Discounted bills are bills (Bill of exchange or Promissory notes) sold by corporates to banks or credit institutions to raise fund. These bills are sold at discounted price than the par value. The discounted amount then credited to the seller’s account.
At the date of maturity, bank collects the amount from customer on behalf of seller and the amount of discount becomes interest for the bank.
It would be better to understand this process with the help of an example.
XYZ Ltd receives an order to deliver 100 chairs from one of its valuable customers ABC Ltd which agrees to make the payment of Rs. 50000 (100 chairs at the rate of Rs. 500 each) after 6 months from the date of delivery. XYZ Ltd delivers 100 chairs on 20th Jan 2015. On the basis of payment terms, ABC Ltd has to pay the amount on 20th july 2015.
On 15th feb 2015, XYZ Ltd gets an order from another customer to deliver 1000 chairs. XYZ Ltd needs to purchase raw material to manufacture 1000 chairs but it does not have enough fund for this. Also the company cannot ask ABC Ltd to pay the bill as there is an agreement between the two that bill will be paid on 20th July 2015.
XYZ Ltd approaches a bank to sell the bill and after due diligence Bank agrees to purchase the bill at Rs. 45000 considering risk and interest factors. Bank now ask the company to inform ABC Ltd that it has to pay the bill to bank instead of XYZ Ltd. After confirmation for the same, Bank credits the amount of Rs. 45000 in the account of XYZ Ltd.
On 20th July 2015, bank collects the amount of Rs. 50000 from ABC Ltd. Now the difference between par value and credited amount to the XYZ Ltd’s account is the earning for bank.