1.0 INTRODUCTION
Transfer of goods or assets from the owner to a user lead to various financial arrangements. The goods or assets can be transferred to the user with the arrangement that he/she would be paying rental charges monthly or annually and the ownership remains with the vendor. That is hire arrangement. The goods or assets can be sold to the user (customer) with the customer paying cash immediately. That is for cash sales (for the owner) or cash purchases (for the customer). But where the sales of the goods or assets to the customer is for other reasons than immediate cash payments, various arrangements have to be considered for the payment, which will definitely be in the future.Payment can be made within an agreed period of time or by the acceptance of bill of exchange after which the ownership would be transferred. Secondly, the transaction may be under a credit sales arrangement whereby the goods become the property of the customer (buyer) immediately but payment for them takes place over a stipulated period. To the customer, it is called credit purchases. Thirdly, the payment can be subjected to Hire-purchase agreement.
This Unit discusses accounting treatments of hire-purchase arrangement and the payments that are to follow the various transactions under the arrangement.
2.0 OBJECTIVES
At the end of this unit, you should be able to:- understand what hire purchase is all about
- appreciate the difference between hire purchase and credit sales
- Observe the accounting treatment with respect to hire purchase transactions
- know how to treat installment payments.
3.0 MAIN CONTENT
3.1 Accounting for Hire-Purchase Transactions
3.1.1 The Concept of Hire-Purchase and Payments under the Arrangement
When goods are bought under a hire purchase agreement, the legal title to the goods does not pass to the purchaser until every installment has been paid and a small amount, usually included in the last payment, is paid which legally exercises an option to buy the goods. Thus to buy any asset on hire purchase arrangement is legally to hire the goods until certain time, when the option can be exercised to take over the legal title to the goods. Normally the hire purchaser is not compelled to complete the transaction. If he so wishes he may return the asset without making any further installmental payment. He will, however, forfeit the right to have any of his previous installments repaid to him. On default the seller can reclaim the goods, subject to certain provisions of the Hire Purchase Acts. The repossessed items taken back into stock are not new and have to be revalued accordingly.A variation of this procedure is that the vendor sells the goods outright to another party (e.g. finance company) which then follows the procedure above and enters into a hire purchase contract with the hire- purchaser.
SELF ASSESSMENT EXERCISE 1
- What do you understand by the concept of hire-purchase?
- How is installmental payment made in a hire-purchase arrangement?
3.2 Accounting Treatment
Under the hire purchase arrangement, the hire purchaser obtains possession of the goods at the outset, but the ownership remains with the vendor until the end of the hiring period. On strict legal interpretation of the facts, the vendor should not take credit for any profit and the hire- purchaser should not debit the cost of the items until the hiring period has ended.Accounting, however, looks at the substance of the transactions rather than at its legal form. Consequently, the vendor recognizes profit as arising over the period of hire-purchase instead of at the end. Similarly, the hire-purchaser makes the necessary entry in purchases or fixed assets account at the beginning of the period and not after the option fee has been paid.
Under a hire purchase arrangement, the selling price consists of cost plus gross profit (thus giving cash price) plus a further sum of hire purchase interest by way of compensation to the vendor for the delay in receiving full payment and for the attendant risks. This is reasonable imposition because the vendor may have had to borrow money from other sources to finance the deal, on which he would pay interest. Another justification is that the money tied up in the deal might have been earning a return by being invested inside or outside the business of the vendor.
Items of hire purchase dealt with in the accounts of the businesses are invariably fixed assets. This is because acquiring trading stock and other short-term items on hire purchase would require so short a hiring period as to nullify the advantages of hire-purchase arrangement.
From the point of view of the buyer, under a hire purchases contract, the purchase price consists of two elements- the “cash” cost price and the hire purchase interest- which together makes up the hire purchase price but which must be accounted for separately. It should be noted that installmental payment can be equal or unequal and the buyer is expected to pay as at when due, failure to do so can lead to repossession of the good/item. In the balance sheet the cash price paid is treated as an asset while the cash price not paid is regarded as liability. Also future interest not paid is not regarded as liability because interest is charged to profit and loss account as it accrues.
From the point of the view of the seller under hire purchase contract, the selling price consists of three elements: (i) the purchase price and (ii) the gross profit, which together give the “cash” selling price, and (iii) the hire purchase interest which makes the latter up to the hire purchase selling price.
SELF ASSESSMENT EXERCISE 2
- Discuss the accounting treatments on the relationship between the vendor and hire-purchaser.
- From the point of view of the seller in a hire-purchase contract, the selling price consists of three elements. Explain them.
3.3 Journal Entries for Hire-Purchase Transactions
Different accounting journal entries apply to the vendor and to the hire- purchaser of goods, as follows:Notes:
- Hire purchase vendor Account is to be closed at the end of the hiring period.
- Assets Accounts will continue to show the historical cost of the asset hire-purchased.
- Hire purchased Interest Account is to be closed, periodically, to the profit and loss account of the hire-purchaser making the interest to form part of his business running expenses.
- Provision for depreciation account is to be accumulating up to the end of the hiring period, and it is the accumulated depreciation that is to be taken to the balance sheet as a deductible expense out of the assets value, at the end of each accounting period.
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