Unit 4 | unit 4 hire purchase

Unit - 4

HIRE – PURCHASE

4.1 Meaning of Hire Purchase System

If you purchase a TV for cash, you pay, say, Rs. 15,000. But if you wish to make the payment by instalments of say, Rs. 3,000 each, every year, you may be required to pay four instalments, that is Rs. 20,000 in all. The extra amount of Rs. 3,000 is for interest. If you choose the latter mode of the payment, you should debit Rs. 5,000 to interest and treat the TV as valued at Rs. 15,000 (and not at Rs. 20,000). In case payment is to be made by instalments, there may be two kinds of arrangements. Each instalment may be treated as a ‘hire’ the purchaser becoming the owner only if he pays all the instalments. In other words, property does not pass to him even if one instalment remains unpaid. The seller will have the right to take away the goods in case of default in respect of any instalment. This is known as ‘Hire Purchase’ system.

The other arrangement may be that property passes immediately on the signing of the contract. The seller will not have the right to repossess the goods in case an instalment is not paid. His right will be to sue the purchaser for the money due. This is known as the Instalment System.

4.2 Interest

Interest: In either case (hire purchase or instalment) interest must be separated from the principal sum due. Since payments continue over two or more financial year’s interest must be calculated for each year separately. Usually information is available regarding cash price and the rate of interest. Calculation of interest then becomes easy. Just prepare the account of one of the parties on ordinary lines and charge interest on the balance due. Suppose on 1st January, 2000 A purchases from B machinery whose cash price is Rs. 15,000; Rs. 5,000 is to be paid down, that is on signing of the contract, and Rs.4,000 is to be paid at the end of each year for 3 years. Rate of interest is 10% p.a. If we prepare B’s account (on a memorandum basis) in A’s books, we shall know the interest for each year.

A’s Books

Dr.			B’s Account		Cr.
		Rs.			Rs.
2000			2000
Jan.1	To Cash	5,000	Jan.1	By Machinery A/c	15,000
Dec.31	To Cash	4,000	Dec.31	By Interest A/c	1,000
’’	To balance c/d	7,000		(10% on Rs. 10,000)
		16,000			16,000
2001			2001
Dec.31	To Cash	4,000	Jan.1	By Balance b/d	7,000
	To Balance c/d	3,700	Dec.31	By Interest A/c
				(10% on Rs. 7,000)	700
		7,700			7,700
2002			2002
Dec.31	To Cash	4,000	Jan.1	By Balance b/d	3,700
			Dec.31	By Interest A/c*	300
		4,000			4,000

* As it is the last year of installment, interest amount will be the difference between the Outstanding balance and the actual amount of installment. [Students should note that if you calculate interest for the last year as per the given percentage on the O/S amount (3700 x 10%=370), total amount payable becomes (3700+370=4070) which is greater than the installment paid. So there will be again Rs. 70 payable even after the last installment being paid.]

If the rate of interest is not given, the interest for each year will be in proportion to amount outstanding in each year. In the example given above, the total sum payable is Rs. 17,000 out of which Rs. 5,000 is paid immediately. This leaves Rs. 12,000 as outstanding throughout the first year at the end of which Rs. 4,000 is paid. In the second year Rs. 8,000 is outstanding and in the third year Rs. 4,000 is due. The total interest is Rs. 2,000. i.e., Rs. 17,000. Minus Rs. 15,000. The interest should be apportioned over the 3 years in the ratio of amounts outstanding, that Rs. 12,000; Rs. 8,000 and Rs. 4,000 or in the ratio of 3 : 2 :1. The interest for the first year is Rs.1,000 : for the second year it is Rs.670 and for the third year it is Rs.333. Note that the amount cannot be the same as worked out when the rate of interest is given.

To ascertain Cash Price, rate of interest and instalments being given. Sometimes the cash price is not given. Since the asset cannot be debited with more than the cash price, it must be ascertained. The process is to take the last year first and separate interest from principal out of the total sum due. In the example given above, Rs. 4,000 is due at the end of 2002. The rate of interest is 10%. If in the beginning of 2001 Rs.100 was due, Rs.10 would be added making Rs.110 as due at the end of 2002. Thus, out of the sum due at the end of the year, one-eleventh is interest; rest is principal. We can proceed year by year like this.

Thus: —

	Rs.
Amount due on 31-12-2001	4,000
Interest @ 1/11	364
Amount due on 1-1-2002 or 31-12-2001	3,636
Paid on 31-12-2001	4,000
Total amount due on 31-12-2001	7,636
Interest @ 1/11	694
Amount due on 1-1-96 or 31-12-2000	6,942
Paid on 31-12-2000	4,000
Total amount due on 31-12-2000	10,942
Interest @ 1/11	995
Amount due on 1-1-2000	9,947
Paid Cash down on 1-1-2000	5,000
Cash Price	14,947
The interest for three years is Rs.995, Rs.694 and Rs.364 respectively.

4.3 Entries in Book: Actual Cash Price Paid Method

This method follows a technical approach and does not treat the hire purchaser as owner until he makes the payment of last instalment. Under this method, the asset is recorded at the cash price actually paid.

* In the last year, the interest is equal to the difference between the amount due and the opening balance. It is not calculated in the usual way.

Journal Entries Under Actual Cash Price Paid Method

The various accounting entries in the books of the hire purchaser and hire vendor are shown below.

Journal Entries Under Actual Cash Price Paid Method

	Case	In the Books of Hire Purchaser		In the Books of Hire Vendor		Amount with which debited or credited

A.	On making down payment due	Asset A/c To Hire Vendor’s A/c	Dr.	Hire Purchaser’s A/c To Hire Purchase Sales A/c	Dr.	(With the amount of down payment)
B.	On making Down Payment	Hire Vendor’s A/c To Bank A/c	Dr.	Bank A/c To Hire Purchaser’s A/c	Dr.	(With the amount of down payment)
C.	On making principal part of the instalment due	Asset A/c To Hire Vendor’s A/c	Dr.	Hire Purchaser’s A/c To Hire Purchase Sales A/c	Dr.	(With the amount of principal part of the instalment)
D.	On making Interest due on Unpaid balance	Interest A/c To Hire Vendor’s A/c	Dr.	Hire Purchaser’s A/c To Interest A/c	Dr.	(With the interest Due on unpaid Balance)
E.	On making payment of instalment	To Hire Vendor’s A/c To Bank A/c	Dr.	Bank A/c To Hire Purchaser’s A/c	Dr.	(With the amount of instalment)
F.	On providing Depreciation	Depreciation A/c To Asset A/c	Dr.	No Entry		(With the amount of (depreciation)
G.	On closure of Depreciation A/c	Profit & Loss A/c To Depreciation A/c	Dr.	No entry		(With the amount Of depreciation)
H.	On closure of Interest A/c	Profit & Loss A/c To Interest A/c	Dr.	Interest A/c To Profit & Loss A/c	Dr.	(With the amount Of interests)

Note: Depreciation is charged on full cash price of the asset and Interest is calculated on total outstanding balance.

4.4 Disclosure In Balance Sheet Under Actual Cash Price Paid Method

At the end each accounting period, the relevant accounts appear in the Balance Sheet as shown below:

Disclosure In Balance Sheet Under Actual Cash Price Paid Method

Balance Sheet of Hire Purchaser			Balance Sheet of Hire Vendor
Liabilities	Rs. Assets	Rs.	Liabilities	Rs. Assets	Rs.
	Fixed Assets :
	Asset (at actual cash)			No disclosure is
	Price paid)	Xxx		Required
	Less : Depreciation till date	Xxx
		Xxx

4.5 Hire Purchase: Books of the Vendor

Books of the Vendor: The vendor follows no special method for recording sales on hire purchase, especially in case of sale of large items. He debits the purchaser with the cash price and credits him with the amount received. Every year the interest due is debited. We illustrate this below.

Illustration-1

Based on particulars given below calculate Interest under the hire purchase system

(a) X & Co.—purchaser Y & Co.-Seller Date of purchase—Jan. 1, 1999

Cash price—Rs. 74,500.

Installments Rs. 20,000 on signing of the agreement. Rest in three instalments of Rs. 20,000 each. Rate of Interest—5%. Depreciation 10% on the diminishing Balance.

(b) All particulars as above except that the rate of interest is not given.

Solution :

(a) Calculation of Interest
		Rs.
Jan.1, 1999	Cash Price	74,500
	Less-Cash down	20,000
	Balance Due	54,500
	Interest @ 5% for 1999	2,725
Dec.31, 1999	Total	57,225
	Amount paid	20,000
Jan.1, 2000	Balance Due	37,225
	Interest for 2000 @ 5%	1,861
Dec.31, 2000	Total	39,086
	Amount paid	20,000
Jan.1,2001	Balance due 2001	19,086
	Interest for (balancing figure) 2001	914
Jan.1,2002	Amount paid	20,000

(b) Calculation of interest when the rate of interest is not given :

Hire Purchase Price				80,000
Cash Price				74,500
Total interest				5,500

Year	Amount Outstanding	Ratio	Interest	Rs.
1	60,000	3	3/6 x 5,500	2,750
2	40,000	2	2/6 x 5,500	1,833
3	20,000	1	1/6 x 5,500	917

Instalment	Amount due at the end of the year (after payment of Installment)	Instalment Paid	Total amount due at the end of the Year (before payment of instalment)		Interest @ 1/21	Principal due in the beginning
	Rs.	Rs.		Rs.	Rs.	Rs.
3	Nil	20,000		20,000	952	19,408
2	19,048	20,000		39,048	1,859	37,189
1	37,189	20,000		57,189	2,723	54,466
					5,534

Cash Price: 54,466 + cash down, Rs. 20,000 or Rs. 74,466.

Illustration-2

Y & Co. Sold machinery whose cash price is Rs. 74,500. To X and Co., on hire purchase basis on 1st January, 2000. Payment was to be made as Rs. 20,000 down and Rs. 20,000 every year for three years. Rate of interest was 5% & Co. Charged depreciation @ 10% p.a. On the diminishing balance. Give ledger accounts in the books of Y & Co.

Ledger of Y & Co.
Dr.			X & Co.		Cr.
		Rs.			Rs.
2000			2000
Jan.1	To Sales	74,500	Jan.1	By Cash	20,000
Dec.31	To Interest A/c		Dec.31	By Cash	20,000
	(5% on Rs. 54,500)	2,725		By Balance c/d	37,225
		77,225			77,225
2001			2001
Jan.1	To Balance b/d	37,225	Dec.31	By Cash	20,000
Dec.31	To Interest A/c	1,861		By Balance c/d	19,086
		39,086			39,086
2002			2002
Jan.1	To Balance b/d	19,086	Dec.31	By Cash	20,000
Dec.31	To Interest A/c	914
		20,000			20,000

Dr.	Sales Account			Cr.
		2000
		Jan. 1	By X & Co.	Rs. 15,000.
Interest Account
Dr.				Cr.
2000		2000
Dec.31 to P & L A/c	2,725	Dec.31	By X & Co.	2,725
2001		2001
Dec.31 to P & L A/c	1,861	Dec.31	By X & Co.	1,861
2002		2002
Dec.31 to P & L A/c	914	Dec.31	By X & Co.	914

4.6 Hire Purchase: Books of Purchaser

Books of Purchaser—First Method. The purchaser can also follow the system adopted by the vendor and make entries like ordinary purchase of an asset. Only, he should credit the vendor with interest due every year and debit him with cash as and when paid. The above given example can be worked out in the following way (ledger accounts.) :—

Dr.		Machinery account			Cr.
		Rs.			Rs.
2000			2000
Jan.1	To Y & Co.	74,500	Dec.31	By Depreciation A/c	7,450
				By Balance c/d	67,050
		74,500			74,500
2001			2001
Jan.1	To Balance b/d	67,050	Dec.31	By Depreciation A/c	6,705
				By Balance c/d	60,345
		67,050			67,050
2002			2002
Jan.1	To Balance b/d	60,345	Dec.31	By Depreciation A/c	6,035
				By Balance c/d	54,310
		60,345			60,345
2003
Jan.1	To Balance b/d	54,310

Y & Co. A/c
2000		Rs.	2000		Rs.
Jan.31	To bank A/c	20,000	Jan.1	By Machinery A/c	74,500
Dec.31	To Bank A/c	20,000	Dec.31	By Interest A/c	2,725
’’	To Balance c/d	37,225
		77,225			77,225
2001			2001
Dec.31	To Bank A/c	20,000	Jan.1	By Balance b/d	37,225
’’	To balance c/d	19,086	Dec.31	By Interest A/c	1,861
		39,086			39,086
2002 Dec.31	To Bank A/c	20,000	2002 Jan.1	By Balance b/d	19,086
			Dec.31	By Interest A/c	914
		20,000			20,000

The student should prepare accounts relating to Interest and Depreciation.

Second Method. Under the second method, entries are passed only when payment is due or made. At this time, the vendor is credited with the amount due. Interest for the period is debited to interest Account and the balance (principal) is debited to the Asset Account. On payment, of course, the vendor is debited and Cash (or Bank) credited. The two entries are:

Debit Asset Account, Debit Interest Account, Credit (hire) Vendor
Debit (Hire) Vendor, Credit Cash or (Bank)

Depreciation has to be charged according to the cash price of the asset

We give below the journal entries and ledger accounts in the books of X & Co., the purchaser, in the example given above.

Journal of X & Co.

			Debit (Rs)	Credit (Rs)
2000
Jan.1	Machinery Account	Dr.	20,000
	To Y & Co.		20,000
	(Amount due to Y & Co. As down payment for purchase of machinery on hire purchase basis.)

Jan.1	Y & Co.	Dr.	20,000
	To Bank Account		20,000
	(Payment made to Y & Co. Down)

Dec.31	Machinery Account	Dr.	17,275
	Interest Account	Dr.	2,725
	To Y & Co.		20,000
	(The amount due to Y & Co. Under the hire purchase Contract for interest (and debited as such) and the balance treated as payment for machinery)

Dec.31	Y & Co.	Dr.	20,000
	To Bank A/c		20,000
	(Payment made to Y & Co.)

Dec.31	Depreciation Account	Dr.	7,450
	To Machinery Account		7,450
	(Depreciation for 1st year-10% on Rs.74,500)

Dec 31	Profit & Loss Account	Dr.	10,175
	To Interest Account		2,725
	To Depreciation Account		7,450
	(Being interest and depreciation transferred to P/L A/c)
2001
Dec.31	Machinery Account	Dr.	18,139
	Interest Account	Dr.	1,861
	To Y & Co.		20,000
	(Amount due to Y & Co. For interest the balance charged to Machinery A/c.)

Dec.31	Y & Co.	Dr.	20,000
	To Bank Account		20,000
	(Payment made to Y & Co.)

Dec. 31	Depreciation	Dr.	6,705
	To Machinery Account		6,705
	(Depreciation for the second year 10% on Rs. 67,050; i.e. Rs. 74,500 - Rs. 7,450).

Dec 31	Profit & Loss Account	Dr.	8,566
	To Interest Account		1,861
	To Depreciation Account		6,705
	(Being interest and depreciation transferred to P/L A/c)
2002
Dec.31	Machinery Account	Dr.	19,086
	Interest Account	Dr.	914
	To Y & Co.		20,000
	(Amount due to Y & Co. In respect of interest and the principal sum.)

Dec.31	Y & Co.	Dr.	20,000
	To Bank Account		20,000
	(Payment made to Y & Co.)

Dec.31	Depreciation Account	Dr.	6,035
	To Machinery Account		6,035
	(Depreciation @ 10% of the diminishing balance charged for the third years).

Dec 31	Profit & Loss Account	Dr.	6,949
	To Interest Account		914
	To Depreciation Account		6,035
	(Being interest and depreciation transferred to P/L A/c)

Ledger Accounts
Dr.		Machinery Account			Cr.
2000		Rs.	2000		Rs.
Jan.1	To Y & Co.	20,000	Dec.31	By Depreciation	7,450
Dec.31	To Y & Co.		Dec.31	By Balance c/d	29,825
	(20,000—2,725)	17,275
		37,275			37,275
2001			2001
Jan.1	To balance b/d	29,825	Dec.31	By Depreciation A/c	6,705
Dec.31	To Y & Co.		Dec.31	By Balance c/d	41,259
	(20,000—1,861)	18,139
		47,964			47,964
2002			2002
Jan.1	To Balance b/d	41,259	Dec.31	By Depreciation A/c	6,035
Dec.31	To Y & Co.	19,086	Dec.31	By Balance c/d	54,310
		60,345			60,345
2003
Jan.1	To Balance b/d	54,310

Dr.		Interest Account			Cr.
2000		Rs.	2000		Rs.
Dec.31	To Y & Co.	2,725	Dec.31	By P & L A/c	2,725
2001			2001
Dec.31	To Y & Co.	1,861	Dec.31	By P & L A/c	1,861
2002			2002
Dec.31	To Y & Co.	914	Dec.31	By P & L A/c	914

Dr.			Y & Co.			Cr.
2000		Rs.		2000		Rs.
Jan.1	To Bank A/c	20,000	Jan.1	By Machinery A/c		20,000
Dec.31	To Bank A/c	20,000	Dec.31	By Sundries—
				Machinery	17,275
				Interest	2,725	20,000
		40,000			40,000
2001			2001
Dec.31	To Bank A/c	20,000	Dec.31	By Machinery A/c		18,139
				By Interest A/c	1,861
		20,000			20,000
2002			2002
Dec.31	To Bank A/c	20,000	Dec.31	By Machinery A/c		19,086
				By Interest A/c	914
		20,000			20,000

Depreciation Account

2000		Rs.	2000		Rs.
Dec.31	To Machinery A/c	7,450	Dec.31	By P & L A/c	7,450
2001		2001
Dec.31	To machinery A/c	6,705	Dec.31	By P & L A/c	6,705
2002		2002
Dec.31	To Machinery A/c	6,035	Dec.31	By P & L A/c	6,035

4.7 Summary

Hire Purchase: Property does not pass to him even if one instalment remains unpaid. The seller will have the right to take away the goods in case of default in respect of any instalment. This is known as ‘Hire Purchase’ system. The other arrangement may be that property passes immediately on the signing of the contract. The seller will not have the right to repossess the goods in case an instalment is not paid. His right will be to sue the purchaser for the money due. This is known as the Instalment System.

Entries In Books : Actual Cash Price Paid Method : This method follows a technical approach and does not treat the hire purchaser as owner until he makes the payment of last instalment. Under this method, the asset is recorded at the cash price actually paid.

Books of the Vendor. The vendor follows no special method for recording sales on hire purchase, specially in case of sale of large items. He debits the purchaser with the cash price and credits him with the amount received. Every year the interest due is debited.

Books of Purchaser

-First Method. The purchaser can also follow the system adopted by the vendor and make entries like ordinary purchase of an asset. Only, he should credit the vendor with interest due every year and debit him with cash as and when paid. The above given example can be worked out in the following way (ledger accounts.) :—

-Second Method. Under the second method, entries are passed only when payment is due or made. At this time, the vendor is credited with the amount due. Interest for the period is debited to interest Account and the balance (principal) is debited to the Asset Account. On payment, of course, the vendor is debited and Cash (or Bank) credited.

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