HIRE-PURCHASE SYSTEM (PART I)

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 :
 * the goods will be delivered to the purchaser at the time of agreement.
 * the purchaser has a right to use the goods delivered.
 * the price of the goods will be paid in instalments.
 * every instalment will be treated to be the hire charges of the goods which is being used by the purchaser.
 * if all instalments are paid as per the terms of agreement, the title of the goods is transferred by vendor to the purchaser.
 * if there is a default in the payment of any of the instalments, the vendor will take away the goods from the possession of the purchaser without refunding him any amount received earlier in the form of various instalments.

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:
 * the cash price of the goods, cash price means the price at which goods may be purchased against cash payment.
 * the hire-purchase price, hire purchase price means the total amount which is payable by the hire-purchaser under the  agreement.
 * the date on which the hire-purchase agreement will commence.
 * the description of the goods that will be delivered to the hire-purchaser at the commencement of the agreement.
 * the number of instalments to be paid by the hire-purchaser along with the amount of each instalment and the date of payment of each instalment.
 * the down payment if any, the down payment means the amount which is required to be paid by hire-purchaser to the hire vendor at the time of commencement of hire-purchase agreement.
 * the rate interest charged by the hire vendor (optional).

Characteristics of Hire-Purchase System

The characteristics of hire-purchase system are as under
 * Hire-purchase is a credit purchase.
 * The price under hire-purchase system is paid in instalments.
 * The goods are delivered in the possession of the purchaser at the time of commencement of the agreement.
 * Hire vendor continues to be the owner of the goods till the payment of last instalment.
 * The hire-purchaser has a right to use the goods as a bailer.
 * The hire-purchaser has a right to terminate the agreement at any time in the capacity of a hirer.
 * The hire-purchaser becomes the owner of the goods after the payment of all instalments as per the agreement.
 * If there is a default in the payment of any instalment, the hire vendor will take away the goods from the possession of the purchaser without refunding him any amount.

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:
 * In Hire-purchase system, the transfer of ownership takes place after the payment of all instalments while in case of Instalment payment system, the ownership is transferred immediately at the time of agreement.
 * In Hire-purchase system, the hire-purchase agreement is like a contract of hire though later on it may become a purchase after the payment of last instalment while in Instalment payment system, the agreement is like a contract of credit purchase.
 * In case of default in payment, in Hire-purchase system the vendor has a right to back goods from the possession of the hire-purchaser while in case of Instalment payment system, the vendor has no right to take back the goods from the possession of the purchaser; he can simply sue for the balance due.
 * In Hire-purchase system, if the purchaser sells the goods to a third party before the payment of last instalment, the third party does not get a better title on the goods purchased. But in case of Instalment payment system, the third party gets a better title on the goods purchased.
 * In Hire-purchase system the provisions of the Hire-purchase Act apply to the transaction while in case of Instalment payment system, the provisions of Sale of Goods Act apply to the transaction.

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.



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.


 * (i)	Hire – Purchaser A/c.
 * (ii)	Hire – Sales A/c. (only in first year)
 * (iii)	Interest A/c.

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:

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

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.


 * ?	Interest included in all proceeding instalment should be calculated in the same manner.
 * ?	In the end, interest included in each instalment should be added. It should be remembered that down payment does not include any interest.
 * ?	Finally cash price = Hire purchse price – Total interest included in various instalments.

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.

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:

Calculation of Cash Price included in each instalment