Hire Purchase – SS3 Book Keeping Lesson Note (First Term)

Hire purchase is a system of instalment payment in which the buyer (hirer) uses the goods at once, but the owner keeps ownership until the final payment is made.

Behavioural objectives

By the end of the lesson, students should be able to:

1. Explain the meaning of hire purchase.
2. List and explain the terms used in hire purchase.
3. Calculate the hire purchase price and the finance charge.
4. Name the two methods of recording hire purchase in the buyer’s books.
5. State the accounting entries in the buyer’s books under the interest paid method.

What is hire purchase?

Hire purchase is a system of instalment payment in which the hirer has possession and use of the goods, while the owner keeps ownership until the final payment is made.

• Possession: the hirer takes the goods and uses them from the start.
• Ownership: it passes to the hirer only after the last instalment is paid.
• Payment: the hirer pays a deposit, then instalments at regular intervals until the balance is cleared.
• Cost: the hire purchase price is higher than the normal selling price because it includes interest.
• Default: if the hirer stops paying, the owner can normally take the goods back.

What are the terms used in hire purchase?

There are five key terms: hirer, hire purchase price, finance charge, deposit and instalment.

• Hirer: the buyer, who has possession and use of the goods.
• Hire purchase price: the total amount paid for the goods, normally higher than the normal selling price.
• Cash price: the price at which the goods would be sold for immediate payment.
• Finance charge: the hire purchase interest, which makes the hire purchase price higher than the cash price.
• Deposit: the initial sum paid by the hirer at the start of the transaction.
• Instalment: a payment made at regular intervals to clear the balance of the hire purchase price.

How are the hire purchase price and finance charge calculated?

The hire purchase price is the deposit plus all the instalments, and the finance charge is the hire purchase price less the cash price.

1. Hire purchase price = deposit + total of all instalments.
2. Finance charge = hire purchase price − cash price.

Worked example

A trader buys a machine with a cash price of N100,000. He pays a deposit of N40,000 and three instalments of N25,000 each.

• Total instalments: 3 × N25,000 = N75,000.
• Hire purchase price: N40,000 + N75,000 = N115,000.
• Finance charge: N115,000 − N100,000 = N15,000.
• Interest in each instalment: N15,000 ÷ 3 = N5,000, if the interest is shared equally.

How is hire purchase different from a cash purchase?

A cash purchase is full payment at the time of buying, so ownership passes at once. Hire purchase is payment by instalments, so ownership passes only at the end.

What are the advantages and disadvantages of hire purchase?

Advantages

• Early use: the buyer uses the asset without paying the full price at once.
• Spread cost: the payment is shared over the hire period.
• Income from asset: a business can use the asset to earn money while paying for it.

Disadvantages

• Higher cost: the total paid is more than the cash price.
• Repossession: the goods can be taken back if the hirer defaults.
• No ownership: the hirer cannot treat the goods as fully his own until the last payment.

How are hire purchase transactions recorded?

The entries are made from the point of view of the two parties to the transaction: the seller and the hirer (buyer).

What are the methods of recording in the buyer’s books?

There are two methods of recording hire purchase in the buyer’s books: the interest paid method and the interest suspense method.

• Interest paid method: the asset is recorded at cash price, and interest is recorded as it falls due.
• Interest suspense method: the full hire purchase price is owed at the start, and the interest is held in an interest suspense account and moved to profit and loss over the hire period.

What is the interest paid method?

The interest paid method is the most common and simplest way of treating hire purchase in the buyer’s books.

What do the entries look like in the worked example?

Using the machine example above, the entries under the interest paid method follow these steps.

1. Machine acquired: debit hire purchase asset N100,000, credit hire purchase creditor N100,000.
2. Deposit paid: debit hire purchase creditor N40,000, credit bank N40,000.
3. Interest due at each instalment: debit hire purchase interest N5,000, credit hire purchase creditor N5,000.
4. Each instalment paid: debit hire purchase creditor N25,000, credit bank N25,000.
5. At the year end: debit profit and loss with the interest charged, credit hire purchase interest account.
6. Also at the year end: debit profit and loss with depreciation, credit provision for depreciation.

• Check: creditor owes N60,000 after the deposit, plus N15,000 interest, less N75,000 paid, leaving nil.

Evaluation

1. Explain the meaning of hire purchase.
2. List and explain five terms used in hire purchase.
3. A cash price is N80,000. The hirer pays a deposit of N20,000 and four instalments of N18,000. Find the hire purchase price and the finance charge.
4. Name the two methods of recording hire purchase in the buyer’s books.

Assignment

1. State the accounting entries in the buyer’s books for the payment of the initial deposit and for interest due at the date of instalment, using the interest paid method.
2. State the entries for writing interest to profit and loss and for depreciation on the asset.