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.
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
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.
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.
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.
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.
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.
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:
Supplier allows the company to use assets after signing the agreement but ownership will transfer to XYZ at the end of the 4 th year when all payments are made.
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.
Interest expense = Lease Liability * Effective rate = 354,600 * 5% = $ 17,730
The journal entry is debiting interest expense and credit lease liability $ 17,730.
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:
Depreciation expense = $ 354,600/6 year = $59,100
The journal entry is debiting depreciation expense and credit right to use assets $ 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.