Hire-Purchase is a type of agreement whereby hiree (purchaser/lessee) instead of purchasing any asset by paying the full amount in cash agrees to pay a particular part as down payment, if agreed (initial payment) and balance as periodical installments (hire charges and principal) for a particular period of time. Under such agreements, the ownership of the goods may/ may not be transferred to the buyer until all the payments as agreed have been made. It is commonly used in the United Kingdom and it’s more commonly known as an installment plan in the United States.
Types of Hire Purchase Agreement
Under the first type, third entity (lender) purchases goods on behalf of the customer and gets into a hire purchase agreement with the customer. Under this agreement, the customer becomes owner on payment of the final installment. The lender owns the ownership of goods, pays the purchase price to the seller and get it recovered from the customer. Here, a lender may seize goods in case of non-payment.
Under the second type of agreement purchaser, himself enters into a hire purchase agreement with the seller and pays to the seller, becomes the owner of goods on payment of the last installment. Here, a seller may seize goods in case of non-payment.
Components of Hire Purchase
Hire Purchaser/Hiree: Entity which purchases goods on a hire purchase basis.
Seller/Dealer: Entity who sells goods.
Down Payment: Initial upfront payment processed. Example; 10% of the cash price.
Hire Charges: Amount paid for hiring or using goods. In simple terms, this can also be said as a rental charge for using an asset.
Hire Charge = Hire Purchase Price – Cash Price
Interest = Total amount due at the time of installment x rate interest /100 t rate of interest
Cash Price: Current market price at which goods can be purchased.
HPP: Price at which goods can be purchased under the hire purchase agreement.
Calculation Examples of Hire Purchase
Following are calculation examples of hire purchase.
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Example #1
An Inc. purchased a machine on hire purchase from Z Ltd, on January 1, 2018, paying $ $80,000 immediately and agreeing to pay three annual installments of $80,000 each on December 31, every year. The cash price of the machine is $2,98,000 and the vendors charge interest @ 5% per annum. Calculate the following:
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Note:
Annuity to recover $1 over the given period of time is given by Cash Price = Annual Instalment x [(1+r)n -1]/r-(1 + r)n – 1
(Where r is the rate of interest, n is number of installment)
Example #2
Calculate Cash Price with the following information: –
HPP =$90,000
Three yearly equal installments (Principal + Interest)
Interest Rate = 5%
The present value of $1 annuity of 3 years value @5% is 2.723
Please refer given excel template above for detailed calculation.
Important Points
Purchaser pays a rental (the charge for hiring) for an agreed period of time.
If the purchaser makes default in payment, the seller has the right to recover/seize asset from the purchaser.
Frequency of installment may be yearly/quarterly/monthly etc.
Goods possession gets transferred initially but ownership of goods remains with the seller until the payment of the final installment.
Usually, the purchaser pays a certain percentage of cash price as a down payment.
Since property in goods vests with a seller, he can claim depreciation on sold goods for income tax benefit purpose. Similarly, the purchaser can claim income tax benefit on hire charges (Hire purchase price minus Cash price).
Advantages
Assets can be bought into use without paying for the full amount.
A convenient method for procuring asset in case entity is facing cash shortage or does not want to spend a huge amount at once.
Since the amount of expenditure is well known in advance, it makes easier for the entity to make budgeting decisions.
It can be said as a convenient way of financing an asset purchase.
Disadvantages
Since it creates a fixed amount payment burden on the purchaser, he may find difficulty in payment during a cash crunch position which may also lead to lose the asset and damage your credit rating.
Cost of purchasing an asset will always be higher than purchasing on the cash price.
Legal ownership vests with the seller which may seize the same in case of non-payment of hire purchase installments.
If the purchased asset gets stolen/ destroyed before it is fully paid for, the insurance may not cover the replacement value which may lead you to face a shortfall (in recovery).
Conclusion
Based on the above discussions, advantages, disadvantages discussed and shared it cannot be outrightly said that purchasing an asset on hire purchase, in cash, a loan or lease is best. Mode of acquisition shall be decided by multiple factors based on each individual organization. But yes, it is a good option in case the entity wants to use the asset without processing 100% payment at once. However, it is a costlier method of acquisition rather than Cash Purchase as it will always include hiring charges/interest element.
Recommended Articles
This has been a guide to what is Hire Purchase Agreement and its meaning. Here we discuss the most common types of hire purchase agreement along with calculation examples & explanations. We also discuss the advantages and disadvantages. You can learn more about accounting from following articles –
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