Accounting for hire purchase and instalment system

Theory and problems

Meaning of hire purchase contract

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A contract of hire purchase is a contract where goods are purchased or sold with the stipulations that: The delivery of goods will be given by the owner of the goods to the hire purchaser The payment of the price for the goods will be made in instalment Ownership of the goods passes to the hire purchaser only on payment of all the instalment In the event of hire purchasers failure to pay any instalment, the hire vendor will be entitled to seize the goods and adjust the money paid by the hire purchaser against the hire charges for the use of goods.

In a contract of hire purchase, the hire vendor parts only with the possession of goods but not with its ownership. He retains the ownership with him till he receives all the stipulated instalments of hire. The hire purchaser, of course, does not get the ownership but gets the right to use the goods as per his choice. He will get the ownership only on payment of all the stipulated instalments . In case he decides not to buy the goods, he may terminate the contract by refusing to pay any future instalments towards the cost

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The total payment to be made by a buyer in the case of purchase of goods under the system of hire purchase is always more than the payment that he will have to make in case he buys goods for cash. This is because the hire purchase price, besides cash price of goods, includes the charges for the following: Interest for payment being made over a period of time instead of a single cash down payment The risk taken by seller in the event of the buyers failure to pay the price of goods The registration, insurance, expenses, etc. of delivering the goods The difference between hire purchase price and the cash price is known by different names such as hire purchase charges, finance charges and interest charges.

Terminology

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3.

Hire purchase agreement- It means 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 of the agreement and includes the agreement under which: Possession of goods is delivered by the owner thereof to a person on condition that such person pays the agreed amount in periodical instalments The property in goods is to pass to such a person on the payment of the last instalment; and Such a person has a right to terminate the agreement at any time before the property so passes

Hire purchase price -Total sum payable by the hirer under a hire purchase agreement Hirer A person who obtains or has obtained possession of the goods from the owner under a hire purchase agreement Cash price Price at which goods may be purchased by hirer for cash Hire purchase charges Difference between hire purchase price and cash price as stated in hire purchase agreement Net cash price - cash price of goods sold less any deposit payable by hirer by way of initial payment

Net hire purchase price - Total amount of hire purchase price less delivery, registration and insurance expenses. Net hire purchase charges Difference between net hire purchase price and net cash price of such goods Cash price instalments Amount which bears to the net cash price, the same proportion, as the amount of hire purchase instalment bears to the total amount of hire purchase price. It can be expressed as : = Hire purchase instalment x Net cash price Hire purchase price

Systems of accounting records

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When goods of substantial sales value are the subject matter of sale. e.g. trucks, heavy machinery etc. When goods of small sales value are the subject matter of sale. e.g. radios, television sets, refrigerators, etc.

Accounting records for goods of substantial sales value

In case of hire purchase transactions relating to goods of substantial value, a proper distinction has to be made between cash price and hire purchase charges. Cash price paid by the hire purchaser is an expenditure of a capital nature and hence debited to the concerned asset account and amount paid as interest is a revenue expenditure and is ultimately charged to profit and loss account.

Calculation of interest
a) When cash price, rate of interest, hire purchase price, number of instalments etc. are all given The interest is to be calculated on the outstanding balance of cash price at the stipulated date.

b) If rate of interest is not given- The interest included in each instalment will be calculated on the basis of the hire purchase price outstanding in the beginning of each year c) If cash price is not given- Interest as well as cash price will be calculated by working backwards

Accounting entries in the books of Hire purchaser

1. 2.

There are two methods for making accounting entries of the hire purchasing transactions in the books of the hire purchaser: When asset is recorded at full cash price When asset is recorded at the cash price actually paid

When asset is recorded at full cash price

In this method, entries regarding hire purchase transactions are recorded on this basis that the hire purchaser having agreed to buy the asset has become practically (not technically) the full owner of the asset. The following journal entries are passed in the books of the buyer for recording hire purchase transactions according to this method:
On purchase of asset: Asset A/c Dr. To Hire vendor (With full cash price of the asset) On making cash down payment: Hire vendor A/c Dr. To Cash/bank (with actual cash down payment)

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3. For interest due: Interest A/c Dr. To Hire vendor (Interest is calculated on outstanding become due)

amount when instalment

4. On payment of hire purchase instalment Hire vendor A/c Dr. To Cash/bank (with amount paid) 5. For depreciation of the asset: Depreciation A/c Dr. To Asset A/c (At the end of the accounting period)

At the end of the accounting period, the total amount of interest due to the hire vendor and depreciation of the asset are transferred to the Profit and Loss A/c. In case any expenditure is incurred on repairs of the asset, the amount will also be charged to the Profit and Loss A/c of the year in which such repairs are done. At the end of the accounting year, the asset account and the vendors account will appear in the balance sheet as follows:
Liabilities Rs. Assets Asset (after depreciation) Less: Amount due to hire vendor Rs.

When asset is recorded at the cash price actually paid

This method recognises the fact that the hire purchaser does not become the owner of the asset till he makes the payment of final instalment. Hence , no entry is passed when agreement for hire purchase is signed. Entries are passed at the time of payment of each instalment. The following journal entries are passed for hire purchase transactions according to this method:

1. On making cash down payment: Asset A/c Dr. To Cash/bank (with actual cash down payment) 2. On hire purchase instalment becoming due Asset A/c Dr. Interest A/c Dr. To Hire vendor (Asset account id debited with the amount of cash price included in each instalment. The interest on outstanding cash price is debited tot the interest account)

3. On payment of hire purchase instalment Hire vendor A/c Dr. To Cash/bank (with amount paid) 4. For depreciation of the asset: Depreciation A/c Dr. To Asset A/c (At the end of the accounting period) At the end of the accounting period, the total amount of interest due to the hire vendor and depreciation of the asset are transferred to the Profit and Loss A/c as in the earlier case. Since hire vendors account is credited only with the amount of instalment due and not with full cash price and, therefore, there will be no balance in his account once his instalment is paid to him. The asset account will appear in the balance sheet as follows:
Liabilities Rs. Assets Asset (after depreciation) Rs.

Accounting entries in the books of Hire vendor

The hire vendor takes the sale of goods on hire purchase as an ordinary sale. He, therefore, debits the account of the hire purchaser and credits the sales account with the full cash price as soon as the contract is signed. The journal entries to be passed by the hire vendor are as follows:

1.

On sale of goods under hire purchase: Hire purchaser A/c Dr. To Sales A/c (with full cash price) On receiving cash down payment: Cash/bank A/c Dr. To Hire purchaser (With the amount of cash down payment)

2.

3. For interest due Hire purchaser A/c Dr. To Interest A/c (Interest is calculated when any instalment becomes due on the outstanding balance in the account of the hire purchaser) 4. On getting payment of the instalment Cash/bank A/c Dr. To Hire purchaser ( With the amount of instalment received)

Default and repossession

In case the hire purchaser fails to make payment of an instalment, the hire vendor may seize the goods and forfeit all amounts paid by the hire purchaser so far. Seizure of goods may be partial or full depending on the circumstances and the agreement between the parties. Of course, in case of partial seizure, only a part of the amount paid by the hire purchaser will be forfeited by the hire vendor. The hire vendor may, after seizing the goods, spend some money on the goods for getting them repaired and reconditioned and later on sell them.

Journal entries for Default and repossession (In the books of buyer)
1.Usual entries for interest and depreciation till due date of the instalment should be passed. 2. In case of full seizure of the asset by the hire vendor, any amount standing to the credit of the hire vendor will be transferred to the asset account. Any balance in the asset account will be transferred to the Profit and Loss account. a) For transferring the balance of the vendors account Hire vendor A/c Dr. To asset A/c b) For transferring the balance of the asset account Profit and Loss A/c Dr. To Asset A/c

Partial seizure

Sometimes hire vendor may leave a portion of the asset with the hire purchaser. In such a case, an agreement is made regarding the value at which the seized asset will be taken back by the hire vendor. The value so agreed will be debited to the hire vendor and credited to the asset account. Such value is generally lower than the value at which the asset is appearing in the books of the hire purchaser. The difference between the book value of the asset and the value at which it has been taken over by the hire vendor is a loss which will be written off from the Profit and Loss account.

Entries in the books of hire vendor

1. The hire vendor will pass usual entry for the interest due from the hire purchaser till the due date of the instalment 2. On repossession of goods: Goods repossessed A/c Dr. To Hire purchaser (With the amount due from the hire purchaser or, in case of partial seizure, with the value agreed) 3. For repairs, etc. of the goods repossessed: Goods repossessed A/c Dr. To Bank 4. On selling of the goods repossessed: Cash/bank A/c Dr. To Goods repossessed A/c 5. Any profit or loss on sale of repossessed goods will be transferred to the Profit and loss account For loss: Profit and loss A/c Dr. To Goods repossessed A/c For profit: The entry will be reversed

Accounting records for goods of small sales value

In cases where the goods sold on hire purchase are of small sales value, the transactions are numerous, and the parties of agreement vary, it is necessary to have a simple but adequate system of maintaining record of hire purchase transactions. It may not be possible for the vendor to keep an account of each individual customer to whom he has sold the goods on hire purchase. He generally maintains a memorandum record of the hire purchase transactions in a hire purchase sales register with appropriate columns.

Information collected from the hire purchase sales register

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Cost price of the goods sold on hire purchase- It is the cost of goods sent on hire purchase. Cost will be recorded only to the extent of instalment due Value of goods sold on hire purchase- It is the value of goods sent on hire purchase and actual sales will be recorded to the extent of hire purchase instalments due. Cash received- Total of the cash down payment and amount of instalment paid by the hire purchase customer during the accounting year Total instalments due but unpaid- Amount of instalments which have become due during the accounting year but has not been paid by the customers. This amount is also called Hire purchase debtors Total amount of instalments not yet due- Total amount of those instalments in respect of goods sold on hire purchase which are to be received in the next accounting period. It is also called hire purchase stock or stock with the customers

Ascertainment of profit

1. 2.

The profit made by the vendor on hire purchase transactions in case of goods of small sales value can be ascertained by any of the following two methods: Debtors method Stock and debtors method

Debtors method

In case of this method, a hire purchase trading account is prepared to ascertain the amount of profit or loss made on goods sold on hire purchase. The accounting entries are shown below: For goods sold on hire purchase: Hire purchase trading A/c Dr. To Goods sold on Hire purchase A/c (At hire purchase price) For cash received from customers: Cash A/c Dr. To Hire purchase trading A/c For instalments due but unpaid at the end of the accounting year: Hire purchase Debtors stock A/c Dr. To Hire purchase trading A/c

For instalments not yet due at the end of the accounting year: Hire purchase stock A/c Dr. To Hire purchase trading A/c For ascertaining profit- Since the goods sold on hire purchase as well as stock lying with hire purchase customers are being shown at hire purchase price, it will be necessary to make proper adjustments for loading in the hire purchase trading account by means of the following entries: a) For loading included in goods sold on hire purchase Goods sold on Hire purchase A/c Dr. To Hire purchase trading A/c b) For loading included in stock with the customers at the end of the accounting year Hire purchase trading A/c Dr. To stock reserve

Hire purchase stock at the end of the accounting year becomes the opening stock of the next accounting year. It will, therefore, be shown on the debit side of the hire purchase trading account next year. The balance in the stock reserve account, carried forward from the last year, will be transferred to the hire purchase trading account by means of the following entry: Stock reserve A/c Dr. To Hire purchase trading A/c For transfer of cost of goods sold on hire purchase- The balance of the goods sold on hire purchase account represents the cost of goods sold on hire purchase. It will be transferred to the ordinary trading account or the purchases account by means of the following journal entry: Goods sold on hire purchase A/c Dr. To Trading/purchase A/c

Default and repossession

In the event of hire purchasers failure to pay the instalment on the due date, the hire vendor may seize the goods and forfeit instalments so far paid by him. The following journal entry will be passed in the event of such a seizure in the books of the hire vendor: Goods repossessed A/c Dr. To Hire purchase trading A/c The true value of the goods repossessed may be ascertained on the basis of following formula: Unpaid amount x Cost price of the goods sold on hire purchase/ hire purchase price

Memorandum hire purchase trading Account

If the hire purchase trading account is prepared at the hire purchase price (without making adjustments for loading), the two sides of the hire purchase trading account will tally. Thus, any missing information can be found out by preparing a Memorandum hire purchase trading Account. After finding out the information, the hire purchase trading account may be prepared and the profit can be ascertained after making adjustments for loading

Proforma of Memorandum hire purchase trading Account

Particulars
To opening balance: Stock with customers Instalment due To goods sold on hire purchase

Rs.

Particulars
By cash received By goods repossessed By closing balances: Hire purchase stock Instalments due

Rs.

Calculation of profit or loss on Hire purchase

Having prepared the memorandum hire purchase trading account, profit or loss made on hire purchase can be ascertained either by preparing a Hire Purchase Adjustment A/c or by a Hire Purchase Trading A/c.

Proforma of Hire Purchase Adjustment A/c

Particulars
To Stock Reserve( with the amount of loading in closing stock) To Loss on goods repossessed( Difference between the amount unpaid and the value of the goods repossessed) To profit

Rs.

Particulars
By stock reserve (with the amount of loading in opening stock) By goods sold on hire purchase (with the amount of loading in goods sold on hire purchase)

Rs.

Proforma of Hire purchase trading Account

Particulars To opening balance: Stock with customers Instalment due To goods sold on hire purchase To stock reserve (loading in closing stock) To Profit transferred to profit and loss A/c Rs. Particulars By cash received By goods repossessed (at realisable value) By stock reserve (loading in opening stock) To goods sold on hire purchase (loading) By closing balances: Hire purchase stock Instalments due By loss transferred to profit and loss A/c Rs.

Stock and Debtors system

The profit made on hire purchase transactions can also be ascertained according to Stock and debtors system is done as in the case of branch accounts. Separate accounts are opened for Hire purchase stock A/c, Hire purchase Debtors A/c, Goods sold on hire purchase A/c, Hire purchase adjustment A/c etc.

Journal entries under stock and Debtors system

For goods sold on hire purchase Hire purchase stock A/c Dr. To Goods sold on hire purchase (at hire purchase price) For receiving cash down payments Cash/bank A/c Dr. To Hire purchase stock A/c For total instalments due during the year Hire purchase Debtors A/c Dr. To Hire purchase stock A/c For instalments received from hire purchase customer Cash/bank A/c Dr. To Hire purchase Debtors A/c

For goods repossessed Goods repossessed A/c To hire purchase stock A/c To Hire purchase debtors A/c

Dr.

(with the amount unpaid) (with the amount not due) (with the amount due)

For loss on goods repossessed Hire purchase adjustment A/c Dr. To Goods repossessed A/c (with the difference between instalments unpaid and realisable value of the goods repossessed) For loading in closing stock with customers Hire purchase adjustment A/c Dr. To Stock reserve

For loading in opening stock with customers Stock reserve A/c Dr. To Hire purchase adjustment A/c (opening stock of this year must have been the closing stock of the last year and hence stock reserve must have been created last year. This account is now closed by transferring it to Hire purchase adjustment A/c)
For loading in goods sold on hire purchase Goods sold on hire purchase A/c Dr. To Hire purchase adjustment A/c For transfer of profit on hire purchase Hire purchase adjustment A/c Dr. To profit and loss A/c For transfer of balance of Goods sold on hire purchase A/c representing goods sold on hire purchase Goods sold on hire purchase A/c Dr. To Purchases (or general trading or Stock at shop) A/c

Lease Accounting

Lease may be defined as, a contract whereby the owner of the asset (lessor) grants another party (lessee) the exclusive right to use the asset usually for an agreed period of time in return for the payment of rent In other words, a contract of lease provides a person (lessee) an opportunity to use an asset which belongs to another person (lessor). Hence it is the 1) right to own and 2) right to use

TYPES OF LEASE AGREEMENTS

Lease agreements are basically of two types. They are (a) Financial lease and (b) Operating lease. (c) Sale and lease back

FINANCIAL LEASE

Long-term, non-cancellable lease contracts are known as financial leases. The essential point of financial lease agreement is that it contains a condition whereby the lessor agrees to transfer the title for the asset at the end of the lease period at a nominal cost. At lease it must give an option to the lessee to purchase the asset he has used at the expiry of the lease. Under this lease the lessor recovers 90% of the fair value of the asset as lease rentals and the lease period is 75% of the economic life of the asset. The lease agreement is irrevocable. Practically all the risks incidental to the asset ownership and all the benefits arising there from are transferred to the lessee who bears the cost of maintenance, insurance and repairs. Only title deeds remain with the lessor. Financial lease is also known as capital lease. In India, financial leases are very popular with high-cost and high technology equipment.

Accounting treatment in the books of lessee

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The lessee strictly capitalises the present value of the minimum lease payments as the fixed asset and this is the amount also recorded as the liability. The present value of the minimum lease payments normally equates to the cash price. The asset has to be depreciated over the shorter of the period of the lease and the useful life of the asset. The loan accrues interest which should be recognised to give a constant periodic return on the balance of the outstanding loan. The rental payment is not therefore simply a revenue expense but represents partly the repayment of the capital element of the loan and partly the finance charge on the loan (i.e., interest). The total finance charge is the difference between the minimum lease payments and the present value of the minimum lease payments.

Accounting treatment in the books of lessor

Such lessors are normally banks or similar lending institutions. When entering into a finance lease the lessor is in substance making a loan which will be repaid with interest. Despite having legal title to the asset subject to the lease, the lessor does not recognise this as an asset on its balance sheet, as it does not control the asset and does not have access to the future economic benefits. The lessor does however have the asset of a future income stream and accordingly recognises a debtor net investment in finance leases .

OPERATING LEASE

An operating lease stands in contrast to the financial lease in almost all aspects. This lease agreement gives to the lessee only a limited right to use the asset. The lessor is responsible for the upkeep and maintenance of the asset. The lessee is not given any uplift to purchase the asset at the end of the lease period. Normally the lease is for a short period and even otherwise is revocable at a short notice. Mines, Computers hardware, trucks and automobiles are found suitable for operating lease because the rate of obsolescence is very high in this kind of assets.

Accounting treatment for operating leases

The accounting treatment for an operating lease is straightforward for both the lessor and the lessee. The lessee has incurred an operating expense, so the lease rental payable is written off in the profit and loss account. The lessee has to disclose in the notes to the accounts the amount charged in the year and the amount of the payments to which the entity is committed at the year end. The lessor has earned revenue from renting out the asset and accordingly recognises the lease rental receivable as income in the profit and loss account.

SALE AND LEASE BACK

It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a party (the buyer), who in turn leases back the same asset to the owner in consideration of lease rentals. However, under this arrangement, the assets are not physically exchanged but it all happens in records only. This is nothing but a paper transaction. Sale and lease back transaction is suitable for those assets, which are not subjected depreciation but appreciation, say land. The advantage of this method is that the lessee can satisfy himself completely regarding the quality of the asset and after possession of the asset convert the sale into a lease arrangement. It is considered as a source of finance.

Accounting treatment
The transaction is regarded purely as a refinancing exercise. The asset is not treated as if it has been sold and the profit on sale is not taken. The asset stays in the vendor's balance sheet at its book value and the sale proceeds is shown as a creditor.