04-01-2013, 04:01 PM
HIRE PURCHASE – ACCOUNTING, REPORTING AND TAXATION
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Introduction
Hire purchase, as a form of financing, differs from lease
financing in one basic respect: while in hire purchase transaction,
the hirer has the option to purchase the asset at the end of the
period on payment of the last installment of hire charge, the
lessee does not have the option to acquire the ownership of the
leased asset. A hire purchase transaction has, therefore, some
typical features from the point of view of accounting and
reporting.
First, although the legal title over the equipment remains with
the hire vendor (financer), all risks and rewards associated with
the asset stand transferred to the hirer at the inception of the
transaction. The accounting implication is that the asset should
be recorded in the books of the hirer. The hire-vendor should
record them as hire asset stock in trade or as receivables.
Secondly, the hirer should be entitled to the depreciation claim.
Finally, the hire charges, like the lease rental in a financial lease,
have two components (a) interest charges (b) recovery of
principal.
Accounting Treatment in the Books of Hirer
The cash purchase price of the asset is capitalized and the capital
content of the hire purchase installment, that is, the cash
purchase price less down payment, if any, is recorded as a
liability. The depreciation is based on the cash purchase price of
the asset in conformity with the policy regarding similar owned
assets. The total charges for credit (unmatured finance charge at
the inception of the hire purchase transaction) is allocated over
the hire period using one of the several alternative methods,
namely, effective rate of interest method, sum of years digits
method and straight line method.
Financial Evaluation
Now let us discuss the framework of financial evaluation of a
hire purchase deal vis-à-vis a finance lease from both the hirer’s
as well as the finance company’s viewpoint.
From the Point of View of the Hirer (Purchaser):
The tax treatment given to hire purchase is exactly the opposite
of that given to lease financing. It may be recalled that in lease
financing, the lessor is entitled to claim depreciation and other
deductions associated with the ownership of the equipment
including interest on the amount borrowed to purchase the
asset, while the lessee enjoys full deduction of lease rentals. In
sharp contrast, in a hire purchase deal, the hirer is entitled to
claim depreciation and the deduction for the finance charge
(interest) component of the hire installment. Thus, hire
purchase and lease financing represent alternative modes of
acquisition of assets. The evaluation of hire purchase transaction
from the hirer’s angle, therefore, has to be done in relation
to leasing alternative.
Decision criterion:
The decision criterion from the point of
view of hirer is the cost of hire purchase vis a vis the cost of
leasing. If the cost of hire purchase is less than the cost of
leasing, the hirer should prefer the hire purchase alternative and
vice-versa.
From the View Point of Vendor / Financer
Hire purchase and leasing represent two alternative investment
decisions of a finance company / financial intermediary / hirevendor.
The decision criterion therefore is based on a
comparison of the net present values of the two alternatives,
namely, hire purchase and lease financing. The alternative with a
higher NPV would be selected and the alternative having a
lower NPV would be rejected.