Accounting for Hire Purchase System?

Accounting for Hire Purchase System

Concept

The hire purchase system is a special method of credit purchase and sale of goods.

Under cash sales system, the goods are sold and delivered to the purchaser only when the payment is made immediately.

In credit sales system, the goods are sold and delivered immediately but the price is paid by the purchaser on some future date mostly without interest up to a certain limit called credit period.

As against these two popular systems of selling goods, under hire purchase system, the good are delivered to the purchaser  immediately on signing the hire purchase agreement but purchase price is recovered or collected from him/her in future in periodic installments' these installments may be monthly or quarterly or yearly or any other period as per the agreement. Although the purchase gets the possession of the goods immediately. Yet he/she will become the owner of the goods only on the payments of all the installments including the last installment. The entire installments paid are treated as a hire charge till the last installments is paid off.

According to Carter, "Hire purchase system is a system under which money is paid for good by means of periodical installments with the view of ultimate purchase. All money being paid in the mean time is regarded as payment of hire and the goods become the property of the buyers only when the entire installments have been paid."

It must be made clear that in case of default in the payment of even the last installment, the seller or vendor will be entitled or authorized to take back of repossess the goods and forfeit the amount already paid by purchase treating it as hire charges.

Under the hire purchase system, the seller of the goods is called the hire vendor and the purchaser is called the hire purchaser.

Features of Hire purchase system

On the basis of this, it can be said that the following are the main feature of hire purchases systems:

1. Agreement in writing: there is a specific agreement in writing and signed by the parties to the agreement, that is, hire vendor and hire purchaser.
2. Possession of goods: the possession of the goods is given immediately to the hire purchase on signing the hire purchase agreement. In other words the hire purchase gets the right to use the goods on getting the possession.
3. Payment in installments: the hire purchaser would make the payment of the hire purchase rice in monthly, quarterly, half yearly or even yearly installments according to the agreement for a fixed period of time.
4. Ownership of the goods:  the hire purchaser would become owner of the goods only on the payment of last installment and not before that.
5. Right to terminate the agreement: the hire purchaser has right to terminate the hire purchase agreement any time before he becomes the owner of the goods.
6. To keep the goods in good condition: the hire purchase is under duty to take reasonable care of the goods in his possession as he/she would have done to his own goods.
7. Loss to goods: any loss occurring to the goods without any fault of the hire purchase would be borne by the hire vendor. It is based on simple rule that risk lies with the ownership.
8. No sale or pledge the goods: the hire purchase cannot sell or pledge the goods until he/she become the owner after paying the last installment.
9. Right to repossess form third party: in the case of default in payment of any installments, the total amount of installments already paid by the hire purchase can be forfeited by the vendor and the vendor will taken away the goods from the possession of the purchaser.

Importance Term of Accounting for hire Purchase System

The following terminologies are used in Accounting for Hire purchase system:

1. Hire purchaser: hire purchaser is a person who acquires or obtains the purchase of assets from the seller under a hire purchase agreement.
2. Hire vendor: hire vendor is a party/person who delivers the goods to the hire purchaser with intention to seller the goods.
3. Hire purchase price: Hire purchase price means the total amount payable by the hire purchaser under a hire purchase agreement.

Hire purchase price = Down payment + Total cash price of all installments + Total interest

Hire purchase price= Down payment + Total amount of all installments'

Hire purchase price = Total cash price + Total interest

1. Down payment: this is initial amount paid by the hire purchase at the time of signing the hire purchase agreement.
2. Cash price: cash price means the price at which the goods may be purchased by the purchaser for immediate cash payment.

Cash price= Hire purchase price – Total interest

Cash price = Down payment + Total amount of all installments – Total interest

Cash price = Down payment + Total cash price of all installments'

• Interest: interest means the difference between the hire purchase price and the cash price as mentioned in the hire purchase agreement.

Normally, all installments will include a part of cash price and a part of interest on outstanding balance. However, the amount of down payment will not include any interest.

Objective of hire purchase system

The following are the objective of hire purchase system

1. To increase purchase and sales: hire purchase system attracts more customers as the payment is to be made in easy installments. It is advantageous to the people having limited income. This leads to increase in the volume of sales and purchase and the large volume of sales ensures increase amount of profit.
2. To take the advantages of interest: to earn interest is another objective of hire purchase systems. In this system, interest is calculated in advance and added to total installments to be paid by the hire purchase.
3. To be owner of the assets in future: it helps buyer to be owner of the assets in future after the payments of final installment.
4. To take advantages of depreciation: ownership is transferred to the purchase only after the payment of final installment. Therefore, depreciation is charged on assets by hire vendor and it will save the amount of income tax of the hire vendor.

Calculation of interest, cash price and installment using analytical Table

The hire purchase price includes two elements namely; (i) ash price (principal amount), (ii) interest 0. The installment paid by hire purchase includes both these two elements. The first element cash price is of a capital nature and is debited to assets account in the books of purchase, which is shown in the balance sheet. The other element i.e. interest is of a revenue nature and is interest is of a revenue nature and is transferred to profit and loss account of the purchaser at the end of financial year. The amount of interest, cash price and installments are calculated in different cases as under.

a.      When rate of interest, total cash price and installments are given

b.      When rate of interest and installments are given but total cash price is not given

c.       When cash price of each installment and rate of interest are given but total cash price is not given

d.      When only installments are given but total cash price and rate of interest are not given

e.      When total cash price and installments are given but rate of interest is not given

f.        When reference to annuity table, rate of interest and installments are given but total cash price is not given.

1.      When rate of interest, total cash price and installments are given

In this case, the following steps are used to determine amount of interest and amount of cash price included in each installment:

a.      First of all, amount of down payment is deducted from total cash price and  then after interest for the first installment is calculated on outstanding cash price multiplying it by given rate of interest

Interest on 1^st installment =(total cash price – down payment) x rate of interest

b.      Now deduct the amount of interest on first installment from amount of first installment and get the balance amount of cash price of first installment.

Cash price of 1^st installment = 1^st installment – interest on 1^st installment

c.       The cash price of first installment is deducted from balance due after down payment.

Balance cash price after 1^st installment = total cash price – down payment – cash price of 1^st installment

d.      The amount of interest on second installment is calculated multiplying it by the given rate of interest on the remaining balance of cash price after first installment.

Interest on 2^nd installment = balance cash price after 1^st installment x rate of interest

e.      The amount of interest on second installment calculated as per no. (d) is deducted from the amount of second installment and balance amount as cash price of second installment.

Cash price of 2^nd installment = 2^nd installment – interest on 2^nd installment

f.        The cash price of second installment as per no (e) is deducted from balance cash price after the first installment calculates as per no. (c) And the balance should be treated as cash price after second installment.

Balance cash price after 2^nd installment = balance cash price after 1^st installment – cash price 2^nd installment

The same procedures are repeated till the second last installment.

The amount of interest on last installment is calculated as under;

Interest on last installment – last installment – Balance cash price after 2^nd last installment

1.      When rate of interest andinstallments are given but total cash price is not given:

In this case, the following steps are used to determine amount of interest and cash price of each installment:

a.      First of all, interest included in the last installment is to be calculated as under:

Interest on last installment = amount of last installment x rate of interest / 100 + rate of interest

b.      Cash price of last installment should be determined by deducting interest on last installment from the amount of last installment.

Cash price of last installment = amount of last installment – interest of last installment

c.       Interest on second last installment can be calculated by adding cash price of last installment to amount of second last installment and multiplying the total of these two by rate of interest divided by 100 plus rate of interest.

Interest on 2^nd last installment = (amount of 2^nd last installment + cash price of last installment) x Rate of interest / 100 + Rate of interest

d.      After this, cash price of second last installment can be ascertained by deducting interest on second last installment from the amount of second last installment.

Cash price of 2^nd last installment= amount of 2^nd last installment – interest on 2^nd last installment

e.      To calculate interest on third last installment, cash price of last installment, cash price of last installment, cash price of second last installment and amount of third last installment are added and their total is multiplied by rate of interest divided by 100 plus rate of interest.

Interest on 3^rd last installment

=(amount of 3^rd last installment + cash price of 2^nd last installment + cash price of last installment) x rate of interest / 100 + rate of interest

The above mentioned procedures should be repeated till the first installment. After determining cash price of first installment, total cash price of the assets can be determined.

Total cash price = down payment + total cash price of all installments

1.      When cash price of each installment and rate of interest are given but total cash price is not given

Under this case, interest is calculated as under;

a.      First of all, total cash price is determined by adding down payment and total cash price of all installments.

 Total cash price = down payment + total cash price of all installments

b.      After determining cash price, interest on first installment can be ascertained by multiplying the amount of total cash price minus down payment by rate of interest.

Interest on 1^st installment = (Total price – down payment) x rate of interest

c.       Amount of first installment can be calculated by adding interest on first installment to cash price of first installment.

Amount of 1^st installment = cash pric of 1^st installment + interest on 1^st installment

d.      To calculate the amount of interest on second instilment, down payment and cash price of first installment should be deducted from total cash price and then after, remaining amount should be multiplied by rate of interest.

Interest on 2^nd installment = (Total cash price – Down payment – cash price of 1^st installment) x rate of interest

Amount of installment and amount of interest of each installment can be ascertained by repeating above mentioned steps (I to IV)

1.      When only installments are given but total cash price and rate of interest are not given

In this case, amount of interest is determined using the following method:      

a.      It is assumed that the cash price of each installment as x and they are equal.

b.      Interest of the last installment should be assumed as i.

c.       Now, the amount of last installment= x + i

d.      Amount of second last installment = x + 2i

e.      Amount of third last installment= x +3i

Similarly, using the same procedures the equations up to the first installment are made: then after, solve these equations and determine the amount of equal cash price of each installment. If amount of cash price of each installment is detected from amount of installment, then amount of interest can easily be ascertained.

2.      When total cash price and installment are given but rate of interest is not given

Under this situation, one of the following two conditions is given:

a.      When amount of each installment is unequal

b.      When amount of each installment is equal

a.      When amount of each installment is unequal: in this case, interest on each installment is determined using the following methods.

1.      Amount of total interest is determined by deducting total cash price from hire purchase price.

Total interest = Hire purchase price – Total cash price

1.      Then after, amount of total outstanding amount before first installment is determined by deducting down payment form hire purchase price.

Amount outstanding before payment of 1^st installment = Hire purchase price – Down payment

2.      After that total amount due before payment of second installment should be determine by deducting amount of first installment form the total amount due or outstanding before payment of first installment.

Amount outstanding before payment of 2^nd installment = amount outstanding before payment of 1^st installment – 1^st installment

3.      Reporting above mentioned steps till the last installment and amount due before last installment should be determined.

4.      Amount of interest of each installment is determined by apportion amount of total interest in the ratio of amount outstanding before payment of each installment.

a.      When amount of each installment is equal: in this case, the total cash price and installment are given but rate of interest is not given in the problem. Here interest on each installment is calculated according to the method described in illustration No. 5(a).

Under this, the following method can also be applied to determine the amount of total interest.

a.      Total amount of interest is ascertained by deducting total cash price from hire purchase price

Total interest = Hire purchase price – Total cash price

b.      Total amount of interest should be distributed on the basis of sum of year's digit method.

5.      When reference to annuity table, rate of interest and installment are given but total cash price is not given

Under this situation, the following formula is used to determine total cash price:

Total cash price = down payment + (Annual equal installment x present value annuity factor)

Accounting treatment in the books of Hire purchaser

Regarding the accounting procedure for goods purchase on the hire purchase system, it must be remember that under this system, the hire purchase obtain the possession of the goods immediately on singing of the agreement, but the ownership is not transferred until the last installment is paid.

Generally, there are two method of recording hire purchase transaction in the books of hire purchaser:

a.      Capitalizing only the portion of cash price paid or the assets is recorded at cash price actually paid in each installment other assets is recorded at full cash price

b.      Capitalizing the full cash price or the assets is recovered at cash price actually paid in cash installment.

a.      Capitalizing only the portion of cash price paid

This method is also known as "Asset accrual Method". Under this method, the assets account is debited initially with the down payment (if any). Each subsequent installment is divided into two parts, one part representing the portion of purchase price (cash price) and the other repressing interest on balance due. The asset is debited with price paid in each installment. Under this method asset is not debited at its full cash price as the assets does not become the property of hire purchaser until the final payment is made. Depreciation under this method must be charged on the fall cash price. The student should note threat in practice this one is selected followed.

1.      Capitalizing the full cash price  or the assets is recorded at fullcash price

This method is also known as "Credit purchase with interest method. Under this method the assets is recorded at its full cash price keeping in view the assumption that the hire purchase ultimately intends to be purchase the assets. Thus asset account is debited at full cash price and hire vendor account at fall cash price and hire vendor account is credited with the same value. On making the down payment, the hire vendor account is debited with the amount of down payment. At the time of payment offset installment, interest is calculated on the outstanding cash price and the amount is debited to interest account and credited to hire vendor account. When installment is paid, again hire vendor account is debited and bank account is credited with the amount of installment is paid. At the end of each financial year, when final accounts are to be prepared, depreciation on the assets (on cash price) according to specified method of depreciation is calculated and is debited to depreciation account and credited to assets account. At the time of preparation of final accounts, interest belong to that period is transferred to profit and loss account. In the same way, depreciation, relating to that period is also transferred to profit and loss account.

On the other hand, the asset is shown in the balance sheet at cost less depreciation and amount of cash price payable to hire vendor on that particular date. Amount of cash price payable to hire vendor can also be shown as a liabilities in the balance sheet interest of a deduction from the assets.

"it should be remembered that depreciation on assets acquired under hire purchase must be charged from the date of acquisition of possession (on from the date of legal ownership) and it is to be calculated on total cash price".

After passing above mentioned journal entries in the books of hire purchaser, the following necessary ledger account can be prepared.

a.       Assets Account

b.      Hire Vender Account

c.       Interest Account

d.      Depreciation Account

Accounting Treatment in the books of Vendor

There are different methods of recording hire purchase transaction in the books of the hire vendor. It is selected according to the type and value of goods sold, volume of transaction, the length of the period of purchase, etc. Generally, the following entrees are made in the books of hire vendor for the sale of goods on hire purchase.

After passing above mentioned journal entries in the books of hire vendor, the following necessary ledger accounts can be prepared.

a.       Hire purchase Account

b.      Hire purchase sale account

c.       Interest Account

  Review of Theoretical Concept

  Write the meaning of hire purchase system.

     Hire purchase system is a special system of purchase and sale of retails business under which goods are delivered to the purchaser immediately on signing the hire purchase agreement but purchase price is recovered or collected from him/her in future in periodic installments. These installments may be monthly or quarterly or yearly or any other period as per the agreement, although the purchase gets the possession of the goods immediately, yet he/she will become the owner of the goods only on the payments of all the installments including the last installment. The entire installments paid are treated as a hire charge till the last installment is paid off.

    According to carter, "hire purchase system is a system under which money is aid for goods by means of periodical installments with the view of mean time is regarded as payment of hire and the goods become the property of the buyers only when all installments have been paid."

    Explain any five feature of hire purchase system.

    On the basis of this, it can be said that the following are te main features of hire purchase system:

a.      Agreement in writing: there is a specific agreement in writing and signed by the parties to the agreement, that is, hire vendor and hire purchaser.

b.      Possession of goods: the possession of the goods is given immediately to the hire purchase on signing the hire purchase agreement. In other words the hire purchase gets the right to use the goods on getting the possession.

c.       Payment in installments: the hire purchaser would make the payment of the hire purchase rice in monthly, quarterly, half yearly or even yearly installments according to the agreement for a fixed period of time.

d.      Ownership of the goods:  the hire purchaser would become owner of the goods only on the payment of last installment and not before that.

e.      Right to terminate the agreement: the hire purchaser has right to terminate the hire purchase agreement any time before he becomes the owner of the goods.

f.        To keep the goods in good condition: the hire purchase is under duty to take reasonable care of the goods in his possession as he/she would have done to his own goods.