Accounting for Hire Purchase
Hire Purchase is the agreement that seller allows buyer to purchase assets with installment rather than paid full amount. The buyer will make an initial down payment and pay the remaining balance plus interest as an installment. The ownership will not transfer to the buyer until the last installment is completed. It is usually used for the sale and purchase of long-term assets such as furniture, home appliance, and higher-cost electronics.
Hire Purchase represents a loan from seller to the buyer and getting the asset to use immediately. The buyer has the obligation to pay the monthly payment to seller until all payments are made. In addition, buyer needs to pay the interest to seller over the outstanding balance. Even the buyer is able to use the asset, he does not have legal ownership over the asset. The seller has the right to take back the asset if the buyer unable to pay the monthly payment.
In order to reduce the credit risk, seller may finance the hire purchase to a third party such bank and other financial institution. It will help the seller to focus on the business operation rather than working on the credit management.
Hire purchase is the term used in the UK to represent the installment plant which we usually saw in the US.
Hire Purchase Example
Mr. A and company ABC have made the hire purchase agreement of the car. The car costs $ 10,000 and it requires to pay 30% initial payment and the remaining balance will be paid monthly with interest expense. The monthly payment over 3 years is equal to $ 200.
Initial payment = 10,000 * 30% = $ 3,000
Total monthly payment = $ 200 * 36 months = $ 7,200
Interest = (3,000 + 7,200) – 10,000 = $ 200
Accounting for Hire Purchase
Hire purchase is the asset financing that allows the company to use the assets over a period of time in exchange for the installment. It means that buyers pay installments for both principal plus interest over the asset’s cost. It will be cheaper to pay the total amount the first time. If they want to pay installment, it must include the interest as the buyer receive cash inflow over in the future.
During the payment, assets still belong to the seller however, buyer has the right to use assets.
From an accounting perspective, buyer cannot record fixed assets yet as they still belong to the sellers. Buyer only has the right to use the assets.
Accounting for hire purchase is very similar to finance lease, so lessee has to record the following item:
- Right to use assets
- Lease liability
- Interest expense
- Depreciation Expense
Journal Entry for Hire Purchase
At the beginning of the hire purchase, buyer pays for the initial deposit which depends on the agreement between both parties. Buyer/lessee has the obligation to pay the installment in exchange for the right to use the underlying asset. The company has to record this asset at it grant the right to enjoy the future economic benefit of assets belong to other entities.
The company can recognize the right to use assets which present on balance sheet. It also requires the recognize lease liabilities which is the obligation to pay for the installment to obtain the assets at the end of the term.
They make journal entry by debiting right to use assets and credit lease liabilities.
| Account | Debit | Credit |
|---|---|---|
| Right to Use Assets | 000 | |
| Lease Liability | 000 |
Right to use assets will be classified as fixed assets on balance sheet, it should show in a separate class that is easy to read. At the same time, the lessee is also required to record lease liabilities which is the obligation to pay the installment. The amount record here is the present value of lease payment discounted at the effective interest rate. It is lower than the balance on the payment schedule.
At the end of the accounting period, lessee needs to recognize interest expense over the lease liability. It will increase the lease liability to the future value that is equal to the payment schedule. The interest expense will calculate base on the effective interest rate.
Company simply debits interest expense and credit lease liability.
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 000 | |
| Lease Liability | 000 |
On the scheduled date, the company needs to pay the installment which depends on the schedule. The payment will reduce cash from company and lease liability. The journal entry is debiting lease liability and credit cash. The lease liability will be zero at the end of a payment schedule.
| Account | Debit | Credit |
|---|---|---|
| Lease Liability | 000 | |
| Cash | 000 |
At the end of the accounting period, the company need to record the depreciation expense over the right to use assets. The fixed assets will be depreciated over time when company uses them in operation, so we have recorded the depreciation expense.
As the assets will be transferred lessee at the end of hire purchase agreement, so depreciation expense must calculate base on fixed assets’ useful life which is longer.
| Account | Debit | Credit |
|---|---|---|
| Depreciation Expense | 000 | |
| Right to use asset | 000 |
Hire Purchase Journal Entry Example
Company XYZ purchase a machinery using hire purchase agreement with the supplier. The hire purchase agreement requires XYZ to pay $ 100,000 for four years. The machinery has a useful life of 6 years. The effective interest rate is 5%.
The payment schedule is base on the following table:
| Year | Amount |
| 1 | 100,000 |
| 2 | 100,000 |
| 3 | 100,000 |
| 4 | 100,000 |
Supplier allows the company to use assets after signing the agreement but ownership will transfer to XYZ at the end of the 4th year when all payments are made.
Solution
- At the beginning of year 1, XYZ needs to record the right of use assets as the supplier gives them to the company. At the same time, it needs to record the lease liability.
Lease liability = Present value of annuity payment
Lease Liability = $ 100,000 * 3.546 = $ 354,600
The journal entry is debiting right to use asset $ 354,600 and credit lease liability the same amount.
| Account | Debit | Credit |
|---|---|---|
| Right to Use Assets | 354,600 | |
| Lease Liability | 354,600 |
- At the end of year 1, we need to record interest expense which equal to lease liability multiply by the effective interest rate.
Interest expense = Lease Liability * Effective rate = 354,600 * 5% = $ 17,730
The journal entry is debiting interest expense and credit lease liability $ 17,730.
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 17,730 | |
| Lease Liability | 17,730 |
The transaction will increase the lease liability to the total of payment schedule from year 1 to year 4 ($ 400,000). It also include the interest expense which presents in the income statement.
- At the end of year 1, company also pay for the installment, it will reduce the lease payment and cash. They need to debit lease liability and credit cash.
| Account | Debit | Credit |
|---|---|---|
| Lease Liability | 100,000 | |
| Cash | 100,000 |
This transaction will reduce lease liability as the company pay the installment.
To show the relation between interest expense and lease liability, we will show the following table:
| Year | Lease Liability (Beg) | Interest Expense | Payment | Lease Liability (End) |
| 1 | 354,595 | 17,730 | (100,000) | 272,325 |
| 2 | 272,325 | 13,616 | (100,000) | 185,941 |
| 3 | 185,941 | 9,297 | 100,000) | 95,238 |
| 4 | 95,238 | 4,762 | (100,000) | – |
Each year, the company need to record interest expense as shown in the table. The payment of installment will reduce lease liability to zero at the end of year 4.
- At the end of year 1, the company is also required to depreciate the fixed assets as we have used them.
Depreciation expense = $ 354,600/6 year = $59,100
The journal entry is debiting depreciation expense and credit right to use assets $ 59,100
| Account | Debit | Credit |
|---|---|---|
| Depreciation Expense | 59,100 | |
| Right to use asset | 59,100 |
This transaction will reduce the right of use assets to depreciation expense. At the end of the hire purchase agreement, the right to use assets will not be zero as the company still uses assets and the ownership will stay with the lessee.
Advantage of Hire Purchase
- Allow the company with a low credit rating to finance the assets to support the operation. Hire purchases do not require a high credit rate if compare to a bank loan.
- Small companies with lower net working capital are still able to use the assets in order to generate more revenue.
- To save on cash flow. The company can save a huge cash flow depending on the cost of assets. The company can spend the monthly installment rather than pay the full amount.
- The company requires huge capital to invest in expensive machines. A hire purchase agreement, allow the company reduces the capital requirement.
- Hire purchase allows the buyer to manage their budget easily as the monthly expense. However, some seller allow having seasonal installment to reflect with the buyers’ seasonal business.
- The seller will be more secure with this type of loan as the asset still belongs to them.
Disadvantage of Hire Purchase
- It is very expensive for the buyer. Besides the asset’s cost, buyer needs to pay for the interest over the outstanding balance. If we total the balance, it will be more expensive in the long run.
- The interest cost that sellers charge to buyers is very high compare to bank loans as they need to face a higher risk. The buyer can save some money by taking bank loan instead of a hire purchase.
Hire Purchase Vs Leasing
| Finance Lease | Hire Purchase |
|---|---|
| The ownership belongs to the lessor. Lessee has the right to purchase assets at the end of the contract. | Ownership belongs to the seller until buyer pays all the remaining balance. |
| Depreciation expense record in the lessor book. | Asset and depreciation charge record in the buyer book. |
| Duration contract must cover the majority of asset useful life. | There is no requirement on the contract term. |
| Lease payment is deductible in lessee tax record. | Depreciation expense is deductible in buyer book. |
| It is the lessee’s obligation to pay for repair & maintenance assets. | It is the buyer responsibility to pay for repair and maintenance assets. |