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Hire Purchase Agreement Meaning
Hire Purchase is a kind of agreement where the buyer buying an expensive asset chooses an option to pay for the asset by paying some down payment at the time of purchase of an asset and clearing the remaining dues in regular installments including interest.
Types of Hire Purchase Agreement
- Under the first type, the third entity (lender) purchases goods on behalf of the customer and gets into this agreement with the customer. Under this agreement, the customer becomes the 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 this 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.
- Cash Price: Current market price at which goods can be purchased.
- HPP: Price at which goods can be purchased under this agreement.
Calculation Examples of Hire Purchase
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:
- Hire Purchase price
- Total Interest Paid
- The breakup of Principal and Interest paid by the buyer to the seller every year.
Solution:
Amount of interest paid will be calculated as follows:
#1 – Hire Purchase Price
#2 – Total Interest
#3 Principal and Interest Paid Every Year
- Outstanding Cash Price at Time of First Instalment = $ 2,18,000
- Interest on First Installment Rate of Interest =$10,900
- Principal Paid in First installment = $69,100
- Outstanding Cash Price =$1,48,900
- Interest on first installment Rate of Interest = $7,445
- Principal Repaid in Second Instalment = $72,555
- Outstanding Cash Price =$76,345
- Interest paid in third Instalment = $3,655
Calculation of Cash Price and Interest
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
Solution:
Calculation of HPP will be –
Alternatively,
Calculation of Cash Price will be –
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 assets 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 purposes. 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 assets in case an entity is facing a 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
Some of the disadvantages are as follows:
- 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 loss of the asset and damage your credit rating.
- The 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. The 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 –
