Meaning of Hire Purchase Accounting
The process through which generally expensive consumer goods are bought by the consumers by making an initial down payment and paying the rest of the amount in installments including interest is called hire purchase accounting.
Carter has defined hire purchase accounting as – “Hire Purchase is a system under which money is paid for goods using periodical installments with the view of ultimate purchase. All money being paid in the meantime is regarded as payment of hire and the goods become the property of the buyers only when all the installments have been paid. “
The term hire purchase is generally used in the United Kingdom and is referred to as the installment plan in the United States. Under the hire purchase accounting system, the customers do not get the ownership rights of the product or the commodity unless and until he or she pays off the complete amount. This includes the principal as well as the interest.
As the interest is also included in the principal amount, the buyer ends up paying more. Thus, hiring purchase arrangements usually proves to be more expensive in the long run than buying a product outright.
This type of service is generally offered by a hired vendor, a seller, or a business entity to its customers. On one hand, hire purchase agreements proves to be expensive in the long run while on the other hand, they act as a feasible option for low-income groups who wish to buy expensive products conveniently. This is a great option even for industries facing cash shortages who do not wish to spend a huge amount at once.
Hire-purchase transactions are even carried out with the help of a financer. The financier buys the product on the behalf of the buyer and makes payment to the seller. Then the amount is collected from the buyer in installments with an interest charge.
This type of business is usually carried out in durable consumer articles like television, refrigerator, mobile phone, sewing machine, product manufacturing machines, etc.
Thus, in simple words, a Hire purchase is a legally binding agreement where the buyer and the seller fork out a percentage of the total cash price as the down payment, and the rest amount with interest is paid in agreed periodic installments.
Features of Hire Purchase Accounting
The main features of a hire purchase agreement are as follows –
1) Possession of goods
The buyer gets possession of the goods immediately. As soon as the buyer makes the first installment or down payment, the seller hands over the goods to the buyer.
2) Ownership of goods
The ownership of the goods remains with the hiree (the seller) until the last installment is made. Once the full amount which includes the principal amount, as well as the interest, is paid by the buyer, the ownership rights of the goods are transferred to him.
3) Installment plan
The payment of the goods is made by the buyer to the seller in agreed periodic installments.
4) Repossession of goods
The hiree or the vendor can repossess the goods in case of default of the payment and can treat the amount received by the way of installments as the hire charged for that period.
5) Interest charge
The interest is usually charged at a flat rate by the vendor.
Advantages of Hire Purchase Accounting
The hire purchase system is considered to be very helpful, especially for the low-income group and industries facing cash shortages because of the following pointers –
1) Convenience in payments
People belonging to low-income groups find the feature of periodic installments very convenient. The buyers are greatly benefited as they have to make payments in small installments which they can afford easily instead of paying the whole amount in one go.
2) Access better equipment
Using a hire purchase system, companies get access to some top-notch equipment. Usually, the companies are not in a position to buy expensive equipment with the option of a one-time payment but with hire purchase, they can buy high specification item, get its possession, use it for their benefit, repay the purchase price in installments and get the ownership of it at the end of the term by paying the full amount.
3) Increased volume of sales
This is one of the biggest advantages of the hire purchase system for the seller. With the system of payment to be made in easy installments, more customers are attracted, and eventually the sales increase.
4) Lower rates of interest
Interest rates of hire purchase accounting systems are usually lower than the interest rates of overdrafts, credit cards, and other forms of finance. A hire purchase agreement does not have to pay VAT, thus monthly payments are likely to be lower than in a leasing agreement.
5) Lesser risk
From the point of the seller, this system is much safer for them as they know that if the buyer fails to pay one installment, he or she can get possession of the goods back.
6) Earning of interest
The installments received by the seller from the buyer include the principal amount as well as the interest in it. Thus, the seller earns more with this system. The interest is calculated in advance and is already added in the installments to be paid by the buyer.
Disadvantages of Hire Purchase Accounting
However, due to some reasons, a hire-purchase accounting system is not considered appropriate for some businesses. These are as follows –
1) Higher price
The buyer has to pay a higher price for the product in this system compared to what he or she will pay in a one-off payment. The installments under the hire purchase accounting system include interest as well which eventually increases the price of the product paid.
2) Artificial demand
A hire-purchase accounting system creates an artificial demand for the product. The system of paying in installments tempts consumers to buy a product even if he or she does not need and afford to buy the product.
3) Affects the credit rating
If the buyer fails to pay any installment or we can say defaults on any of it the credit rating of the buyer is affected adversely. This impacts a lot on the buyer in the long run.
4) Asset becomes obsolete
After completing all the installments when the buyer becomes the legal owner of the asset, the value of the asset gets depreciated and becomes obsolete.
5) Financial burden
The system of hire-purchase accounting puts a lot of financial pressure on families which cannot afford to buy luxurious items. Many studies have revealed that thousands of families have been broken by the hire purchase accounting system.
Calculation of interest under the Hire Purchase Accounting System
We know that under the hire purchase accounting system the price consists of two elements:
- The cash price
- The interest.
The cash price is the amount left after deducting the interest amount from the hire purchase price. Interest is charged on the amount outstanding. Thus, the down payment made in the beginning does not include any interest.
While calculating the interest on the installments, mainly two cases are faced by the students:
1) Case 1 – when the cash price, rate of interest, and the total amount of all installments are given.
In this case, the total amount of interest is calculated first. It is calculated by taking out the difference between the hire purchase price (down payment + total installments) and the cash price. The following steps are practiced to calculate the amount of interest in each installment –
Step 1: Firstly, deduct the down payment from the cash price and calculate the interest at the given rate on the remaining balance. This represents the amount of interest included in the first installment.
Step 2: Then, Deduct the interest of Step 1 from the amount of the first installment. The remaining value is the cash price included in the first installment.
Step 3: Deduct the cash price of the 1st installment (Step 2) from the remaining balance after the down payment. This value is equal to the amount outstanding after the 1st installment is paid.
Step 4: Calculate the interest at the given rate on the balance outstanding after the 1st installment. Deduct this interest from the amount of the 2nd installment to get the cash price included in the 2nd installment.
Step 5: Deduct the cash price of the 2nd installment (Step 4) from the balance due after the 1st installment. This amount is equal to the amount outstanding after the 2nd installment is paid.
Repeat the above steps till the last installment is paid
2) Case 2 – When the cash price and the total amount of all installments are given, but the rate of interest is not given.
When the rate of interest is not given in any problem of hire purchase accounting and only the cash price and the total amount of all installments are given, then the total interest is calculated by taking out the difference between the cash price of the asset and total amount paid as per the agreement. Then this interest amount is allocated in the ratio of the amount outstanding at the end of each year.
For example, Mr. A bought a machine under the hire purchase agreement, the cash price of the machine being Rs 18,000. As per the terms, the buyer has to pay Rs 4,000 on signing the agreement and the balance in four installments of Rs 4,000 each, payable at the end of each year. Find out the interest chargeable at the end of each year.
Repossession of goods: Complete and Partial
When the buyer defaults at completing any installment, the vendor has the right to repossess his goods and forfeit the installment already paid. The seller repossesses the goods in two manners: complete or partial repossession of goods.
1) Complete repossession
Under complete repossession, the vendor takes the repossession of all the goods. The seller (hire vendor) closes the books of the buyer (Hire-Purchaser’s Account) by transferring them to Repossess Goods Account.
Similarly, the hire-purchaser also closes the account of the Hire-Vendor Account by transferring to the balance of the Asset Account.
Accounting treatment in the books of the seller –
- On Repossession of goods
|Goods Repossessed A/c Dr.||x x x|
|To Hire Purchaser’s A/c||x x x|
- For the amount spent on reconditioning goods Repossessed
|Goods Repossessed A/c Dr. To Cash A/c / Bank A/c||x x x||x x x|
- For the sale of Goods Repossessed
|Cash A/c Bank A/c Dr. To Goods Repossessed A/c||x x x||x x x|
- For Loss on Sale Goods Repossessed
|Profit & Loss A/c Dr. To Goods Repossessed A/c||x x x||x x x|
Accounting treatment in the books of the buyer –
- For Closing Hire Vendor’s Account
|Hire Vendor’s A/c Dr. To Asset A/c||x x x||x x x|
- For Closing Asset Account
- If the Book value of the Asset exceeds the amount due to the Hire vendor:
|Profit & Loss A/c Dr. To Asset A/c||x x x||x x x|
- If the amount due to Hire-vendor exceeds the book value of the asset:
|Asset Alc Dr. To Profit & Loss A/c||x x x||x x x|
2) Partial repossession
Sometimes during the repossession of goods, the seller does not repossess the whole quantity of goods but seizes only a partial part of it. The valuation of these partial goods depends upon the agreement between the buyer and seller.
All the entries till the date of default are made in the usual manner. Then the hire vendor account is debited with the agreed value of repossessed goods and the Asset Account is credited with the same value.
Now the Asset Account shows the value of the portion left with the buyer; of course, less depreciation. Any difference in the Asset Account represents profit or loss on default and the same is transferred to the Profit and Loss Account. The Repossessed Goods Account in the books of the vendor will be prepared on the same lines as it was done in Complete Repossession.
Profit computation under Hire-Purchase Accounting System
The stock and debtor method is an alternative method under the hire purchase accounting system which is used to maintain Hire Purchase Stock Account, Hire Purchase Debtors Account, and Hire Purchase Adjustment Account.
When a seller sells goods on hire purchase –
- Hire Purchase Stock Account is debited and Goods Sold on Hire Purchase Account are credited with the full hire purchase price.
- Installments that become due for payment are debited to the Hire Purchase Debtors Account and credited to the Hire Purchase Stock Account.
- Cash received is credited to the Hire Purchase Debtors Account.
As a result of this method, at any time, the balance of the Hire Purchase Stock Account reveals the number of installments that are yet to accrue and the balance of the Hire Purchase Debtors Account reveals the balance of installments which have fallen due but which have not yet been received.
If goods are repossessed due to default –
- Hire Purchase Debtors Account is credited with installments accrued but not received.
- Hire Purchase Stock Account is credited with installments that were yet to accrue.
- Goods Repossessed Account is debited with the estimated value of goods repossessed.
- The difference in debits and credits (being profit or loss on repossession) is debited or credited respectively, to the Hire Purchase Adjustment Account.
At the end of the financial year –
- Loading (difference between Hire Purchase Price and Cost Price) in respect of goods sold during the year is debited to Goods Sold on Hire Purchase Account and credited to Hire Purchase Adjustment Account.
- The cost of goods sold is transferred from the Goods Sold on Hire Purchase Account to Trading Account.
- Hire Purchase Stock Reserve is created in respect of loading on the closing balance of the Hire Purchase Stock Account by debiting the Hire Purchase Adjustment Account and crediting the Hire Purchase Stock Reserve Account.
- The profit disclosed by Hire Purchase Adjustment Account is transferred to Profit & Loss Account.
- The balances of distinct accounts are carried forward and shown in the balance sheet.