HIRE PURCHASE ACCOUNTING
Financial Accounting-II
HIRE PURCHASE ACCOUNTING
(A) INTRODUCTION
There are many ways to purchase and sell the goods and services including
the assets. The important methods are cash sales and credit sales. In the case
of cash sales, the buyer purchases the goods and services by making the cash
payment, and both the possession and ownership are transferred immediately from
the seller to the buyer. Even in the case of credit sales, both the possession
and ownership are transferred from the seller to the buyer immediately after
finalization of the negotiation but the payment of the price is deferred.
Besides these traditional methods of sales, one can also find today a few
more methods of sale and purchase. One such method is the hire purchase system.
With this introduction, let us now discuss the meaning, definitions,
features and conditions of hire purchase system/transactions.
(B) HIRE PURCHASE SYSTEM – MEANING AND DEFINITIONS
A review of available literature on hire purchase system shows different
interpretations to the term ‘hire purchase’. However, a study of these views
enables to understand the meaning of the term in the right perspective. Hence,
the different views on hire purchase are summarized below.
The term ‘hire purchase’ originated in the United Kingdom and this is
similar to rent-to own system in the United States of America. Hire
Purchase System is a method of purchasing the goods with an arrangement to make
payment (of the purchase price) in instalments over time. The purchaser is,
therefore, leasing the goods and does not obtain the ownership of the goods
until he pays the full amount of the contract. However, physical possession of
goods is given by the seller to the buyer immediately after the finalization
and signing of the agreement called, hire purchase agreement.
Hire purchase is a system for purchasing merchandise such as cars,
furniture, etc., in which the buyer takes possession of the merchandise on
payment of a deposit and completes the purchase by paying a series of regular
instalments while the seller retains the ownership of the merchandise until the
final instalment is paid.
It (i.e., hire purchase system) is also defined as a system by which a
buyer pays for a thing in regular instalments while enjoying the use of it.
During the repayment period, ownership (i.e., title) of the item does not pass
to the buyer. Upon the full payment of the amount/loan, the title passes to the
buyer.
It (i.e., hire purchase system) is a method of paying for something in
which the buyer pays part of the cost immediately and then makes small regular
payments until the debt is completely paid.
It (i.e., hire purchase system) is a system of purchase wherein the seller
gives the physical possession of the goods to the buyer immediately after
signing of the agreement on the condition that the purchase price should be
paid by the buyer in a specific number of instalments and the ownership of the
goods will be transferred after the receipt of all instalments.
Like the above, few more definitions, interpretations, views, etc., of hire
purchase system can be found in the literature. However, all these definitions,
views, etc., focus on some of the important parts of hire purchase system and
these important parts are in the form of the features. A careful observation of
the above definitions, etc., helps to identify the important features of hire
purchase system as presented below.
(C) FEATURES OF HIRE PURCHASE SYSTEM
Based on the definitions, interpretations, etc., presented above,
the important features of hire purchase system are identified and presented
below.
(1) There is an agreement between the seller (called, hire seller or
hire vendor) and the buyer (called, hire purchaser or hirer)
and this agreement is called, hire purchase agreement.
(2) Purchase price of the goods and services is paid in a number of agreed
instalments (also called, hire). That means, purchase price is not paid
in one lump sum either at the time of signing the agreement or at a future
date. Instead, it is paid in a few instalments over a period of time.
(3) As the purchase price is not paid in one lump sum at the time of time
of purchase, it (i.e., hire purchase) is a kind of credit purchase.
(4) Under the system of hire purchase, though the full amount is not paid
at the time of purchasing (i.e., at the time of signing the agreement), the
seller hands over the goods to the buyer on signing the agreement. In other
words, the hire purchaser takes possession of the goods purchased on hire
purchase basis. Therefore, the buyer is able to start using these goods for the
intended purpose immediately after signing the agreement. And the hire
purchaser has the right to use the goods purchased on hire purchase basis as
the bailer.
(5) However, the legal ownership of the goods (i.e., title to the goods)
remains with the seller and it is passed on to the hire purchaser only after
the receipt of all instalments including the last instalment as per the
agreement. As a result, the hire vendor continues to be the owner of the goods
till the receipt of last instalment from the hire purchaser.
(6) As the title to the goods is not transferred from seller to buyer till
the receipt of last instalment in accordance with the Provisions of the
agreement, all earlier instalments paid (prior to the payment of last instalment)
are considered as hire charges (till the payment of last instalment).
And the hire purchaser becomes the owner of the goods only after the payment of
all instalments as per the Provisions of the agreement (i.e., after the payment
of last instalment, the hire vendor transfers the ownership of the goods to
hire purchaser).
(7) As already stated, the legal ownership of the goods sold on hire
purchase system is not transferred to the buyer by the seller until the receipt
of last instalment from the buyer. Therefore, if the hire purchaser fails to
pay any of the instalments, the hire vendor has the right to take back (i.e., repossess)
the goods from the hire purchaser.
(8) Similarly, the hire purchaser also has an option to terminate the
agreement any time but before the payment of last instalment and return
the goods to the seller (if he is not willing and/or not able to pay the
remaining instalments).
(9) When the agreement is terminated [either because the seller takes back
the possession of the goods from the hire purchaser (for non-payment of any of
the instalments) or because of hire purchaser returning the goods to hire
vendor any time before the last instalment is paid], the hire vendor need not
return or refund the instalments already paid (by the buyer) to the buyer. Hence,
the instalments already paid are considered as the hire charges for using the
goods by the hirer till the goods are taken back by the hire vendor or returned
by the hire purchaser.
(10) The unique feature of hire purchase system is that the payment of
every instalment is considered as the payment of hire charges by the hirer to
the hire vendor till the payment of the last instalment. After the payment of
the last instalment, the amount of different instalments paid is appropriated
towards the payment of the price of the goods sold and the ownership of the
goods is transferred to the hire purchaser by the owner (i.e., hire vendor).
(D) CONDITIONS OF HIRE PURCHASE TRANSACTIONS
Sale and purchase of goods and services under hire purchase system are
subject to certain conditions. The important conditions are (in addition to a
few more presented under the head
‘Important Terms in Hire Purchase Accounting’) are identified and presented
below.
(1) The hire vendor delivers the goods or asset to the hire purchaser at
the time of agreement i.e., after singing agreement.
(2) The hire purchaser has the right to use the goods delivered to him by
the hire vendor under hire purchase system.
(3) The purchase price of the goods acquired under hire purchase system is
paid in instalments.
(4) Each instalment (paid by the hire purchaser) is treated as the hire
charges for allowing the hirer to use the goods.
(5) If all instalments are paid by the hirer in accordance with the
Provisions of the agreement, the title to the goods (i.e., legal ownership) is
transferred by the hire vendor to the hire purchaser. Besides, the hirer has
the right to buy the goods (purchased on hire purchase system) at any time
before the payment of last instalment. In this case, the hirer is expected to
give at least 14 days’ notice to the hire vendor and he is eligible for the rebate
calculated as shown below. That means, the hirer has to pay the hire vendor
only hire purchase price or the balance thereof as reduced by the rebate as
shown below.
Rebate=(Hire Purchase Charges × Number of Instalments due × 2) /
Total Number of Instalments × 3
Total Number of Instalments × 3
(6) If there is a default in the
payment of any of the instalments, the hire vendor has the right take back the
goods from the possession of the hire purchaser without refunding him any amount
received earlier in the form of instalments. Similarly, the hirer has the right
to terminate the hire purchase agreement for valid reasons any time before the
payment of last instalment.
In the light of above, let us now discuss a few important terms used in
Hire Purchase Accounting System.
(E) IMPORTANT TERMS USED IN HIRE PURCHASE ACCOUNTING
A few terms which are used frequently in this chapter and the terms which
are new require some description. Hence, the important terms used in Hire
Purchase Accounting are analyzed and presented below.
(1) Hire Purchase Agreement is an agreement under which goods are
let on hire and under which the hirer has an option to purchase them in
accordance with the terms/conditions of the agreement and includes an agreement
under which (i) possession of goods is delivered by the owner thereof to a
person on the condition that such person pays the agreed amount in periodical
instalments, (ii) the property in the goods is to pass to such person on the payment
of the last of such instalments, and (iii) such person has a right to terminate
the agreement at any time before the property so passes [Section 2 (c) of Hire
Purchase Act, 1972 rescinded by a subsequent government notification of 30
August 1973]. This agreement, to be valid, must include/specify, among others,
the following.
(a) The agreement should be in writing (preferably in print) so that
anybody can read the contents of the agreement without any difficulty.
(b) The agreement should be signed by both the hire vendor and hire
purchaser. If there is a contract of guarantee, the agreement should be signed
even by the surety. Contract of Guarantee in relation to hire purchase
agreement means a contract whereby a person (i.e., surety) guarantees
the performance of all or any of the hirer’s obligations under the hire
purchase agreement.
(c) The agreement should state clearly (i) the hire purchase price, (ii)
cash price of the goods, (iii) the date of commencement of the agreement, (iv)
number of instalments, amount of each instalment, date upon which each
instalment is payable, mode of payment, the person to whom the payment should
be made, place of payment, etc., (v) the goods to which the agreement
relates, etc.
(d) The agreement should also specify unequivocally the rights of both the
hire vendor (including the right to cancel the agreement and to take back the
possession of goods) and the hire purchaser (including the right to terminate
the agreement if he wishes for valid reasons).
(2) Hire purchase price (i.e., purchase price) represents the total
sum payable by the hirer under a hire purchase agreement by way of a deposit or
initial payment (called, down payment) and subsequent periodical
instalments. Usually, the purchase price under hire purchase system (called, hire
purchase price) is higher than the purchase price if the same goods had
been purchased on cash basis (called, cash price). That means, Hire
Purchase Price > Cash (Purchase) Price. Hire purchase price is also
called, net hire purchase price. If the hire purchase price includes the
charges for (a) delivery expenses, (b) registration fee, (c) insurance premium,
etc., they should be subtracted to arrive at the net hire purchase price.
(3) Cash price represents the price at which the goods may be
purchased by the hirer for cash (i.e., on cash basis).
(4) Interest, therefore, represents the difference between the hire
purchase price of the goods and the cash price of the same goods. Hence, Interest
= (Hire Purchase Price – Cash Price). However, it (i.e., either interest or
hire purchase price) does not include any amount payable by the hirer as
penalty or compensation or damages for breach of any of the Provisions of the
agreement. It (i.e., interest) is also called, hire purchase charges. It
(i.e., hire purchase charges), therefore, represents the difference between the
hire purchase price and the cash price of the goods sold on hire purchase
system. In order to restrict the hire vendor from charging exorbitant hire
purchase charges, Section 7 (2) of the Hire Purchase Act, 1972 (Limitation
on Hire Purchase Charges) imposes not more than 30% or a lower rate
computed by using the following formula.
Statutory Charges = Cash Price Instalment × Rate × Time/100
where,
(a) Cash Price Instalment represents the amount of cash price
instalment (`). The cash price instalment with respect to a hire purchase
instalment may be determined by using the following formula.
Cash Price = Hire Purchase Instalment × Net Cash Price/ Hire Purchase Price
(b) Time (expressed in years and fractions of a year) refers to the
time that elapses between the date of agreement and the date on which the hire
purchase instalment corresponding to the cash price is payable under the
agreement.
(5) Hirer or Hire Purchaser means the person who obtains the
possession of goods from the owner of the goods under hire purchase agreement.
(6) Owner or Hire Seller or Hire Vendor is the person
who lets and delivers the possession of goods to a hirer under hire purchase
agreement.
(7) Hire represents the sum payable periodically by the hirer to the
hire vendor for the goods purchased under a hire purchase agreement.
(8) Down Payment is the amount paid by the hirer to the hire vendor
at the time of signing the agreement or at the time of taking delivery of the
goods by the hirer from hire vendor.
(9) Instalment represents a part of the difference between the hire
purchase price and down payment (payable by the hirer to the hire vendor
periodically as per agreement). After making the down payment, the remaining
amount (i.e., the difference between the hire purchase price and the
down payment) of the hire purchase price is paid periodically (say, yearly,
half-yearly, quarterly, monthly, etc) in few parts at the end of each of the
period.
Instalment Amount = (Hire Purchase Price – Down Payment) / Number of
Instalment given
As the hire purchase price comprises both cash price and interest, the
amount of each instalment includes a part towards cash price (i.e., principal
amount) and another part towards interest for a particular period (on the
outstanding balance).
(10) Repossession refers to the hire seller taking back the
possession of the asset which was sold to the hire purchaser on hire purchase
system for non-payment of one or more instalments.
After discussing the meaning of a few important terms used in Hire Purchase
Accounting, let us now discuss the differences between Hire Purchase and Sales.
(F) ACCOUNTING ENTRIES FOR HIRE PURCHASE TRANSACTIONS IN THE BOOKS OF HIRE
PURCHASER AND HIRE SELLER
Different hire purchase transactions are recorded in the books of both the
hire vendor and hire purchaser. Further, one or more method/s is/are available
for recording the hire purchase transactions in the books of each of the two
parties.
A. Asset Accrual Method
B. Credit Purchase with Interest Method
I. ACCOUNTING ENTRIES IN THE BOOKS OF HIRE PURCHASER
As already pointed out, there are three methods to account for different
hire purchase transactions in the books of hirer or hire purchaser. They are
(A) Asset Accrual Method, (B) Credit Purchase with Interest Method and (C)
Interest Suspense Account Method.
(A) Asset Accrual Method
This method is also called, Proportional Capitalization Method, Gradual
Capitalization
Method or Actual Cash Price Paid Method. As the name
itself indicates, this method assumes that the asset accrues to the hirer
gradually to the extent of payment made towards the cash price of the asset
acquired on hire purchase basis. Therefore, in the books of the hirer or hire
purchaser, Asset Account is debited to the extent of only the instalment amount
paid towards the cash price of the asset.
In other words, Asset Account is debited with the instalment towards cash
price of the asset every time instalment is paid. The salient features of this
method are as follows.
(1) As both the amount due and the interest due thereon (i.e., on the
amount due) are zero at the time of signing the hire purchase agreement (i.e.,
at the time of delivery of the asset), down payment, if any, made is only
towards the cash price of the asset (but not towards interest also). Therefore,
the amount of down payment is debited to Asset A/c crediting Cash or Bank A/c.
(2) Each instalment payable is towards both the cash price of the asset
(called, instalment cash price) and the interest accrued on the amount
outstanding (from the date of immediately preceding instalment paid and the
date of the current instalment payment). When the instalment is due for
payment, a portion of instalment towards cash price is debited to Assets A/c
and the remaining portion pertaining to interest is debited to Interest A/c crediting
Hire Seller’s A/c. When the payment is made, Hire Seller’s A/c is debited and Cash
or Bank A/c is credited.
(3) Since the hire purchaser starts using the asset acquired under hire
purchase system, the asset is subject to wear and tear. Hence, depreciation is
provided in the books of the hirer, usually, at the end of each accounting
year. Therefore, Depreciation A/c is debited and Asset A/c is credited.
(4) As both the amounts of interest paid (as a part of instalment amount)
and depreciation charged constitute the expenses (i.e., items of Nominal
Accounts), both are transferred to Profit and Loss A/c at the end of each
accounting year by debiting Profit and Loss A/c (for the aggregate of interest
and depreciation) crediting Interest A/c (for the amount of interest) and
Depreciation A/c (for the amount of depreciation). With this introduction about
the nature of Asset Accrual Method, the journal entries for different hire
purchase transactions in the books of hire purchaser are presented below.
(1) For recording down payment made
at the time of signing the hire purchase agreement, the following entry is
passed. It may be noted here that if no down payment is made, the following
entry is not required.
Asset A/c Dr.
`
To Bank/Cash A/c `
(Being the amount of down payment made)
Alternatively, the following two entries may be passed:
Asset A/c Dr.
`
To Hire Seller’s A/c `
(Being the down payment due)
Hire Seller’s A/c Dr.
`
To Bank/Cash A/c `
(Being the payment of down payment)
The number of journal entries for the subsequent instalment payment/s
(subsequent to down payment or signing of hire purchase agreement if no down
payment is made) depends upon the whether the instalments are paid annually or
more frequently (such as half-yearly, quarterly, monthly, etc).
Therefore, both the cases are analyzed separately below.
When the instalments are paid annually, the
following four entries should be passed –
one each for recording (i) instalment amount due, (ii) payment of
instalment amount, (iii) for charging depreciation on the asset acquired on
hire purchase basis, and (iv) for transferring the amounts of interest and
depreciation to the Profit and Loss A/c as presented below.
(2) For recording the amount of instalment due to the hire vendor, the
following entry is passed.
Asset A/c Dr.
`
Interest A/c Dr.
`
To Hire Seller’s A/c `
(Being the instalment due)
(3) For recording the payment of instalment amount to the hire vendor, the
following entry is passed.
Hire Seller’s A/c Dr.
`
To Bank/Cash A/c `
(Being instalment amount paid to hire seller)
(4) For recording the depreciation on the asset, the following entry is
passed at the end of the year.
Depreciation A/c Dr.
`
To Asset A/c `
(Being the amount of depreciation charge)
(5) For transferring the amounts of interest and depreciation to the Profit
and Loss A/c, the following entry is passed at the end of the year.
Profit and Loss A/c Dr.
`
To Interest A/c `
To Depreciation A/c `
(Being the amounts of interest and depreciation transferred to Profit and
Loss A/c)
If the instalments are paid more frequently such as half-yearly, quarterly, etc., then two sets of entries are passed – one set of
entries for each of all instalments (for the accounting year) except the last
instalment, and the second set of entries for the last instalment (of the accounting
year). The following two entries are passed at the end of each of the
instalments (except the last instalment for the accounting year) in the year
(entries for the instalment due and paying the instalment. These two entries
are same as that for annual instalments).
(6) For recording the amount of instalment due to the hire vendor, the following
entry is passed.
Asset A/c Dr.
`
Interest A/c Dr.
`
To Hire Seller’s A/c `
(Being the amount of instalment due – towards both the cash price and
interest)
(7) For recording the payment of instalment amount to the hire vendor, the
following entry is passed.
Hire Seller’s A/c Dr.
`
To Bank/Cash A/c `
(Being the amount of instalment paid)
Further, all the four entries (as in the case of annual instalment) are
passed at the end of the accounting year (i.e., with the payment of last
instalment of the accounting year) as presented below.
(8) For recording the amount of last instalment of the accounting year due
to the hire vendor, the following entry is passed.
Asset A/c Dr.
`
Interest A/c Dr.
`
To Hire Seller’s A/c `
(Being the instalment due – towards both the cash price and interest)
(9) For recording the payment of last instalment amount of the accounting
year to the hire vendor, the following entry is passed.
Hire Seller’s A/c Dr.
`
To Bank/Cash A/c `
(Being the amount of instalment paid)
(10) For recording the depreciation on the asset for the whole accounting
year, the following entry is passed at the end of the year.
Depreciation A/c Dr.
`
To Asset A/c `
(Being the amount of depreciation charge)
(11) For transferring the amounts of interest and depreciation (for the
whole year) to the Profit and Loss A/c, the following entry is passed at the
end of the year.
Profit and Loss A/c Dr.
`
To Interest A/c `
To Depreciation A/c `
(Being the amounts of interest and depreciation transferred to Profit and
Loss A/c)
(B) Credit Purchase with Interest Method
This method considers the assets acquired on hire purchase basis as
acquired on outright credit basis with interest. Therefore, on the date of
signing the hire purchase agreement, the asset acquired is debited to Asset A/c
with cash price and Hire Seller’s A/c is credited in the books of the hire
purchaser. The important features of this method are as follows.
(1) As the asset acquired (on hire purchase basis) is considered as
acquired on outright credit basis, cash purchase price (of the assets) is
debited to the Asset A/c crediting Hire Seller’s A/c on the date of signing the
hire purchase agreement.
(2) Down payment made, if any, at the time of signing hire purchase
agreement is considered as a payment made to the hire vendor on account. Hence,
an entry debiting Hire Seller’s A/c and crediting Bank/Cash A/c is passed.
(3) Interest on the outstanding balance of the cash price of the asset
acquired is brought into book, at the end of each instalment, by debiting
Interest A/c and crediting Hire Seller’s A/c. (4) Each instalment paid is
treated as a payment made to the hire vendor on account by debiting Hire
Seller’s A/c and crediting Bank/Cash A/c.
(5) Depreciation computed on the basis of cash price of asset is charged
annually (accounting
year) by debiting Depreciation A/c and crediting the Asset A/c.
(6) At the end of each accounting year, both the interest and depreciation
are transferred to the Profit and Loss A/c by debiting Profit and Loss A/c, and
crediting Interest A/c and Depreciation A/c.
In the light of the above introduction, an analysis of entries for hire
purchase transactions under Credit Purchase with Interest Method is made below.
(1) For recording the asset acquired on hire purchase basis, the following
entry is passed for the cash price of the asset so acquired and this entry is
passed on the date of signing the hire purchase agreement.
Asset A/c Dr.
`
To Hire Seller’s A/c `
(Being the cash price of the asset acquired on hire purchase basis)
(2) For recording the down payment made, if any, the following entry is
passed. It may be noted here that the down payment is made to hire seller on
account.
Hire Seller’s A/c Dr.
`
To Bank/Cash A/c `
(Being the amount of down payment made)
For the purpose of recording the instalment amount paid, the procedure
differs (as under Asset Accrual Method) from annual instalments to half-yearly,
quarterly, etc. In the case of annual instalments, the following
four entries are passed at the end of each of the annual instalments.
(3) For recording the amount of instalment interest due to the hire vendor,
the following entry is passed.
Interest A/c Dr.
`
To Hire Seller’s A/c `
(Being the amount of instalment interest due)
(4) For recording the payment of instalment amount to the hire vendor, the
following entry is passed.
Hire Seller’s A/c Dr.
`
To Bank/Cash A/c `
(Being the amount of instalment paid)
(5) For recording the depreciation on the asset, the following entry is
passed at the end of the year.
Depreciation A/c Dr.
`
To Asset A/c `
(Being the amount of depreciation charge)
(6) For transferring the amounts of interest and depreciation to the Profit
and Loss A/c, the following entry is passed at the end of the accounting year.
Profit and Loss A/c Dr.
`
To Interest A/c `
To Depreciation A/c `
(Being the amounts of interest and depreciation transferred to Profit and
Loss A/c)
On the other hand, if the instalments are paid more frequently such as half-yearly,
quarterly, etc., then, the following two entries (for instalment
interest amount due and for payment of instalment amount) are passed at the end
of each of the instalments (except the last instalment for the accounting
year).
(7) For recording the amount of instalment interest due to the hire vendor,
the following entry is passed.
Interest A/c Dr.
`
To Hire Seller’s A/c `
(Being the amount of instalment interest due)
(8) For recording the payment of instalment amount to the hire vendor, the following
entry is passed.
Hire Seller’s A/c Dr.
`
To Bank/Cash A/c `
(Being the amount of instalment paid)
Besides, at the end of the last instalment for the accounting year, all the
four entries (as required for annual instalment) are passed as reproduced
below.
(9) For recording the amount of last instalment interest due (for the
accounting year) to the hire vendor, the following entry is passed.
Interest A/c Dr.
`
To Hire Seller’s A/c `
(Being the amount of instalment interest due)
(10) For recording the payment of last instalment amount (for the
accounting year) to the hire vendor, the following entry is passed.
Hire Seller’s A/c Dr.
`
To Bank/Cash A/c `
(Being the amount of instalment paid)
(11) For recording the depreciation on the asset for the whole accounting
year, the following entry is passed at the end of the year.
Depreciation A/c Dr.
`
To Asset A/c `
(Being the amount of depreciation charge)
(12) For transferring the amounts of interest and depreciation (for the
entire accounting year) to the Profit and Loss A/c, the following entry is
passed at the end of the year.
Profit and Loss A/c Dr.
`
To Interest A/c `
To Depreciation A/c `
(Being the amounts of interest and depreciation transferred to Profit and
Loss A/c)
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