HIRE-PURCHASE SYSTEM (PART I)

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1.0 HIRE-PURCHASE SYSTEM ( PART I )




Chapter Outline


1.1 Introduction
1.2 Objectives
1.3 Meaning and concept of Hire-purchase System
1.4 Characteristics of Hire-purchase system
1.5 Difference between Hire-purchase system and Instalment payment system
1.6 Accounting entries in the books of Hire-purchaser
1.7 Accounting entries in the books of Hire vendor
1.8 Calculation of Cash Price, if Cash Price is not given
1.9 Calculation of Amount of Interest,if rate of Interest is not given
1.10 Let's Sum up
1.11 Home Assignments
1.12 Further Readings
1.13 Answer to SAQs





Introduction

By now you must have been familiar to various aspects of Book-keeping and Accountancy. You must have understood the concept of double entry system. Now-a-days the books of accounts are maintained under double entry system by all big business houses and multinationals. You know that the sales is the Key factor of success of business. The profit of a business always depends on the volume of its sales. A big business house can effect sales on cash basis as well as on credit basis. The credit sales are very important and essential for the growth of business. The sale proceeds under such sales are not immediately collected but are collected under certain arrangements such as Hire-purchase system or Instalment payment system or collection after a certain period together with interest on outstanding balances. Hire-purchase system is the most secured and effective tool of collecting the proceeds of a credit sale.




Learning Objectives
After reading this chapter, you are expected to learn about:
  • identify a hire purchase transaction;
  • record the transaction in the journal of hire-purchaser and hire vendor;
  • prepare necessary accounts in the ledger of hire-purchaser and hire vendor;
  • calculate cash price in a transaction of hire-purchase with and without the help of annuity table; and
  • solve the accounting problems of hire- purchase system and record hire purchase transactions in the books of accounts maintained in “Big Malls”.






1.3 Meaning and Concept of Hire-purchase system


Hire-puchase system is a special system of purchase and sale of goods. Under this system purchaser pays the price of the goods in instalments. The instalments may be annual, six monthly, quarterly, monthly fortnightly etc. Under this system the goods are delivered to the purchaser at the time of agreement before the payment of instalments but the title on the goods is transferred after the payment of all instalments as per the hire-purchase agreement. The special feature of a hire-purchase transaction is that the payment of every instalment is treated as the payment of hire charges by the purchaser to the hire vendor till the payment of the last instalment.. After the payment of the last instalment, the amount of various instalments paid is appropriated towards the payment of the price of the goods sold and the ownership or the goods is transferred to the purchaser. Thus hire-purchase means a transaction where the goods are sold by vendor to the purchaser under the following conditions :


1.4 Characteristics of Hire-purchase system


Before discussing the characteristics of hire-purchase system, we must know what is a hire purchase agreement and what are the contents of a hire-purchase agreement. Hire-purchase agreement means a contract between the hire vendor and the hire purchaser regarding the sale of goods under certain conditions. Usually every hire-purchase agreement shall contain the following terms:

Characteristics of Hire-Purchase System
The characteristics of hire-purchase system are as under


Self-Assessment Questions (SAQs) -1
(1) Define Hire-purchase system in your own words. ( 100 words )











(2) State any FIVE important elements of Hire-purchase agreement.









(3) State whether the following statements are True or False:

(a) The hire vendor has to refund the amount received after repossession of goods due to default in payment by hire-purchaser.
(b) Under hire-purchase system the purchaser becomes the owner of the goods immediately after the down payment.
(c)The last instalment under hire-purchase system comprises cash price only.
(d) Under hire-purchase system the buyer does not charge the depreciation on the asset till he becomes the owner.
(e) Interest is calculated on the hire purchase price at the given rate of interest.


1.5 Difference between Hire-purchase system and Instalment payment system


Instalment Payment System is system of purchase and sale of goods in which title of goods is immediately transferred to the purchaser at the time of sale of goods and the sale price of the goods is paid in instalments. In the event of default in payment of any instalment, the seller has no right to take back goods from the possession of the purchaser. He can file a suit for the recovery of the outstanding balance of the price of goods sold. The followings are the differences between Hire-purchase system and Instalment payment system:

1.6 Accounting In the books of Hire-purchaser


There are two methods of accounting in the books of Hire-purchaser. Their detailed description is as under:-

Asset Accrual Method:
Under this method it is considered that the hire-purchaser is the owner of the asset up to the value of the cash price paid by him in the from of down payment or the cash price paid included in various instalments. The following journal entries are recorded under this method.

(i)On taking the delivery of asset:

    No entry is recorded.

(ii)On making the down payment (if any)

    Asset A/c  Dr.			(Amount of down payment)	
To Cash/Bank A/c.

(iii)On becoming the instalment due

     Asset a/c. Dr				(Balancing figure)
Intt. A/c. Dr. (Amt. of Intt.)
To Hire-Vendor A/c. (Amt. of Instalment)

(iv)On payment of instalment:

    Hire-Vendor A/c Dr.			(Amt. of Instalment)
To Cash/Bank A/c.

(v)On charging the Depreciation:

  Depreciation A/c Dr.			(Amt. of Depreciation)
To Asset A/c.

(vi)On Transfer of interest and depreciation to P/L A/c:

   P/L A/c.			                (Total  amt.)
To Interest A/c (Bal. of Intt. A/c.)
To Depreciation A/c. (Bal. of Dep. A/c.)

Under Total Assets Value Method:
Under this method of accounting in the books of hire-purchaser, is done on the assumption that the ownership of the asset is also transferred to the purchaser with the delivery of goods. The following journal entries are recorded under this method.

(i)On taking the delivery of assets at the time of agreement:

  Asset A/c Dr.					(Cash price of Asset)
To Hire vendor A/c.

(ii)On making the down-payment (if any):

   Hire-Vendor....... A/c. Dr.			(Amount of down payment)
To Cash/Bank A/c

(iii)On becoming the instalment due:

  Interest A/c. Dr.				(Amount of interest)
To Hire-Vendor A/c

(iv)On payment of instalment:

    Hire-Vendor a/c Dr.				(Amount of instalment)
To Cash/Bank A/c

(v)On charging the depreciations:

   Depreciation A/c. Dr.				(Amount of depreciation)
To Asset A/c.

(vi)On Transfer of interest and depreciation to P/L A/c:

    P/L A/c. Dr.				        (Total)
To Interest A/c. (Bal. of Intt. A/c.)
To Depreciation A/c. (Bal. of Dep. A/c.)


Posting in Ledger Accounts: After passing journal entries under any of the methods discussed above, the following ledger accounts are opened in the ledger and the postings are made accordingly.

(i) Asset A/c. (e.g. Trucks A/c, Machinery A/c. etc.)
(ii) Vendor's A/c.
(iii) Interest A/c.
(iv) Depreciation A/c.

Note: Before recording the entries the amounts of interest and depreciation will be calculated in two separate tables showing the calculations of interest and depreciation.

Calculation of Interest

The total payment made under hire-purchase system is more than cash price. In fact, this excess of payment over the cash price is interest. It is very essential to calculate interest because the amount paid for interest is charged to revenue and the asset is capitalized at cash price. Thus normally all instalments will include a part of cash price and a part of interest on the outstanding balance. However the amount paid at the time of agreement (down payment) will not include any interest. The calculation of interest is made under two conditions:

(a) When interest is included in amount of instalment: Where the hire-purchase price i.e. payment made in the form of down payment and all instalments is more than the cash price, it is regarded that the interest is included in instalments. It is explained in the following example.

Worked out Example-1 (Calculation of Interest)
On Ist April,2005 Mr. X purchased from M/s Y & Co. one 'Motor Truck' under hire-purchase system, Rs. 5,000 being paid on delivery and the balance in five annual instalments of Rs. 7,500 each payable on 31st March each year. The cash price of the motor truck is Rs. 37,500 and vendors charge interest at the rate of 5 per cent per annum on yearly balances. Find out the amounts of principal and interest included in each instalment.


(b) When interest is not included in instalments: Where the total amount paid in the form of down payment and all instalments is exactly equal to the cash price, it is regarded that the interest is not included in instalments. It means that interest is payable in addition to the agreed amount of instalment. It is explained in the following example.

Workedout Example-2 (Calculation of Interest): On April 1,2005, A Transport Company purchased a Motor Lorry from Motor Supply Co. Ltd. on hire-purchase basis, the cash price being Rs. 60,000. Rs. 15,000 on signing of the contract and balance in three annual instalments of Rs. 15,000 each on 31st March every year. In addition to it, interest at 5 per cent per annum was also payable to vendors on outstanding balances.


1.7 Accounting in the books of Hire-vendor


Hire Vendor: There is only one method of recording the entries in the books of hire-vendor. Irrespective of the fact whether the entries in the books of hire-purchaser are passed under the Asset Accrual Method or under the Total asset value Method.But the accounting entries in the books of hire-vendor are always passed under the total Asset Method. These entries are as under:-

(i)On delivery of goods to the hire-purchaser at the time of agreement:

  Hire – purchaser A/c Dr.			Cash Price
To Hire – Sales A/c.

(ii)On receipt of cash at the time of agreement (down payment), if any:

 Cash/Bank A/c. Dr.				(Amt. of down payment)
To Hire-Purchaser

(iii)On interest being due:

 Hire – Purchaser A/c Dr.			Amt. of Interest
To Interest A/c.

(iv)On receipt of instalment:

 Cash/bank A/c.					(Amt. of Instalment)
To Hire – Purchaser

(v)On Transfer of Balance of Hire-Sales A/c. to Trading A/c. (at the end of first year only):

  Hire – Sales A/c Dr.				Cash Price
To Trading A/c.

(vi)On Transfer of amount of interest to P/L A/c:

   Interest A/c. Dr.				(Balance of Intt. A/c.)
To P/L A/c.

Note: In solving a numerical problem, before recording the entries, the amount of interest included in various instalments will be separately calculated as already explained.

Posting in Ledger Accounts:

After passing entries in the journall of hire – vendor the following accounts will be opened in the ledger of hire – vendor and the postings will be made accordingly.


Calculate the amount of annual instalment, and show the Journal entries and necessary ledger accounts in the books of Moti Ltd. for three years. The present value of Annuity of Rupees one for three years at 5% is 2.72325.

Worked out examples-3:

On 1st April,2005 X Company Ltd. purchased a machine from Y Machines Ltd. on hire-purchase basis, the cash price being Rs. 55,850 Rs. 15,000 was paid on the signing of the contract and the balance in three annual instalments of Rs. 15,000 each on 31st March each year. Interest is charged at 5% per annum. Depreciation was written off at rate of 10% per annum on the diminishing balance system.

Give journal entries in the books of X Company Ltd. whose accounting year ends on 31st March each year, under Asset Accrual Method.


Solution:



(a) under Asset Accrual Method
Journal Entries in the Books of X Co. Ltd.
Date Particulars LF Dr.(Rs.) Cr.(Rs.)
2005
April 1
Machinery A/c …………….Dr.

To Bank A/c
(Being down payment made at the time of delivery)

15,000

15,000
2006
March 31
Machinery A/c ……………………………………...Dr.

Interest A/c ....................Dr.
To Y Machine Ltd.
(Being the first instalment due).

12,957

2,043



15,000
" Y MachinesLtd. …………………Dr.

To Bank
(Being the amount paid in first instalment)

15,000

15,000
" Depreciation A/c …………………Dr.

To Machinery A/c
(Being the depreciation charged)

5,585

5,585
" Profit & Loss A/c …………………Dr.

To Interest A/c
ToDepreciation A/c
(Being the amount transferred)

7,628


2,043

5,585

2007
March 31
Machinery A/c ……………………………………...Dr.

Interest A/c ....................Dr.
To Y Machine Ltd.
(Being the second instalment due).

13,605

1,395



15,000
" Y Machines Ltd. …………………Dr.

To Bank
(Being the amount paid in second instalment)

15,000

15,000
" Depreciation A/c …………………Dr.

To Machinery A/c
(Being the depreciation charged)

5,027

5,027
" Profit & Loss A/c …………………Dr.

To Interest A/c
ToDepreciation A/c
(Being the amount transferred)

6,422

1,395

5,027

2008
March 31
Machinery A/c ……………………………………...Dr.

Interest A/c ....................Dr.
To Y Machine Ltd.
(Being the third instalment due).

14,288

712



15,000
" Y Machines Ltd. …………………Dr.

To Bank
(Being the amount paid in third instalment)

15,000

15,000
" Depreciation A/c …………………Dr.

To Machinery A/c
(Being the depreciation charged)

4,524

4,524
" Profit & Loss A/c …………………Dr.

To Interest A/c
To Depreciation A/c
(Being the amount transferred)

5,236

712

4,524


Note1:Interest has been calculated in the manner already explained in workedout example-1.

1.8 Calculation of Cash Price, if Cash Price is not given


Some times in a problem of hire-purchase, cash price of goods sold is not given. Only hire-purchase price is given under such situation first of all, cash price is to be calculated in order to find out the amount of interest included in each instalment. the cash price can be calculated under following two situations.

(a)By Annuity Method, if the annity value of Re. 1 is given:

Cash Price = (Annuity, Value of Re.1 x Amt. of one instalment) + down payment if, any.

Calculation of Cash Price by Annuity Method

Worked out Example-4

On 1st April,2005 a manufacturing company buys on Hire-purchase system a machinery for Rs. 60,000, payable by three equal annual instalments combining principal and interest, the rate of interest was 5% per annum. Calculate the amount of cash price and interest. The present value of an annuity of one rupee for three years at 5% interest is Rs. 2,72325.

Solution:

Calculation of Cash Price – The present value of an annuity of Re. 1 paid for 3 year @ 5% = Rs. 2,72325 Then the present value of Rs. 20,000 for 3 years = 2,72325 x 20,000 = Rs. 54,465 Cash Price Rs. 54,465


(b) By Arithmetic Method, if the annuity value of Re. 1 is not given:

? First take the last instalment and calculate interest included in that instalment. Interest: = (Amount of instalment x Rate of Int) / 100+Rate of Int.

Thereafter interest included in last but one instalment should be calculated. Interest = [(Amt. of last but one instalment + principal price included in the last instalment) x Rate of Interest] / 100+ Rate of Int.


Calculation of Cash Price by Arithmetic Method

Worked out Example-5

Mr. X purchased a machine on Hire-Purchase system on 1st April,2005. He paid Rs. 5,000 at spot and then three annual instalments of Rs. 5,000 each. The rate of interest was 5% per annum. Find out the amount of interest included in instalments and cash price of the machine.

Solution:


(1)First of all Interest included in the 3rd instalment is to be calculated.

Interest=(5000x5)/105=Rs. 238,Principal= 5000-238=4762

(2)Interest included in second instalment = [(5000+4762)x5]/105 = 465, Principal=4535

(3)Interest included in 1st instalment = [(5000+4762+4535)x5]/105 = 681,Principal=4319

Cash Price = 4762+4535+4319+down payment Rs.5000 = Rs.=18616

Total Interest=Rs20000-18616=1384. I Yr. rs.681, IIYr. Rs465, III Yr.Rs238

Note: Now you can make the interest table in the usual manner as explained in worked out example-1 and check your calculation of amount of interest.



1.9 Calculation of Amount of Interest, if Rate of Interest is not given


Wherever, rate of interest is not given in the problem, again there can be two situations.

(a) When cash price and the amounts of instalments are given and the amount of each instalment is same. the following worked out example will make the calculation clear.

Worked out Example-6


(Calculation of Interest When Rate of Interest is not given) A machine was sold on hire-purchase system on 1st April,2005 Rs. 10,000 was paid at spot and rest was paid by four equal quarterly instalments of 22,000 each. The cash price of machine was Rs. 90,000. Find out the amount of interest included in each instalment.

Soluton:

Hire-purchase Price = 10,000 + (22,000 x 4) = Rs.98,000 Less: Cash Price Rs.90,000 Total Interest= Rs.8,000

The total Interest of Rs 8,000 is to be apportioned among the various instalments i.e. 4th, 3rd, 2nd and 1st instalment in the ratio of 1:2:3:4 (i.e. among 1st, 2nd, 3rd and 4th instalment in the ratio of 4:3:2:1)

(1)Share of 1st instalment in the Interest= 8,000x4/10 = Rs.3,200

(2)Share of 2nd instalment in the Interest= 8,000x3/10 = Rs.2,400

(3)Share of 3rd instalment in the interest= 8,000x2/10 = Rs.1,600

(4)Share of 2nd instalment in the interest= 8,000x1/10 = Rs. 800





(b) When cash price and amounts of instalments are given but the amount of each instalment is not equal: The following worked out example will clear the doubts.

Rate of Interest not known and Instalments of different amounts

Worked out Example-7

Cash price of a machine is Rs. 37,400 on 1st January,2003. Its hire-purchase price is Rs. 50,000. This hire-purchase price is paid in five annual instalments in the following manner: Rs. 15,000 at the end of the first year Rs. 12,000 at the end of second year; Rs. 10,000 at the end of third year, Rs. 8,000 at the end of fourth year, Rs. 5,000 at the end of fifth year. Calculate interest and cash price included in each instalment.



Solution:

Calculation of Interest Included in each Instalment

Total Interest= Hire-purchase price-Cash Price

Total Interest=Rs.50,000-37,400=12600

Total Interest of Rs12,600 is to be apportioned among the five instalments in the following manner:


Instalment No Unpaid Amount(Rs.) Calculation of Int.(Rs.)
First 50000 (12600x50000)/126000=5000
Second 50000-15000=35000 (12600x35000)/126000=3500
Third 35000-12000=23000 (12600x23000)/126000=2300
Fourth 23000-10000=13000 (12600x13000)/126000=1300
Fifth 13000-8000=5000 (12600x5000)/126000=500
Total 126000

Calculation of Cash Price included in each instalment

Instalment No. Instalment(Rs.) Interest(Rs.) Cash Price(Rs.)
First 15000 5000 10000
Second 12000 3500 8500
Third 10000 2300 7700
Fourth 8000 1300 6700
Fifth 5000 500 4500
Total 50000 12600 37400









Results



Glossary







Practice Test


1.11 Home Assignments:

Exercise-1:

AB Transport Company purchased a Truck from XY Automobiles Ltd. on Ist January,2001 on hire-purchase system. The cash price of the truck was Rs. 3,20,000 which was payable as under:


On 01-01-2001 Rs.1,00,000

On 31-12-2001 RS.80,000

On 31-12-2002 RS.80,000

On 31-12-2003 RS.82,478

XY Automobiles Ltd. charged interest @ 5% per annum on the unpaid amount. The purchasing company decided to write off depreciation @ 20% of the cost price each year. You are required to give the necessary journal entries in the books of both the parties for three years. Also show the calculation of interest, depreciation and the instalment.


Exercise-2 On Ist April,2001 Modern Traders Ltd. took delivery of one Truck from GE Motors Ltd. on Hire-Purchase Agreement, payable in three equal instalments of Rs. 60,000 each on 31st March,2002, 2003, 2004. The cash value of the Truck on delivery was Rs. 1,63,400. Vendor charges interest at 5 per cent per annum on the yearly balances. The purchaser wrote off depreciation @ 25 per cent on the diminishing value method for each year. Pass the necessary Journal entries to record the above transactions in the books of both the parties.


Exercise-3 A machinery is taken under the Hire-Purchase System for Rs. 2,500 to be paid as follows:

On delivery Rs. 400; at the end of first year Rs. 600; at the end of second year Rs.400; at the end of third year Rs. 1,100. Interest included in Rs. 2,500 being charged on the cash value at 10% per annum. Pass Journal entries in the books of hire-purchaser writing off depreciation @ 5% per annum on Diminishing Balance Method. Also give necessary accounts in the ledger of hire-purchaser.

Exercise-4 On Ist January,2001 Moti Ltd. purchased on Hire-Purchase System from Hire-Vendor some machinery for Rs. 25,500 payable in three equal instalments combining principal and interest, the latter being a normal rate of 5% per annum.

Calculate the amount of annual instalment, and show the Journal entries and necessary ledger accounts in the books of Moti Ltd. for three years. The present value of Annuity of Rupees one for three years at 5% interest is 2.72325.







Answers to SAQs


Answers to SAQs-1, Q. No. 3:

(a) False

(b) False

(c) False

(d) False

(e) True






References and Further Readings


(i) Chapter on Hire-puchase System in the Text Book “Advanced Accountancy” Volume I by R. L. Gupta and M Radhaswamy published by Sultan Chand & Co. New Delhi ( ISBN 81-8054-110-X )

(ii) Chapter on Hire-purchase System in the Text Book “Advanced Accountancy” by S. N. Maheshwari and S. K. Maheshari published by Vikas Publishing House New Delhi






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