A hire purchase contract is a contract for the hire of an asset with a provision for the hirer to acquire ownership, usually by payment of a small acceptance fee, with the last instalment. Legal title does not actually pass to the hirer until all instalments have been paid.
Though legally the hirer does not actually own the asset until the end of the agreement, in effect hire purchase is analogous to buying an asset and receiving a loan at the date the agreement is signed.
Accounting for buying an asset on hire purchase follows the substance rather than the legal form of the transaction with the item being included as an asset of the business hiring it. This is an example of the concept of substance over form.
The required accounting entries at the date a hire purchase agreement is signed are:
Payments, usually monthly, will be made to the hire purchase company to pay off the "loan". In addition to the capital element of the monthly instalment, hire purchase charges, (equivalent to loan interest) must also be paid. These will be an expense of the business and will be debited to an expense account for Hire purchase charges. Note that, as with bank interest, no VAT is charged on HP interest.
On 30 June 2008 Mr Waterman enters into a hire purchase agreement with the Weller Finance Co for a new car for use in his plumber's business. Below the numbers on the agreement are described:
8260 | The basic price of the car. This figure includes VAT (which cannot be reclaimed by Mr Waterman). |
1420 | The deposit paid at the outset by Mr Waterman. |
7200 | The hire purchase "loan". |
1728 | The HP interest/charges. (Note that the true rate of interest is a lot higher than 8% as this is applied to the original, not the reducing balance of capital). |
8928 | Total of capital and interest to be paid over the next 3 years in 36 instalments. |
248 | The monthly instalment to be paid to the HP company. This will be partly repayment of capital and partly the repayment of interest/charges. |
There are various ways of allocating the interest over the 36 instalments. The easiest way is to assume that it is spread evenly over the 3 years i.e. each instalment contains an equal amount of interest:
Weller Finance Co Leasing Agreement |
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Lesee: | |||||||
Mr Waterman, plumber Canal St Wellingborough |
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Agreement date | 30/06/08 | ||||||
Cash price (inc VAT)- Car | 8,620 | ||||||
less: Deposit | 1,420 | ||||||
Amount of credit | 7,200 | ||||||
add interest 3 years @ 8% | 1,728 | ||||||
8,928 | |||||||
Repayable by 36 monthly payments of | 248 | ||||||
Commencing | 30/07/08 | ||||||
We must make postings to the asset account and the Bank account.
We will also need 2 new accounts:
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Note that the full cash price is now recorded in the asset account: £1,420 + £7,200 = £8,620
This will be treated just like any other asset of the business, even though it is not actually legally owned until the last payment is made.
It will be depreciated in the normal way, and will appear in the balance sheet along with the other assets of the business.
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The amount now recorded in the HP creditor account is the amount of credit obtained from the HP company.
This is the amount of capital that will be repaid over the period of the agreement.
Over the same period, interest will also be paid. This, however, has nothing to do with the capital outstanding and does not affect the HP creditor account.
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Similar repayments will be recorded on 30 August and 30 September, when Mr Waterman will be ready to prepare his annual accounts.
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The balance in the HP creditor account will show in the balance sheet as a liability.
Technically, part of this balance is a current liability:
(12 x £200 = £2,400 which will be repaid inside the next year),
and part is a long-term liability:
(21 x £200 = £4,200 which will be repaid later than one year).
This split will be necessary for company accounts, but for the sole trader the balance will probably just be shown as a long-term liability.
Balance sheet | |
LONG-TERM LIABILITIES | |
Bank loan | 14,222 |
HP Creditor | 6,600 |
20,822 | |
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The motor car will show as an asset, at the cash price of £8,620. This will be depreciated in the same way as other assets in its class.
Note that, if we are purchasing an asset on which we can claim back the VAT, the deposit will usually be treated as including the full VAT charge. For example, purchase of a van [right].
The payment of the deposit will be treated as including the VAT of £600. The balance of £900 will be payment of part of the cash price.
This will be recorded:
2008 | Dr | Cr | |
June 30 | Motor van | 900 | |
VAT | 600 | ||
Bank | 1,500 | ||
Payment of deposit on van |
The HP creditor will be recorded:
2008 | Dr | Cr | |
June 30 | Motor van | 5,100 | |
HP creditor | 5,100 | ||
Balance of cost of van on hire purchase |
Note that we now have the full cash price recorded in the Motor van account:
£900 + £5,100 = £6,000.
Weller Finance Co Hire Purchase Agreement |
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Customer: | |||||||
Mr Whitehouse, builder South St Yard Northampton |
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Agreement date | 30/06/08 | ||||||
Cash price - Van | 6,000 | ||||||
VAT | 600 | ||||||
6,600 | |||||||
less: Deposit | 1,500 | ||||||
Amount of credit | 5,100 | ||||||
add: Interest | 1,400 | ||||||
6,500 | |||||||
Repayable by monthly payments of | 180 | ||||||
Commencing | 30/07/08 | ||||||