Accounting for Hire Purchases PDF

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Accounting for Hire Purchases In any business sales is the Key factor of success of business. The profit of a business always depends on the volume of its sales. A big business house can affect sales on cash basis as well as on credit basis. The sale proceeds under such sales are not immediately collected but are collected under certain arrangements such as Hire-purchase system or installment system or collection after a certain period of together with interest on outstanding balances. Hire- purchase system is the most secured and effective tool of collecting the proceeds of a credit sale. Meaning and Concept of Hire-purchase system Hire-purchase system is a special system of purchase and sale of goods. Under this system purchaser pays the price of the goods in installments. The installments may be annual, six monthly, quarterly, monthly, fortnightly etc. Under this system the goods are delivered to the purchaser at the time of the agreement before the payment of installments but the title on the goods is transferred after the payment of all installments as per the hire-purchase agreement. The special feature of a hire-purchase transaction is that the payment of every installment is treated as the payment of hire charges by the purchaser to the hire vendor till the payment of the last installment. After the payment of the last installment, the amount of various installments paid is transferred to the purchaser. Thus hire-purchase means a transaction where the goods are sold by the vendor to the purchaser under the following conditions;      

The goods will be delivered to the purchaser at the time of agreement The purchaser has a right to use the goods delivered. The price of the goods will be paid in installments. Every installment will be treated to be the hire charges of the goods which is being used by the purchaser. If all installments are paid as per terms of the agreement, the title of the goods is transferred by the vendor to the purchaser. If there is a default in the payment of any installments, the vendor will take away the goods from the possession of the purchaser without refunding him any amount received earlier in the form of various installments.

Characteristics of hire-purchase system Hire-purchase agreement means a contract between the hire vendor and the hire purchaser regarding the sale of goods under the certain conditions. Usually every hire-purchase agreement shall contain the following terms;

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The cash price of the goods, cash price means the price at which goods may be purchased against cash payment. The hire-purchase price, hire-purchase price means the total amount which is payable by the hire-purchase under the agreement, The date on which the hire purchase agreement will commence. The description of the goods that will be delivered to the hire-purchaser at the commencement of the agreement. The number of installments to be paid by the hire-purchaser along with the amount of each installment and the date of payment of each installment. The down payment if any, the down payment means the amount which is required to be paid by the hire-purchaser to the hire vendor at the time of commencement of the hire-purchase agreement. The rate of interest charged by the hire vendor (optional).

Characteristics of Hire-Purchase System The characteristics of hire-purchase system are as under:

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Hire-purchase is a credit purchase. The price under the hire-purchase system is paid in installments. The goods are delivered in the possession of the purchaser at the time of commencement of the commencement of the agreement. Hire vendor continues to be the owner of the goods till the payment of last installment. The hire-purchaser has a right to use the goods as security/guarantee. The hire-purchaser has a right to terminate the agreement at any time in the capacity of a hirer. The hire-purchaser becomes the owner of the goods after payment of all the installments as per the agreement. If there is a default in the payment of any installment the hire vendor will take away the goods from the possession of the purchaser without refunding him any amount.

Difference between Hire-Purchase system and Installment payment system Installment Payment System is a system of purchase and sale of goods in which the title of goods is immediately transferred to the purchaser at the time of sale of goods and the sale price of the goods is paid in installments. In the event of default in payment of any installment, the seller has no right to take back the goods from the possession of the purchaser. He can file a suit for the 2

recovery of the outstanding balance of the price of goods sold. The following are the differences between Hire-purchaser system and Installment payment system: 

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In Hire-purchase system, the transfer of ownership takes place after the payment of all installments while in case of Installment payment system, the ownership is transferred immediately at the time of agreement. In Hire-purchase system, the hire-purchase agreement is like a contract of hire though later on it may become a purchase after the payment of last installment while in installment payment system; the agreement is like a contract of credit purchase. In case of default in payment, in hire-purchase system the vendor has a right to back goods from the possession of the hire-purchaser while in case of installment payment system, the vendor has no right to take back the goods from the possession of the purchaser, he can simply sue for the balance due. In Hire-purchase system, if the purchaser sells goods to a third party before the payment of last installment, the third party does not get a better title on the goods purchased. But in case of installment payment system, the third party gets a better title on the goods purchased.

Accounting in the books of the buyer (Hire-purchaser) There are two methods of accounting in the books of the buyer. Their detailed description is as under:-

Method A    

The asset account is debited with the “cash” cost of the item and the finance company is credited with the same amount. Interest is debited to HP interest and credited to the finance company when each installment is due. Deposit and installments paid are debited to the finance company`s a/c the balance of which is included in creditors in the balance sheet. The balance carried down each year on the finance co`s a/c is the unpaid portion of the cash cost.

The journal entries in summary are as follows: 3

1. DR CR

Asset a/c Finance Co.

2. DR

HP Interest

CR

Finance Co

3. DR CR

Finance Co. Cash/Bank

-“Cash” cost

-Interest paid when each installment is due.

–Deposit and installment paid

With the hire purchase agreement the buyer treats his acquisitions fixed assets when he obtains possessions after becoming party to the contract, despite the fact that he is not the legal owner at that stage. Depreciation on fixed assets bought on hire purchase must be charged from the date of acquisition of possession (not from the date of legal ownership) and calculated on the cash cost price. Method B 

 

The asset a/c is debited with the “cash” cost of the item but the finance co. is credited with the full hire purchase price, the interest element of which is debited to HP Interest Suspense. When each installment is due, the appropriate amount if interest is released from the HP Interest suspense to HP Interest. Deposit and installments paid are deposited to the finance co`s a/c, the balance of which,, minus the balance on the HP Interest Suspense, is included in creditors in the balance sheet.

The journal entries in summary are as follows: 1. DR DR CR

Fixed Asset HP Interest Suspense Finance Co.

2. DR CR

HP Interest expense HP Interest Suspense

-Interest

3. DR CR

Finance Co. Cash/Bank

–Deposit & Installment

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-Cash price -Interest -Full Hire Purchase price

Example 1 On 1st April 2009 Mr X purchased from Ms Y and Co. one ‘Motor Truck’ under hire purchase system, $5 000 being paid on delivery and the balance in five annual installments of $7 500 each payable on the 31st March each year. The cash price of the motor truck is $37 500 and vendors charge interest at the rate of 5% per annum on yearly balances. The depreciation policy of Mr X is to write off 20% per annum on a straight line basis assuming a residual nil. Required: Prepare the appropriate a/cs in the books of Mr X to record the above transactions using Method A and Method B. Exercise 1 On 30 September 2006, A. Mashu who prepares final accounts annually to 30 September bought a lorry on hire purchase from the Vehicle and Finance Co.Ltd. The cash price of the lorry was $3 081 000. Under the terms of the hire purchase agreement, Mashu paid a deposit of $1 000 000 on September 2006, and two installments of $1 199 000 on 30 September 2007 and 2008. The hire vendor charged interest at 10 percent per annum on the balance outstanding on 1 October each year. All payments were made on the due dates. Mashu maintained the motor lorry account at cost and accumulated the annual provision for depreciation, at 25 percent on the diminishing balance method, in a separate account. Required to: 1) Prepare the following accounts as they would appear in the ledger of A. Mashu for the period of the contract: a) Vehicles and Finance Co Ltd b) Motor lorry on hire purchase c) Provision for depreciation of motor lorry d) Hire purchase interest payable 2) Show how the above matters would appear in the balance sheet of A. Mashu at 30 September 2008. The Vehicle and Finance Co Ltd prepares final accounts annually to 30 September, on which date it charges A. Mashu with the interest due.

Exercise 2 5

Takura Ltd acquired two big 50 ton trucks on 1st January 2008 for 129 150. The cash price of these trucks was 90 000. The deal was financed by Granite (Financing) Ltd and the terms of the hire purchase contract required a deposit of 30 000 on delivery, followed by three installments on 31st December 2008, 2009 and 2010 of 33 000 and 33 150 respectively. The true rate of interest was 30% per annum. The depreciation policy of Takura Ltd was to write off 20% per annum on a straight line basis assuming a residual value of nil. Required: Prepare the appropriate a/cs in the books of Takura Ltd to record the above transactions using method A and B. You should ignore the fact that this company has an opening balance on its vehicles and provisions for depreciation on vehicle a/cs. Accounts after 2010 need not be prepared. Show the relevant balance sheet entries at the end of 2008.

Accounting in the books of Seller (Hire-Vendor) There are many ways of drawing up the final accounts of a business which sells goods on hire purchase. The method used should be the one most suitable for the business.  

The supplier can spread the gross profit and hire purchase interest over the contract period without much difficulty. Where a supplier sells goods to a customer via a finance co. the seller can take full credit for gross profit at point of sale, but the finance co. should take credit for hire purchase interest over the contract period on some suitable basis.

There are two methods of accounting for assets bought through hire purchase arrangement. Method A 1. DR CR

Customer a/c HP Sales

-“Cash” sale price

2. DR CR

Interest to customer`s a/c HP Interest Received

-when each installment is due

3. DR CR

Bank Customer a/c

- Deposit & installments received

The customer`s a/c at the end of the period represents that part of the cash sale price not yet due or received.

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At the end of each period the balance on HP Sales and on HP Interest Received are transferred to HP Trading as credit. The HP Trading a/c is then debited with the cost of the hire purchase goods sold. A provision for unrealized profit is raised to suspend the appropriate portion of gross profit included in selling price. Movements in this provision are reflected in HP Trading and in Provision for Unrealized profit a/c. The balance of HP Trading is called gross profit but is really a combined figure of pure gross profit & of hire purchase interest earned during the period and is transferred to the P & L a/c. The seller treats his disposal of goods as sales on parting with possession of them after becoming party to the contract, despite the fact that he is still the legal owner at that stage. The provision for unrealized profit required under both methods is calculated using the formula: Balance of cash selling price not yet due X Gross Profit Total cash selling price

OR Gross Profit % X Balance of cash selling price not yet due

REPOSSESSIONS      

When customers stop paying their installments before they should do, the goods can be taken away from them this is called repossession. The amount already paid by the customers will be kept by the seller. Goods repossessed in this manner may be sold. Firstly, however, they may need to be repaired or reconditioned. The figures relating to repossessed items should be segregated from those which continue under hire purchase contracts in the normal way. Repossessions are then accounted for in a separate a/c of that name. One advantage of this approach is that the gross profit (from which the gross profit % is then calculated) appearing in Hire Purchase Trading, is not distorted by the (abnormal) profit or loss on repossessed goods.

The journal entries are as follows: 1. DR

HP Sales

-HP selling price of the repossessed goods 7

CR

Debtors

Under the provision for unrealized profit method the effect of this is to reduce the amount subsequently transferred to HP Trading 2. DR 3. CR

Debtors Repossession

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-with the deposits % installment already -received on the repossessed goods

The cost of goods sold on hire purchase is split. That relating to repossessed goods is debited to repossessions & the rest relating to goods still under hire purchase in the normal way, is debited to HP Trading. In this case the corresponding credit is in (general) Trading. The valuation figure of repossessed stock is credited to Repossession and then carried down that a/c as a debit balance. The balance on Repossession is P/L and is transferred to (general) Trading a/c.

Example 3 The following figures are a summary of the sales on hire purchase made by a retailer of electrical goods during his first year of trading. Goods sold on hire purchase @ cost price

$45 000

@ Hire purchase selling price

$75 000

Deposits received

$25 000

Installments

$30 000

The terms of the standard contract require a deposit of one third of the hire purchase price of the goods followed by 12 equal monthly installments.

Goods costing $900 and sold on hire purchase for $1 500 were repossessed after deposits of $500 and installments of $200 had been received. These goods were then valued at $300, subject to reconditioning estimated at $50. Required: 8

Prepare appropriate accounts to record these transactions.

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