Hire Purchase and Instalment Sale Transaction

1. Introduction
2. Nature of Hire Purchase Agreement
3. Special Features of Hire Purchase Agreement
4. Terms used in Hire Purchase Agreements
5. Ascertainment of Cash Price
6. Ascertainment of Interest
7. Accounting for Hire Purchase Transaction
8. Repossession
9. Instalment Payment System
10. Difference of Hire Purchase Agreement and Instalment Payment Agreement

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1. INTRODUCTION

With an increasing demand for better life, the consumption of goods has been on the expanding scale. But this has not been backed up by adequate purchasing power, transforming it into effectual demand, i.e., actual sale at set or settled prices. This has created the market for what is called hire purchase.

When a person wants to acquire an asset, but is not sure how to make payment within a stipulated period of time he may pay in instalments if the vendor agrees. This enables the purchaser to use the asset while paying for it in instalments over an agreed period of time. This type of a business deal is known as hire purchase transaction. Here, the customer pays the entire amount either in monthly or quarterly or yearly instalments, while the asset remains the property of the seller until the buyer squares up his entire liability. For the seller, the agreed instalments include his interest on the assets given on credit to the purchaser. Therefore, when the total amount (being paid in instalments over a period of time) is certainly higher than the cash down price of the asset because of interest charges. Obviously, both the parties benefit in the bargain. By virtue of this, the purchaser has the right of immediate use of the asset without making immediate full payment for the asset, by this, he gets both credit and product from the same seller. From seller’s view point, he derives the benefits by way of increase in sales and also he recovers his own cost of credit.

Under the Hire Purchase System the Hire Purchaser gets possession of the goods at the outset and can use it, while paying for it in instalments over a specified period of time as per the agreement. However, the ownership of the goods remains with the Hire Vendor until the hire purchaser has paid all the instalments. Each instalment paid by the hire purchaser is treated as hire charges for using the asset. In case he fails to pay any of the instalments (even the last one) the hire vendor has the right to take back his goods without compensating the buyer, i.e., the hire vendor is not going to pay back a part or whole of the amount received through instalments till the date of default from the buyer.

1. Possession: The hire vendor transfers only possession of the goods to the hire purchaser immediately after the contract for hire purchase is made.
2. Installments: The goods are delivered by the hire vendor on the condition that a hire purchaser should pay the amount in periodical instalments.
3. Down Payment: The hire purchaser generally makes a down payment, i.e., an amount on signing the agreement.
4. Constituents of Hire purchase instalments: Each instalment consists of two elements- finance charge (interest on unpaid amount) and capital payment.
5. Ownership: The property in goods is to pass to the hire purchaser on the payment of the last instalment and exercising the option conferred upon him under the agreement.
6. Repossession: In case of default in respect of payment of even the last instalment, the hire vendor has the right to take the goods back without making any compensation.

1. Hire Vendor: Hire vendor is a person who delivers the goods along with its possession to the hire purchaser under a hire purchase agreement.
2. Hire Purchaser: Hire purchaser is a person who obtains the goods and rights to use the same from hire vendor under a hire purchase agreement.
3. Cash Price: Cash price is the amount to be paid by the buyer on outright purchase in cash.
4. Down Payment: Down payment is the initial payment made to the hire vendor by the hire purchaser at the time of entering into a hire purchase agreement.
5. Hire Purchase Instalment: Hire purchase instalment is the amount which the hire purchaser has to pay after a regular interval upto certain period as specified in the agreement to obtain the ownership of the asset purchased (on payment of the last instalment) under a hire purchase agreement. It comprises of principal amount and the interest on the unpaid amount.
6. Hire purchase price: It means the total sum payable by the hire purchaser to obtain the ownership of the asset purchased under hire purchase agreement. It comprises of cash price and interest on outstanding balances.

 

We know that the basis for accounting in the books of the hire purchaser is the total cash price. Sometimes, the total cash price may not be given. For the purpose of ascertaining the total cash price, we can use any of the following methods according to the need.

 

 

In this method, the interest included in the last instalment is to be calculated first with the help of the appropriate formula (explained below).

For example in a hire purchase transaction, apart from down payment, four other instalments are payable. The interest will be calculated first on the 4th instalment, then on the 3rd instalment, then on the 2nd instalment and lastly on the 1st instalment. Interest on down payment will be nil.

In this connection, it should be noted that the amount of interest will go on increasing from the 4th instalment to the 3rd instalment, from the 3rd instalment to the 2nd instalment and from the 2nd instalment to the 1st instalment.

We know that interest is to be calculated on the outstanding balance of cash price.

In this case, we will have to calculate the interest with the help of the total amount due on hire purchase price since the cash price is not known. For the purpose of calculating the interest, the following steps should be followed:

Step 1 : Calculate the ratio between interest and the amount due with the help of the following formula:

Ratio of interest and amount due =  Rate of interest /  (100 + Rate of interest)

 

Step 2: Calculate the interest included in the last instalment by applying the following formula:

 

Interest = Total amount due at the time of instalment x Ratio of interest and amount due (as calculated in step 1)

Step 3: Subtract the interest (as calculated in step 2) from this instalment to get the amount of outstanding cash price at the time of last instalment.

Step 4: Add the cash price calculated in Step 3 to the amount of instalment due at the end of the third year.

Step 5: Calculate the interest on the entire sum (cash price included in the 4 th instalment + amount of 3rd instalment). Deduct this interest from the total amount due at the end of 3rd year to get the outstanding cash price at the time of 3rd instalment.

Step 6: Add the cash price calculated in step 5 to the amount of instalment due at the end of 2nd year.

Step 7: Calculate the interest on the entire sum so obtained in Step 6. Deduct this interest from the total amount due at the end of 2nd year to get the outstanding cash price at the time of 2nd instalment.

Step 8: Add the cash price calculated in Step 7 to the amount of instalment due at the end of 1st year.

Step 9: Calculate the interest on the entire sum so obtained in Step 8. Deduct this interest from the total amount due at the end of 1st year to get the outstanding cash price at the time of 1st instalment.

Step 10: Add the cash price calculated in Step 9 to the amount of down payment, if any. The sum so obtained will be the cash price.

Present value of instalments is calculated as follows:

1. If present value of an annuity of ` 1 for a given period, at given rate of interest, is given Present value of instalments = Annual instalments x Present value of an annuity of ` 1 for a given period at given rate of interest
   = Annual instalment * (1+r)
2. (b) If annuity to recover ` 1 during a given period at given rate of interest is given

 

We know that the hire purchase price consists of two elements: (i) cash price; and

(ii) interest. Cash price is an expenditure incurred for the acquisition of an asset towards payment of capital (principal) amount and (ii) interest is a expense in the nature of revenue for delay in making the full payment. Ascertainment of any of these two gives the answer for the other, e.g., if we ascertain the total amount of interest, it becomes very simple to ascertain the cash price just by deducting the amount of interest from the hire purchase price.

Interest is charged on the amount outstanding. Therefore, if the hire purchaser makes a down payment on signing the contract, it will not include any amount of interest. It should be noted that though the instalments of a hire purchase agreement may be equal, the interest element in each instalment is not the same.

At the time of calculating interest, students may face the following two situations:

1. When the cash price, rate of interest and the amount of instalments are given; and
2. When the cash price and the amount of instalments are given, but the rate of interest is not given.

Now, let us consider the above two situations.

 

 

In this situation, the total amount of interest is to be ascertained first. It is the difference between the hire purchase price (down payment + total instalments) and the cash price. To calculate the amount of interest involved in each instalment the following steps are followed:

Step 1 : Deduct down payment from the cash price. Calculate the interest at the given rate on the remaining balance. This represents the amount of interest included in the first instalment.

Step 2 : Deduct the interest of Step 1 from the amount of first instalment. The resultant figure is the cash price included in the first instalment.

Step 3 : Deduct the cash price of the 1st instalment (Step 2) from the balance due after down payment. It represents the amount outstanding after the 1st instalment is paid.

Step 4 : Calculate the interest at the given rate on the balance outstanding after the 1st instalment. Deduct this interest from the amount of the 2nd instalment to get the cash price included in the 2nd instalment.

Step 5 : Deduct the cash price of the 2nd instalment (Step 4) from the balance due after the 1st instalment. It represents the amount outstanding after the 2nd instalment is paid.

Repeat the above steps till the last instalment is paid.

When the rate of interest is not given, but the cash price and the amount of instalments are given, we have to find interest rate implicit in the transaction by bifurcating the instalments between reduction in liability and finance charges (interest).

Internal rate of return (IRR) is the discount rate that equates the present value of the expected net cash outflows (amount of down-payment and instalments) with the cash price. When the net cash flows are not uniform over the life of the investment, the determination of the discount rate can involve trial and error and interpolation between interest rates.

In case of hire purchase, Internal Rate of Return Method (IRR)• method considers the time value of money, the cash price, and all cash outflows (amount of down- payment and instalments) relating to the purchase of the asset on hire purchase basis. IRR method does not use the desired rate of return but estimates the discount rate that makes the present value of subsequent net cash outflows equal to the cash price.

There are following two methods of recording the hire purchase transactions in the books of the hire-purchaser:

1. Cash price method
2. Interest suspense method

It is necessary to disclose assets taken on hire purchase basis by classifying it as “Asset on Hire Purchase”. Accordingly, amount due to the hire vendor should also be shown in his books as a liability—“Hire Purchase Creditors” with additional such classifications of amount of hire purchase instalment due and amount of hire purchase instalment not yet due.

 

 

Under this method, the full cash price of the asset is debited to the Asset Account and credited to the Hire Vendor Account, therefore, it is also called Full Cash Price Method. At the time of payment of instalment, Interest Account is debited and Hire Vendor Account is credited (with the interest on outstanding balance). When instalment is paid, the Hire Vendor Account is debited and Bank Account is credited. At the time of preparation of Final Accounts, interest is transferred to Profit and Loss Account and asset is shown in the Balance Sheet at cost less depreciation. The balance due to hire vendor is shown in the Balance Sheet as a liability.

To have proper accounting record, one should know: (1) Date of purchase of the asset; (2) Cash price of the asset; (3) Hire purchase price of the asset; (4) The amount of down payment; (5) Number and amount of each instalment; (6) Rate of interest;

(7) Method and rate of depreciation; (8) Date of payment of every instalment; and

(9) Date of closing the books of account.

1	At the time of entering into the agreement Asset Account     To Hire Vendor Account	Dr. [Full cash price]
2	When down payment is made Hire Vendor Account     To Cash / Bank Account	Dr. [Down Payment]
3	When an instalment becomes due Hire Vendor Account     To Hire Vendor Account	Dr. [Interest on outstanding balance]
4	When an instalment is paid Hire Vendor Account     To Bank Account	Dr. [Amount of Instalment]
5	When depreciation is cahrged on the asset Depreiation Account      To Asset Account	Dr. [Calcualted on cash price]
6	For closing interest and depreciation account Profit an Loss Account      To Interest Account      To Depreciation Account	Dr.

Disclosure in the balance sheet

Assets

Fixed Assets:

Asset (at cash price) xxxxxxx.xx

Less: Depreciation    xxxx.xx

xxxxxxx.xx

Liabilities

Hire Purchase Creditors:

Balance in hire vendor's A/c xxxxx.xx

Interest accrued not yet due xxxxx.xx

In the books of the Hire Vendor

There are two methods of recording hire purchase transactions in the books of the hire vendor. The selection of the method is based on the type and value of goods sold, volume of transactions, the length of the period of purchase, etc. These two methods are as follows:

 

 

 

A business that sells relatively large items on hire purchase may adopt this method. Under this method, hire purchase sale is treated as a credit sale. The only exception is that the vendor agrees to accept payments in instalments and for that he charges interest. Generally, a special Sales Day Book is maintained for recording all sales under hire purchase agreement. The amount due from the hire purchaser at the end of the year is shown in the Balance sheet on the assets side as Hire Purchase Debtors.

Journal Entries in the books of Hire Vendor

1	When goods are sold and delivered under hire purchase Hire Purchaser Account      To H.P. Sale Account	Dr. [Full cash price]
2	When the down payment is received Bank Account      To Hire Purchaser Account	Dr. [Down Payment]
3	When an instalment becomes due Hire Purchaser Account      To Interest Account	Dr. [Amount of instalment]
4	When the amount of instalment is received Bank Account      To Hire Purchaser Account	Dr. [Amount of instalment]
5	For clsoing interest Account Interest Account       To Profit and Loss Account	Dr.
6	For clsoing Hire Purchase Sales Account H.P. Sales Account        To Trading Account	Dr.

It is worth noting that

1. The entire profit on sale under hire purchase agreement is credited to the Profit and Loss account of the year in which the sale has taken place; and
2. Interest pertaining to each accounting period is credited to the Profit and Loss Account of the respective year.

This method is almost similar to the sales method, except the accounting for interest. Under this method, the hire purchaser is debited with full cash price and interest (total) included in the hire selling price. Credit is given to the H.P. Sales Account and Interest Suspense Account. When the instalment is received, the Bank Account is debited and the Hire Purchaser Account is credited. At the same time an appropriate amount of interest (i.e., interest for the relevant accounting period) is removed from the Interest Suspense Account and credited to the Interest Account. At the time of preparation of Final Accounts, interest is transferred to the credit of the Profit and Loss Account. The balance of the Interest Suspense Account is shown in the Balance Sheet as a deduction from Hire Purchase Debtors.

1	When goods are sold and delivered under hire purchase Hire Purchaser Account      To H.P. Sales Account      To Interest Suspense Account	Dr. [Full cash price + total inetrest]
2	When down payment / instalment Bank Account       To Hire Purchaser Account	Dr. [Amount of down payment/instalment]
3	For interest of teh relevant accounting period Interest Account       To Interest Account	Dr. [Amount of interest]
4	For closing interest Account Interest Account       To Profit and Loss Account	Dr.
5	For closing Hire Purchase Sales Account H.P. Sales Account       To Trading Account	Dr.

The disclosure in balance sheet of the respective parties will be:

Balance Sheet of Hire Purchaser
Asset on Hire purchase
Less: Depreciation
Liabilities
Balance Sheet of Vendor
Assets
Current assets:

Hire purchase debtors

Less: Balance in Interest suspense A/c

Liabilities

In a hire purchase agreement, the hire purchaser has to pay up to the last instalment to obtain the ownership of goods. If the hire purchaser fails to pay any one or more of the instalments, the hire vendor has the right to take the asset back in its actual form without any refund of the earlier payments to the hire purchaser. The amounts received from the hire purchaser through down payment and instalments are treated as the hire charges by the hire vendor. This act of recovery of possession of the asset is termed as repossession.

Repossessed assets are resold to any other customer after repairing or reconditioning (if necessary). Accounting figures relating to repossessed assets are segregated from the normal hire purchase entries. Repossessions are then accounted for in a separate “Goods Repossessed Account”.

So far as the repossession of assets are concerned, the hire vendor can take back the whole of the asset or a part thereof depending on the agreement between the parties. The former is called “Complete Repossession” and the latter is called “Partial Repossession”.

 

The hire vendor closes Hire Purchaser’s Account by transferring balance of Hire

Purchaser Account to Goods Repossessed Account.

The hire purchaser closes the Hire Vendor’s Account by transferring the balance of Hire Vendor Account to Hire Purchase Asset and then finding the profit and loss on repossession in Asset Account.

After repossession, the vendor may incur expenses on repossessed stock and may sell the same in due course of time.

Particulars	Books of hire purchaser	Books of hire vendor
Purchase / Sales	Asset A/c Dr.     To Hire Vendor A/c	Hire Purchaser A/c Dr.      To Sales A/c
Instalment	Hire Vendor A/c Dr.      To Cash A/c	Cash A/c Dr.       To Hire Purchaser A/c
Interest	Interest A/c Dr.      To Hire Vendor	Hire Purchaser A/c Dr.       To Interest A/c
Repossession	Hire Vendor A/c Dr.      To Asset A/c	Goods Repossessed A/c Dr.        To Hire Purchaser

Partial Repossession

In case of a partial repossession, only a part of the asset is taken back by the hire vendor and other part is left with the hire purchaser. The Journal Entries are as usual up to the date of default (excepting entry for payment) in the books of both the parties. As a portion of the asset is still left with the hire purchaser, neither party closes the account of the other in their respective books.

Assets are repossessed at a mutually agreed value (based on agreed rate of depreciation which is an enhanced rate). The hire vendor debits the Goods Repossessed Account and credit the Hire Purchaser Account with the value as agreed upon on the repossession. Similarly, the hire purchaser debits the Hire Vendor Account and credits the Assets Account with the same amount. If the repossessed value is less than the book value of the asset which is repossessed, the difference is charged to the Profit and Loss Account of the hire purchaser as ‘loss on surrender’.

 

For the remaining portion of the asset lying with the hire purchaser, the (Hire Purchaser) applies the usual rate of depreciation and shows the Asset Account at its usual written-down value.

 

In instalment payment system, the ownership of the goods is passed immediately to the buyer on the signing the agreement. The accounting entries under instalment payment system are similar to those passed under the hire-purchase system. The scheme of entries is as under:

• Buyer debits asset account with full cash price, credits vendor’s account with full instalment price and debits interest suspense account with the difference between full cash price and full instalment price. Interest is debited to interest suspense account (not interest account) because it includes interest unaccrued in respect of number of years of the contract.
• Every year interest account is debited and interest suspense account is credited with the interest of current year. Interest account.
• At the end of the year, is closed by transferring to profit and loss account.
• Vendor is paid the instalment due to him and
• Entry for the depreciation is passed in the usual way.
• The balance of vendor account should be shown in the balance sheet after deducting amount in interest suspense account.

• The seller debits the purchaser with the full amount (instalment price) payable by him and credits sales account by the full cash price and credits interest suspense account by the difference between the total instalment price and total cash price.
• Seller, like the buyer, also transfers the amount of interest due from the interest suspense account interest account every year.
• Interest account is closed by transferring to profit and loss account.
• On receiving the instalment the vendor debits cash/bank account and credits purchaser’s account.
• The purchaser’s account should be shown in the balance sheet after deducting amount in interest suspense account.

A hire purchase agreement is a contract of bailment coupled with an option to the hire purchaser to acquire the goods delivered to him under such an agreement. By the delivery of goods to the hire purchaser, the hire vendor merely pass with their possession, but not the ownership. The property or title to the goods is transferred to the hire-purchaser, on his paying the last instalment of the hire price or complying with some other conditions stipulated in the contract. At any time before that the hire-purchaser has the option to return the goods and, if he does so, he has only to pay the instalments of price that by then have fallen due. The right or option to purchase is the essence of hire-purchase agreement. In the event of a default by the buyer (hire purchaser) in the payment of any of the instalments of hire price, the vendor can take back the goods into his possession. This is legally permissible since the property in the goods is still with the vendor.

On the other hand, it may have been agreed between the buyer and the seller that the price of the goods would be payable by instalments and the property would immediately pass to the buyer; in the event of a default of instalments, it would not be possible for the vendor to recover back the goods. He, however, would have the right to bring an action against the purchaser for the recovery of the part of the price that has not been paid to him.

Analysis of the hire purchase price: The hire purchase price is always greater than the cash price, since it includes interest payable over and above the price of the goods to compensate the seller for the sacrifice he has made by agreeing to receive the price by instalments and the risk that he thereby undertakes. It is thus made up of following elements:

1. cash price;
2. interest on unpaid instalments; and
3. a charge to cover the risk involved in the buyer defaulting to pay one or more of instalments of price or that of his returning the goods in a damaged condition.

Interest is the charge for the facility to pay the price for the goods by instalments after they have been delivered. The rate of interest is generally higher than that payable in respect of an advance or a loan since it also includes a charge to cover the risk that the hirer may fail to pay any of the instalments and, in such an event, the goods may have to be taken back into possession in whatever condition they are at the time. A separate charge on this account is not made as that would not be in keeping with the fundamental character of the hire-purchase sale.

Basis of Distinction	Hire Purchase	Instalment System
Governing Act	It is governed by Hire Purchase Act, 1972.	It is governed by the Sale of Goods Act, 1930.
Nature of Contract	It is an agreement of hiring.	It is an agreement of sale.
Passing of Title (ownership)	The title to goods passes on last payment.	The title to goods passes immediately as in the case of usual sale.
Right to returm goods	The hirer may return goods without further payment except for accrued instalments.	Unless seller defaults, good are not returnable.
Seller's right to repossess	The seller may take possession of the goods if hirer is in default.	The seller can sue for price if the buyer is in default. He cannot take possession of the goods.
Rights of Disposal	Hirer cannot hire out sell, pledge or assign entitling transferee to retain possession as against the hire vendor.	The buyer amy dispose off the goods and give good title to the bona fide purchaser.
Responsibility for Risk of Loss	The hirer is not responsible for risk of lossof goods if he has taken reasonable precaution because the ownership has not yet transferred.	The buyer is responsible for risk of loss of goods because of the ownership has transferred.
Name of Parties involved	The parties involved are called Hire purchaser and Hire vendor.	The parties involved are called buyer and seller.
Component other than cash price	Components other than Cash Price include in instalment is called Hire charges.	Component other than Cash Price included in Instalment is called Interest.