HIRE PURCHASE AND CREDIT SALE

Introduction The transfer of goods from a supplier or a seller to a customer for other than an immediate cash payment givens rise to various financial arrangements For example, the transaction may be financed by the normal terms of trade which require settlement within an agreed period or by the acceptance of a bill of exchange or the transaction may be under a credit sale agreement whereby, the goods become the property of the buyer immediately but payment for them takes place over a stipulated period.

The other alternative is for the transaction to be subject to a hire purchase agreement. The goods remain the property of the seller and the buyer pays hire charges over a stipulated period at the end of which he pays a further amount, termed an option to purchase, which then gives him ownership.

The arrangement Under a hire purchase agreement the customer obtains possession of the goods at the outset, but that the supplier until the end of the hiring period. On a strict legal interpretation of the facts, the supplier should not take credit for any profit and the customer should not debit the cost of the terms until the hiring period has ended. Accounting, however, looks at the substance of the transaction rather that at its legal form. Consequently the supplier recognizes profit as arising over the period of hire instead of at the end. Similarly the customer makes the necessary entry in Purchases or Fixed Assets Accounts at the beginning of the period and not after the option fees has been paid. With both credit sale and hire purchase agreements the accounting arrangements are identical and from this subsection onwards references to hire purchase transactions would apply equally to credit sale transactions. Under a hire purchase transaction, the selling price consists of cost price plus gross profit (thus giving cash selling price) plus a further sum of hire purchase interest by way of compensation to the supplier for the delay in receiving full payment and for the attendant risks. This is a reasonable imposition because the seller may have had to borrow money to finance the deal; alternatively the money tied up in the deal might have been earning a return by being invested inside the business.

Accounting For Hire Purchase Transactions Goods Brought On Hire Purchase Basis There are two recognized ways of accounting for items bought on hire purchase bases. Method 1 The assets account is debited with the cash cost of the item and the sellers account is credited with the same amount. Interest is debited to HP Interest account and credited to the sellers account when each installment is due. Deposit and installments paid are debited to the sellers account, the balance of which is included in creditors in the balance sheet. The balance carried down each year on the sellers account is the unpaid portion of the cash cost.

Method 2 The asset account is debited with the cash cost of the item but the sellers account is credited with the full hire purchase price, the interest element of which is debited to HP Interest Suspense. When each installment is due, the appropriate amount of interest is released from the HP Interest. Deposit and installments paid are debited to the sellers account, the balance of which, minus the balance on the HP Interest Suspense, is included in creditors in the balance sheet.

Focal Point For reasons stated above the buyer treats his acquisitions as fixed assets when he obtains possession after becoming party to the contract, despite the fact that he is not the legal owner at that stage. Depreciation on fixed assets bought on ire purchase must be charged from the date of acquisition of possession (not from date of legal ownership) and calculated on the cash cost price. Under Method A and B an account is maintained for the seller and, under Method B, for the suspended interest. The amount shown as the balance on the sellers account is not due for payment within the immediate future on the sellers account is not due for payment within the immediate future or in one lump sum but as a series of payment, possibly over a number of years. Similarly, the balance on HP Interest Suspense represents interest due to be paid at various future times but not immediately due.
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Example An example illustrating, the points mentioned so far now follows and is solved using each of the methods A and B in turn, so that their effects can be compared and contrasted. Kay Transport Co. Ltd, acquired two new motor bikes on 1st January, 2003 for GH129,150,000. The cash price of these bikes was GH90,000,000. The deal was financed by Ben Financing Ltd, and the terms of the hire purchase contract required a deposit of GH30,000,000 on delivery, followed by three installments on 31st December, 2003, 2004 and 2005 of GH33,000,000, GH33,000,000 and GH 33,150,000 respectively. The true rate of interest was 30% per annum.

The depreciation policy of Kay Transport Ltd was to write off 20% per annum on a straight line basis assuming a residual value of nil.

Required Prepare the appropriate accounts in the books of Kay Transport Ltd to record the above transactions. Show the relevant balance sheet entries at the end of accounting year.

Solution 3.2 A separate answer for each of the two methods outline in 3.2 now follows: Method A

Kay Transport Ltds Books Vehicles 2003 Jan 1 2004 Jan.1 2005 Jan. 1 Ben. (financing) Lid Balance b/d Balance b/d GH000 2003 Balance c/d Balance c/d Balance c/d GH000 90,000 90,000 90,000

90,000 Dec. 31 2004 90,000 Dec. 31 2005 90,000 Dec. 31

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Ben Financings Ltd 2003 Jan 1 Dec 31 Bank - deposit Bank 1st Installment 30,000 33,000 GH000 2003 Jan 1 Dec 31 Vehicles Hp Interest
30% x (90,000 30,000)

GH000 90,000 18,000

Dec 31

Balance c/d

45,000 108,000 108,000 Balance b/d HP Interest (30% x 45,000) 45,000 13,500 58,500 Balance b/d HP interest (30 % x 25,000) 25,000 7,000 33,150

2004 Dec 31 Dec 31

Bank-2 Installment Balance c/d

nd

2004 33,000 Jan 1 25,000 Dec 31 58,000

2005 Dec 31

Ben-Final Installment

2005 Jan 33,000 Dec 31 33,150

HP Interest 2003 Dec 31 2004 Dec 31 2005 Dec 31 Ben Financings Ltd. GH000 18,000 2003 Dec 31 2004 Dec 31 2005 Dec 31 Profit or Loss GH000 18,000

Ben Financings Ltd.

13,500

Profit and Loss

13,500

Ben Financings Ltd.

7,650

Profit or Loss

7,650

Provision for Depreciation on Vehicles 2003 Dec 31 2004 Dec 31 GH000 2003 18,000 Dec 31 2004 36,000 Jan 1 Dec 31 36,000 2005 54,000 Jan 1 Dec 31 54,000 GH000 18,000

Balance c/d

Profit or Loss

Balance c/d

Balance b/d Profit and Loss

18,000 18,000 36,000 36,000 18,000 54,000

2005 Dec 31

Balance c/d

Balance b/d Profit or Loss

Method B The Vehicles, Hire Purchase Interest and Provision for depreciation accounts are exactly the same as for Method A and are not repeated.

Ben Financings Ltd. 2003 Bank deposit Dec 31 Bank-1st Installment Dec 31 Balance c/d 2004 Dec 31 Bank- 2nd Installment Dec 31 Balance c/d 2005 Dec 31 Bank Final Installment GH000 2003 30,000 Jan 1 33,000 66,150 129,150 2004 33,000 Jan 1 33,150 66,150 2005 33,150 Jan 1 Sundries GH000 129,150

129,000 Balance b/d 66,150 66,150 Balance b/d 33,150

Hire Purchase Interest Suspense 2003 Jan 1 GH000 2003 39,150 Dec 31 Dec 31 39,150 2004 21,150 Dec 31 Dec 31 21,150 2005 7,650 Dec 31 GH000 18,000 21,150 39,150 13,500 7,650 21,150 7,650

TSPT (Financings Ltd.)

Hire Purchase Interest Balance c/d

2004 Jan 1

Balance b/d

Hire Purchase Interest Balance c/d

2005 Jan 1

Balance b/d

Hire Purchase Interest

The calculation of the amount of interest transferred out each year is the same as under Method A and the workings are not repeated here. The amounts which would be disclosed in the balance sheet at the end of each year would be identical for methods A and B, but different in composition. Thus, at the end of the first year (2003) the following would appear. Method A ( Fixed assets ) Vehicle (at cost ) Less provision of depreciation (Creditors: amounts falling due within one year) Other creditors: hire purchase [33,000 13,500] or [ 45,000 25,500 ] (Creditors: amounts falling due after one year Other creditors: hire purchase [ 33,000 7650 ] Method B ( Fixed assets ) Vehicle (at cost ) Less provision for depreciation (Creditors: amounts falling due within one year ) Other creditors: hire purchase [66,150 (33,150 +13,500] ( Creditors: amounts falling due after one year ) Other creditors: hire purchase [33,150 7650] GH000 90,000 18,000 GH000 72,000

19,500 25,500

90,000 18,000

72,000

19,500

25,500

In each case, the net effect of fixed assets (72,000) less combined GH45,000 that is (GH19,500 plus GH25,500) is GH27,000. This figure is equivalent to: GH,000 Deposit paid 1st Installment paid Less interest element 33,000 18,000 GH000 30,000 15,000 45,000 18,000 27,000 In other words, it represents the written off value of the accumulated deposit plus interest exclusive element of installments paid Additionally, a note should be lappended showing the hire purchase payments to which Kay Transport Ltd is committed separately for the next year, for the second to fifth year and in total after that. In fact in this question there are only two further years involved.

The note required could be worded: Hire Purchase Payments The payment to which the company is committed under the hire purchase contracts are: Payable in next year Payment in two to five years Less finance charges allocated to future Periods [ 13,500 + 7,6500] GH 000 33,000 33,150 66,150 21,150 45,000

It can be seen that this figure is equal to the aggregate of the two creditors figures included in the balance sheet extract at 31st December, 2003, [GH19,500 + GH25,500 = GH45,000] Another note should disclose the gross amounts of assets held under hire purchase contract s together with the related aggregated depreciation and the deprecation charge for the period should be disclose d for each major class of asset.

The note could be worded Assets held under hire purchase contracts Cost Depreciation Accumulated Current year GH 000 GH 000 90,000 18,000

GH 000 72,000

Hire Purchase Interest As has been noted above and following hire purchase interest is an element of the hire purchase price which must be written off as an expense over the life of the contract. Ideally, hire purchase interest should be written off during the contract period in such a way as to produce a constant periodic rate of return on the remaining balance of the interest exclusive liability for each period.

Operating Arrangements Goods Sold On Hire Purchase Goods which are sold on hire purchase terms tend to fall into one of two broad categories: 1. Large item which buyers treat as fixed assets, or 2. Small items most of which are retailed to members of the general public and for which therefore, the corresponding buying entries are not raised in the books of any business. From tee point of view of the seller under a hire purchase contract, the selling price consists of three elements the cost price and gross profit, which together give the cash selling price, and hire purchase interest, which add the latter up to the hire purchase selling price.

Accounting Methods The accounting method employed depends upon the category of item above. Category 1 Items For category 1, Items (large items) the amounts involved are substantial and/or relatively infrequent and the supplier or finance company is a le to identify the transaction surrounding each hire purchase contract with ease

Consequently the suppler clan spread the gross profit and hire purchase interest over the contract period without much difficulty. Where a supplier sells goods to a customer via a finance company, the seller can take full credit for gross profit at the point of sale, but the finance company should take credit for hire purchase interest over the contract period on some suitable basis. The objective is to produce a constant rate of return on the net investment in the contract in each period. Net investment is hire purchase installments less finance charges allocated to future periods. There are two common method of accounting for category 1. Items sold on hire purchase. The main features are:

Method A The customers account is debited with the cash sale l price of the items and HP Sales account is credited. Interest is debited to the customers account (when each installment is due) and credited to HP Interest Received. Deposits and installments received are credited to the customers account. At the end of the period the balance on this account represent to that part of the cash sale price not yet due or received. In the balance sheet it is included under current assets as HP Debtors not yet due. At the end of each of each period the balance on HP Sales and on HP Interest Received are transferred to HP Trading as credits. This latter account is then debited with the cost of the hire purchase goods sold. A provision for unrealized profit is raised to suspend the appropriate portion of gross profit included in selling price. Movements in this provision are reflected in Provision for unrealized profit account. The balance on HP Trading is called gross profit but is really a combined figure of pure gross profit and of hire purchase interest earned during the period and is transferred to the general trading account if different classes of business are transacted or to profit and loss account if they are not.

Method B This is the same as Method A except for the following variations. The customers account is debited with the hire purchase sale price of the item, HP Sales account is credited with the cash price and HP Interest Suspense with the full amount of interest on the contract. Deposits and Installments received are credited to the customers account, as under Method A, but the balance on this account at the end of the period represents that part of the hire purchase sale price not yet
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due or received. In the balance sheet it is included under current assets, minus the balance on HP Interest Suspense, as HP Debtors not yet due. The appropriate amount of interest, calculate don the outstanding balance of the cash price, as under Method A, is transferred at the due date by debiting HP Interest Suspense and crediting HP Interest Received. This latter account is then disposed of as under Method A. For reasons stated above, the seller treats his disposals of goods as sales on parting with possession of them after becoming party to the contract, despite the fact that he is still the legal owner at that stage. The amount shown as the balance on the customers account is not due for collection within the immediate future or in one lump sum but as a series of receipts, possibly over a number of years. Similarly, the balance on HP Interest Suspense represents interest receivable at various future times but not immediately due. The provision for unrealized profit required under both methods is calculated using the formula. Balance of cash selling price not yet due x Total cash selling price Gross Profit

Or more simply, Gross profit % x Balance of cash selling price not yet due

Example An example using each of the methods A and B so that their effects can be compared and contrasted now follows: Kay Transport Ltd. Acquired two new motor bikes on 1st January 2003 for GH129,150,000. The vehicles were supplied and financed by TOYOTA Ltd. and the terms of the hire purchase contract required a deposit of GH30,000,000 on delivery, followed by three installments on 31st December 2003, 2004, and 2005 of GH33,000,000 GH33,000,000 and GH 33,150,000 respectively. The true rate of interest was 30% per annum. The cost of the vehicles to the suppliers was GH60,000,000 and their cash selling price was GH90,000,000.

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Required Prepare the appropriate accounts in the books of TOYOTA LTD. to record the above transactions for each of the three years.

Show the relevant balance sheet entries at the end of 2003.

A separate answer for each of the two methods outlined above now follows.

Method A TOYOTA Ltd. Ledger 2003 Jan 1 Dec 31 HP Sales HP Interest Received (30% x (90,000-30,000) GH000 90,000 18,000 2003 Jan 1 Dec 31 Bank Deposit Bank 1st Installment Balance c/d 108,000 2004 Jan 1 Dec 31 Balance b/d HP Interest Received (30% x 45,000) 45,000 13,500 58,500 25,500 7,650 33,150 2005 Dec 31 Bank Final Installment 2004 Dec 31 Dec 31 Bank 2nd Installment Balance c/d GH000 30,000 33,000 45,000 108,000 33,000 25,500 58,000 33,150

2005 Jan 1 Dec 31

Balance b/d HP Interest Received (30% x 25,000)

33,150

HP Interest Received 2003 Dec 31 2004 Dec 31 2005 Dec 3 HP Trading GH000 60,000 2003 Dec 31 2004 Dec 31 2005 Dec 31 Kay Transport Co. Ltd. GH000 18,000

HP Trading HP Trading

13,500 7,650

Kay Transport Co. Ltd Kay Transport Co. Ltd.

13,500 7,650

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HP Sales 2003 Dec 31 HP Trading GH000 90,000 2003 Jan 1 Kay Transport Co. Ltd. GH000 90,000

HP Trading For the year ended 31/12/2003 HP Cost of Sales Provision For unrealized profit Gross Profit GH000 60,000 15,000 33,000 108,000 HP Sales HP Interest Received GH000 90,000 18,000 108,000

For year ended 31/12/2004 Gross Profit GH000 20,000 HP Interest Received Provision For unrealized profit (released) 20,000 GH000 13,500 6,500 20,000

For year ended 31/12/2005 Gross Profit GH000 16,150 HP Interest Recieved Provision for unrealized profit (released) GH000 7,650 8,500 16,150

16,150 Provision for unrealized profit 2003 Dec 31 GH000 Balance c/d (331/3% x 45,000) 45,000 2004 Balance c/d (331/3% x 25,000) HP Trading 8,500 6,500
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2003 Dec 31

Trading

GH000 15,000

2004 Dec 31 Dec 31

Jan 1

Balance b/d

15,000

2005 Dec 31

HP Trading

8,500

2005 Jan 1

Balance b/d

8,500

Method B The HP Sales, HP Trading and Provision for unrealized profit accounts are the same as under Method A and are not repeated. Kay Transport Ltd. 2003 Jan 1 Sundries GH000 129,150 2003 Jan 1 Dec 31 Dec 31 129,150 2004 Jan 1 Balance b/d 66,150 66,150 2005 Jan 1 Balance b/d 33,150 2005 Dec 31 Bank Final installment 2004 Dec 31 Dec 31 Bank 2nd Installment Balance c/d Bank - ?Deposit Ban -1st Installment Balance c/d GH000 30,000 33,000 66,150 129,150 33,000 33,150 66,150 33,150

HP Interest Suspense 2003 Dec 31 Dec 31 2004 Dec 31 HP Interest Received Balance c/d GH000 18,000 21,150 39,150 13,500 7,650 21,150 7,650 2003 Jan 1 Kay Transport Co. Ltd. GH000 39,150 39,150 2004 Jan 1 Balance b/d 21,150 21,150 2005 Jan 1 Balance b/d 7,650

HP Interest Received Balance c/d

2005 Dec 31

HP Interest Received

The amount which would be disclosed in the balance sheet at the end of each year would be identical for Methods A and B but different in composition. Thus at the end of the first year (2003) the following would appear.

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Method A (Current Assets) Debtors: Net Investment in hire purchase contracts (Provision for liabilities and charges) Other Provisions: Provision for unrealized profit on hire purchase Contracts

GH000

45,000

15,000 GH000

Method B (Current Assets) Debtors: amounts due within one year Net Investment in hire purchase contracts [66,150 21,150] (Provision for liabilities and charges) Other Provisions: Provision for unrealized profit on hire purchase contracts Under both Methods it is essential to append a note to the balance sheet, as Cost of assets acquired for hiring under Hire purchase contracts Net investment represents in hire purchase contracts

45,000

15,000 Follows: GH000 60,000 45,000

This latter figure, GH45,000,000 equals the aggregate of the two individual amounts shown as debtors (19,500 + 25,500). The gross investment represents the interest exclusive outstanding installments.

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Category 2 Items For items which are categorized under this (small items), the amounts involved (per item) are relatively small but the volume of such items is likely to be large. It would be impractical for the supplier to employ the methods outlined 4.5 as it would require an amount of clerical effort disproportionately greater than the resultant advantages. An acceptable expedient is employed in that no attempt is made to calculate the amount of gross profit and hire purchase interests neither received for separate crediting to HP Trading account nor are calculations made for each individual contract. Instead, calculations are based on the total of all transaction in a particular accounting period of a particular class of items under hire purchase contracts and for the purposes of the calculations, pure gross profit and hire purchase interest are combined into one figure. It is this combined figure which is apportioned over the hire purchase period.

There are two common methods of accounting for category 2, items sold on hire purchase, these are termed a) Stock on hire method, and b) Provision for unrealized profit method. Stock on Hire Method This method is so called because goods on hire purchase in customers hands are regarded as stock out on hire at cost. Accounting Entries Goods sold on hire purchase are debited to HP Debtors and credited to HP Sales at hire purchase selling price. Deposits and installments received are debited to Bank and credited to HP Debtors. The balance of this latter account represents sums owing on hire purchase contracts but not yet due. An amount equivalent to the deposits and installments received in a particular period is debited to HP Sales and credited to HP Trading. The balance on HP Sales account is then equal and opposite to that on HP Debtors and the two therefore cancels out and do not appear in the balance sheet. The cost price of goods sold on hire purchase is debited to HP trading and credited to the (general), Trading account.

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At the end of each period stock on hire is calculated, using the formula. HP Debtors owing not yet due x Cost of HP goods Total HP Sales 1 This figure is credited to the HP Trading Account and carried down as a debit to the next period. In the balance sheet, net investment in hire purchase contracts is shown. The balancing figure HP Trading then represents pure gross profit plus hire purchase interest earned during the period and is carried to (general) Trading account. The hire purchase interest component is calculated as shown above. Example The following figures are a summary of the sales on hire purchase made by a retailer of electrical goods during his first year of trading.

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