holder of the bill is required to give notice of such dishonor to the drawer and all subsequent transferors of the bill. The intention of giving such a notice is so that the holder can hold the drawer liable for the amount of the bill that has been dishonored by the drawee.
- If a promissory note is dishonored no such notice of dishonor is required to be given as the drawer himself is responsible for the dishonor.
7. Parties involved
- A bill of exchange has three parties – drawer, drawee and payee/holder.
- A promissory note has two parties – the drawer and drawee (who is also the payee).
Conclusion – bill of exchange vs promissory note
The purpose of bill of exchange and promissory note is to provide legal certainty to credit transactions. It provides security to the creditor as well as allows him to avail early payments by discounting with commercial banks. Their characteristic of being legally binding also allows them to use by the creditor as means for settling his liabilities. In case of dishonor, jurisdictional law also provides for legal action against the defaulter which can include monetary penalty, imprisonment or enforcing liquidation of securities, if any.