Accounting For Hire Purchase

  • Post last modified:12 February 2022
  • Reading time:11 mins read

Hire Purchase

A hire purchase agreement is one under which the buyer takes delivery of goods, promising to pay the price in certain number of instalments and until full payment is made, to treat the payment as hire charges for using the said goods.

In fact, a hire purchase agreement stipulates that

  • The delivery of goods will be given by the owner of goods to the hire purchaser.

  • Payment will be made in instalments.

  • Each instalment will be treated as hire charge so that if default in respect of payment of even the last instalment is made, the seller will be entitled to take away the goods without compensating, the hire purchaser in any form, and

  • If all instalments are paid and the other conditions are fulfilled, the ownership of the goods will pass to the buyer.

Difference between Hire Purchase and Instalment system

Points of DifferenceHire Purchase SystemInstalment System
Nature of contractIt is a hiring goods agreement.It is an agreement of sale.
OwnershipOwnership of goods is
transferred after the payment
of final instalment
Ownership of the goods passes
to the buyer just signing the agreement.
RightsThe buyer cannot sell, destroy
or transfer the goods.
The buyer can sell, destroy or
mortgage or transfer as his/her
wish.
RiskAll the risks are borne by the
vendor before the payment of
final instalment.
All the risks are to be borne by
the buyer from the date of
agreement.
Risk of returnThe buyer can return the
goods before making the final
instalment.
The buyer cannot return the
goods to the seller.
Repair and maintenancehe liability of repair and
maintenance lies with the
seller provided that the buyer
takes the utmost good care
The buyer is responsible for
repair and maintenance.
Forfeiture of nstalment
paid
In case of default in payment
of instalment, paid instalment
will be forfeited and treated
as hire charges.
The act of forfeiture cannot be
activated.
Difference between Hire Purchase and Instalment system

Ascertaining the interest rate

Aa mentioned earlier, when the goods are sold on hire purchase, the price so charged by the vendor is always higher than the cash price. The excess price Let, the difference between the hire purchase price and the cash price, includes the interest charges and the compensation for risk.

However for accounting purposes the difference between the two prices is treated as the payment for interest. Thus there are basically four figures to be remembered which are as follows :

  1. Cash Price: It is a capital expenditure for purchase of an asset.

  2. Interest

  3. Down Payment

  4. Instalments

Thus one can say that

Hire Purchase price= Cash Price + Interest


Accounting records under Hire Purchase System

There are two parties to a hire purchase agreement, i.e., the Vendor (Seller) and Hirer (Purchaser). Both these parties have to maintain books of account and record all the transactions relating to that particular hire purchase.

Before explaining the accounting records let us first see what information is required for recording the hire purchase transaction in the books of account.

The list of items required for accounting records is as follows:

  1. Date of Purchase and down payment

  2. Date at which the instalments become due

  3. Date of closure of accounts
  1. Cash Price

  2. Hire Purchase Price

  3. Number, Amount and Mode of each instalment

  4. Rate of Interest VU –

  5. Rate of depreciation

  6. Method of Depreciation

Let us now see how accounting records are maintained in the books of the purchase. There are two methods by which the purchaser can record the hire purchase transaction in the books of account.

FIRST METHOD

You know that in case of hire purchase, the ownership of the goods passes to the hire purchaser after the last instalment has been paid. Since the goods do not become the property of the purchaser, he does not have any right to debit the asset at its full price.

Hence, no entry is passed when the asset is purchased unless it involves down payment. The entries are passed as and when the instalments become due and the amount is paid towards the price of the article. The journal entries are as follows :

(Books of HIRER)

  1. When the asset is purchased
    No entry

  2. When the down payments is made
    Asset A/c Dr
    To Bank A/c

  3. When the instalment becomes due
    Asset A/c Dr (cash price part of instalment)
    Interest A/c Dr (interest on instalment)
    To Hire Vendor

  4. When instalment is paid
    Hire Vendor Dr
    To Bank A/c

  5. When Depreciation is charged
    Depreciation A/c Dr
    To Asset A/c

  6. When Interest and depreciation accounts are closed by transfer to Profit &
    Loss A/c Profit & Loss A/c Dr
    To Interest A/c
    To Depreciation A/c

(Books of VENDOR)

  1. sale of goods under hire purchase
    Hire Purchaser Dr (with full cash price)
    To Sales A/c

  2. On receiving cash down payment
    Bank A/c Dr
    To Hire Purchaser

  3. On instalment becoming due
    Hire Purchaser Dr
    To Interest A/c

  4. On getting payment on the due instalment
    Bank A/c Dr
    To Hire Purchaser

Thereafter entries nos 3 to 6 would be made on payment of each instalment at the end of the year.

SECOND METHOD

In this method when the asset is purchased on hire purchase, it is assumed that the purchaser has full intention of paying all the instalments. It is believed that hire purchase is just B method of financing fixed assets.

Under this method, on purchase of plant and machinery, the Plant & Machinery Account (Fixed Asset) is debited with the total amount of Cash Price, and the corresponding credit is given to Hire Vendor’s Account.

Interest is recognised and accounted for at the time of instalments becomes due by debiting the Interest Account and crediting the Hire Vendor’s Account. For the purpose of accounting for initial cash down payment and annual instalments, the Hire Vendor’s A/c is debited on the relevant date, and the credit is given to Bank Account.

The following journal entries are passed in the books of the purchaser.

1.When the asset is purchased on hire purchase

Asset A/c Dr

To Hire Vendor (With total cash price)

2. For cash down payment –

Hire Vendor Dr

To Bank A/c

3. When the first instalment becomes due

Interest A/c Dr

To Hire Vendor a/c

4. When the first instalment is paid

Hire Vendor a/c Dr

To Bank A/c

5.For Depreciation Charge (at–the end of accounting period)

Depreciation a/c Dr

To Asset A/c

6. For transfer of interest and depreciation to

Profit & Loss A/c Profit & Loss A/c Dr

To Interest A/c

To Depreciation A/c

Entries 3 and 4 will be repeated for all subsequent instalments. Entries in books of vendor are same for both the method.


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