2. Chapter 8 Hire purchase

3. Three types of Sale Cash sale Credit sale Sale on hire purchase agreement.

4. Hire purchase considerations Cash price Hire purchase price Interest element

5. Accounting for the Hire Purchase Element Sales at cash price should be recognized at the date of delivery. Interest element in hire purchase price should be apportioned during the hire purchase period.

6. Five Methods for the Apportionment Straight-line method Reducing balance method Sum of the digits method In the proportion to cash received Actuarial method

7. Definition of Hire Purchase A hire purchase contract is a contract for the hire of an asset that contains a provision giving the hirer an option to acquire legal title to the asset upon fulfillment of certain condition stated in the agreement. These conditions are usually the payment of an agreed number of installments or the payment of a notional sum at the end of the contracted hire period.

8. Two categories of leases Operating lease Finance lease

9. Example of Apportioning the interest Cash price of goods: $9,600 Number of instalments: 3 years Amount of each instalment: $4,000 per annum So, amount of interest should be: $4,000×3 -$9,600=$2,400

10. Straight line Year $ Interest 1800 2800 3800 $2,400

11. Sum of the digits YearOutstandingInterest $ 133/6× $2,400=1,200 222/6 × $2,400=800 311/6 × $2,400= 400 $2,400

12. Example of Reducing balance method Cash price $9,600 payable in three equal instalments and then each instalment would be $3,200 plus interest at 12% on the outstanding balance at the end of each year.

13. Receivable a/c Sale in year 1 9,600 Bank 3,200 Interest in year 1 768* Balance c/d 7,168 10,368 10,368 Balance b/d in year 2 7,168 Bank 3,200 Bank 768 Interest in year 2 384** Balance c/d 3,584 7,552 7,552 Balance b/d in year 3 3,584 Bank 3,200 Bank 384 3,584 3,584

14. Receivable a/c Sale in year 1 9,600 Bank 3,200 Interest in year 1 1,152 Bank 1,152 Balance c/d 6,400 10,752 10,752 Balance b/d 6,400 Bank 3,200 Interest in year 2 768 Bank 768 Balance c/d 3,200 7,168 7,168 Balance b/d 3,200 Bank 3,200 Interest in year 3 384 Bank 384 3,584 3,584

15. Comment on the accounting treatment Comparing above two reducing balance methods, we can find that total interest in the later $2,304 (1,152+768+384) is twice of that in first one $1,152(768+384). So, we can conclude that which reducing balance adopted in a hire purchase transaction would affect the hire purchase price, and the profit; even it is a matter of hire purchase agreement. In accounting practice, most veteran accountants always choose them expediently. In this case, there is no indication about the hire purchase price, but the interest rate and cash price. If there is indication about the hire purchase price and cash price, but no indication about the interest rate, that mean no room to choose the reducing balance methods. We will discuss it in example 8.3.

16. Leaseholds property The person or company that owns the property and grants the lease is called the lessor. The person or company that secures the right to possess and use the property is called the lessee The right granted to the lessee by the lessor under the lease are called a leasehold. A leasehold is an intangible asset for the lessee. Long-term leases often require the lessee to pay for any alterations or improvements to the leased property, such as new partitions and store fronts. Normally, the cost of these leasehold improvements are debited to an account called Leasehold Improvement.

17. Accounting for Leasehold Improvement Open an account called Leasehold improvement. Record the cost of leasehold improvement in the debit side and credit other appropriated account Amortize the balance of leasehold improvements over the life of the lease or the life of the improvement whichever is shorter.

18. Financial Lease and operating lease IAS17 defined as a lease that transfers substantially all the risks and rewards of ownership. Such lease is called as Financial lease. And Operating lease is a lease other than a finance lease, that is one that does not transfer the risks and rewards of ownership.

19. Lease includes hire purchase contracts Hire purchase with a financing lease characteristics should be accounted for as a basis of financial lease. And Hire purchase with a operating lease characteristics should be accounted for as an operating lease basis.

20. Capital transaction and revenue one Accounting for capital transaction would not affect profit and loss a/c when the transaction occurred. However, if it directly affect the profit and loss account, that would be regarded as revenue transaction. To identify the capital transaction and revenue transaction would be a principle to prepare accounting treatment of hire purchase with financial or operating lease characteristics

21. Accounting for hire purchase with financial lease characteristics For a view of buyer, we should open some appropriated account such as: Asset account Vendor’s account Interest account

22. Accounting treatment for interest element in hire purchase Two methods would be adopted to prepare accounting treatment of interest element in hire purchase. 1. No accounting entry is made for the interest until it become due 2. Open an account called “interest suspense a/c if interest element is implied.

23. Example 8.3 On 1 January 20x1, Bus Transportation Ltd acquired a lorry from Homenda Motors Ltd under a hire purchase agreement. The cash price of the lorry was $15,000. The agreement calls for three equal payments of $6,000 to be made on 31 December each year. Interest in the contract is 9.7%.

24. Method 1 First journal entry for the hire purchase Dr Cr Asset a/c 15,000 Homenda Motors Ltd 15,000 To acquire the lorry

25. Second step Accounting for interest in first year under method 1 Dr Cr Interest a/c 1,455 Homenda Motors Ltd 1,455

26. Third step Pay the first instalment of hire purchase Dr Cr Homenda Motors Ltd 6,000 Bank 6,000

27. Homenda Motors Ltd a/c 20x1 $ 20x1 $ Dec 31 Bank 6,000 Jan 1 Asset account 15,000 Balance c/d 10,455 Dec 31 Interest at 9.7% 1,455 $16,455 $16,455 20x2 20x2 Dec 31 Bank 6,000 Jan 1 Balance b/d 10,455 Balance c/d 5,469 Dec 31 Interest 1,014 $ 11,469 $ 11,469 20x3 20x3 Dec 31 Bank 6,000 Jan 1 Balance b/d 5,469 Dec 31 20X2 Interest 531 6,000 6,000

28. Method 2 Under method 2, the first journal entry is similar with method 1 but open a interest suspense a/c and prepare a journal entry like: Dr Cr Interest suspense a/c 3,000 Homenda Motors Ltd 3,000 To accounting for the implied interest in the hire purchase.

29. Aftermath of accounting for interest After accounting the interest in the interest suspense a/c, the total obligation to Homenda would be 15,000+3,000=18,000 and then we can easily to divide it into three instalments of $6,000 Next job is to amortize the interest suspense a/c into the profit and loss a/c

30. Consideration of depreciation In the case of a hire purchase contract with the characteristics of a finance lease, the purchaser should depreciate the asset using the method and rate of depreciation appropriate to the type of asset and in accordance with company's policy on depreciation.

31. Disclosure requirements Where the hire purchase agreement is similar to a finance lease, the lessee must disclose the following: Gross amounts of assets held under hire purchase agreements, the related accumulated depreciation and the total depreciation charged to the period by each major class of asset. Amounts of obligations related to hire purchase agreements net of future finance charges (interest) should be separately disclosed, and analyzed between those payable in the next year, years two to five, and after five years (all from the balance sheet date). The aggregate finance charges allocated to the period. Commitments which exist at the balance sheet date but which commence after the year end.

32. Seller’s book in hire purchase From the view of the seller, we should ascertain: 1.Cost of sold 2.Gross profit in the hire purchase 3.Interest income in the hire purchase

33. Example 8.4 Continue from example 8.3, the asset, its cash price is $15,000 but its original cost was $12,000. It is sold under a hire purchase agreement calling for three instalments of $6,000 per annum payable at the end of each year. The amount of profit and interest to be taken each year is as follows: hire purchase price will be $18,000; cash received $6,000 per annum; profit and interest $6,000 (profit $3,000, interest $3,000).

34. Seller’s book of hire purchase Generally speaking, from the view of seller, the profit should be recognized after the completion of the contract and amortize the element of interest during the hire purchase period. However, this rule is not available to all countries that are members of International Accounting Standards Committee. In particular accounting practice. The accounting treatment would be various.

35. Different accounting treatment of profit in Hire purchase In some country, the element of the profit in hire purchase also would be apportioned with the element of interest. Because it is believed more prudent.

36. Example 8.6 On 1 January 20x1 Homenda Ltd sold a machine, costing $15,000, to Bus Transportation Ltd under a hire purchase agreement requesting a deposit of $5,000 and three equal instalments of $6,000 per annum payable at the end of each year. Interest in the contract is at 9.7% per annum. The cash price is $20,000.

37. Analysis of example 8.6 Hire purchase price 23,000 Cash price 20,000 Interest element 3,000 profit in the hire purchase would be: cash price 20,000 cost 15,000 5,000

38. Method 1 Profit is taken immediately and the interest is spread on the reducing balance method

39. Method 2 Both profit and interest are taken on the sum of the digits method.

40. Method 3 Profit is taken on equal instalments; interest is taken on the sum of the digit method

41. Workings in method 3 Profit=$5,000/3=$1,667 per annum (two years unearned) $ Interest=$3,000 spread year 1 3/6=1,500 year 2 2/6=1,000 year 3 1/6= 500 (Year 2 and 3 not earned) $ Year 2 Profit taken 1,667 Interest taken 1,000

42. Calculation of method 3 $ $ Year 1 Sales at HP price 23,000 Less: Cost of sales 15,000 Gross profit (including interest) 8,000 Less : Transfer to unearned profit 3,333 Less: Transfer to unearned interest 1,500 4,833 3,167

43. Method 4 Profit and interest are taken in proportion to cash received.

44. Payments in typical Hire Purchase transaction 1) Deposit 2), Rent or instalment 3), Residual value, at the end of the lease term, guaranteed by lessee 4), Residual value, at the end of the lease term, guaranteed by a third party 5), Unguaranteed Residual value accruing to the lessor. 6), Pre-emptive bid 7), Operating cost 8), Contingent rent

45. Deposit The amount paid by buyer to seller before the contract to ensure the transaction, Deposit represent a right to continue the transaction from both buyer and seller.

46. Residual value, at the end of the lease term, guaranteed by lesee The amount to ensure the reclaim leased asset back to the lessor and protect the lessor from unreasonable loss

47. Residual value, at the end of the lease term, guaranteed by a third party At the end of the lease term, if the amount, residual value guaranteed by lesee, do not ensure to the lessor, in this case, guarantee from a third party is necessary.

48. Unguaranteed Residual value accruing to the lessor This is an expected value of the leased asset at the end of the lease period from the lessor.

49. Pre-emptive bid The amount paid by the lessee at the end of lease period for the pre-emptive right over the ownership of leased asset. It is not always necessary to distinguish the financial lease and operating lease. However, it is necessary to distinguish the financial lease and operating lease in Chinese accounting practice.

50. Operating cost The amount paid by the lessee to operate the leased asset. For example, a lorry, as a leased asset, the lessee must pay running expenses for it. Such running expenses can be regarded as operating cost.

51. Contingent rent Some uncertain rent, such as, increased rent if opulent profit become true in the future. However, any amount of contingent rent should be a matter of agreement, only the condition of it is uncertain.

52. Analysis of cash flow in the hire purchase from the view of buyer 1) to 3) and 6) would be element of the cost from the buyer, but we can not use these amount directly because it is cash flow at different time. The total of the present value can be treated as cost of hire purchased equipment from view of buyer. A question would arose: what interest rate would be available to calculate the present value?

53. Determine the interest rate the interest rate charged in the contract would be available to calculated the present value. If no interest is stated then the implied rate of interest is used. For this purpose the technique described above using present value tables (and if necessary interpolation) should be employed. In excel soft-ware, we can use IRR to help

54. From the view of seller Compared with cost from the view of buyer, the cash flow 4) would be an element of proceeds, because a third party guarantees it. Similarly, the proceeds should be the total present value of these cash flows, if the proceeds were recognized as revenue at once.

55. Example 8.7 Company B has equipment book valued as $255,000 but fair value is $213,231; useful live is designed of 8 years. Suppose that the residual value of the equipment at the end of 8 year would be $5,000, and the straight-line method is adopted for it’s depreciation, and then annual depreciation would be $31,250 that can make annual profit increased by $40,000. However, Company A intended to rent the equipment with following conditions

56. Conditions of example 8.7 1). Company A should pay $5,000 to Company B as deposit in bid to buy the equipment from B in a hire purchase contract. 2). Company A should pay annually $40,000 in 5 years to Company B. 3). Company A ensured that the value of the equipment would be, at least, $10,000, to return to Company B at the end of the hire purchase period if they would not purchase it. 4). To accelerate the transaction, Company C ensured to Company B that the value of the equipment would be $20,000 at the end of 5 years if Company A would not purchase it. 5). At the end of 5 years, Company A can offer $34,737 as a pre-emptive bid to purchase the equipment 6). During the year 3, year 4 and year 5, if company A can increase its annual profit exceed $50,000 by using the equipment, the instalments in these year would be increased by 10%. 7). However, if Company A must pay annually $4,000 as operating and maintaining cost to use the equipment.

57. Buyer’s Book Step 1, analysis of payments and fair value of the hire purchased assets Step 2, sort out the Minimum Lease Payment (MLP) Step 3, calculate present value of MLP. Step 4, determine the cost of hire purchase assets (present value of MIP and fair value of the hire purchased assets, whichever is littler.) Why? Step 5, determine what is the Internal Return Rate (IRR), and use this rate as the actuarial interest rate to amortize deferred interest expenses.

58. Step 4 Why? If the present value of MLP< the fair value of the hire purchase assets, we should take the present value of MLP as cost of hire purchase cost. Because the present value of MLP is based on the marketable interest rate. selecting the present value of MLP as cost would ensure the marketable interest rate as the IRR.

59. Step4 why? continue On the contrary, if the present value of MLP> the fair value of the hire purchase assets, we should take the fair value as cost of hire purchase cost. In this case, the IRR of the hire purchase would be higher that the marketable interest rate. So step 4, selecting present value of MLP or fair value of the hire purchased assets, whichever is littler, as the cost of hire purchase can ensure the minimum interest rate adopted to amortize the deferred interest expenses would be, at least, marketable interest rate.

60. Analysis of payments In this case, if Company A successfully purchased the equipment, what cash flow can be elements of the cost from the view of Company A? Obviously, cash flow 1), 2), 3) and 5) would be the element of the cost. Cash flow 6) would be a contingent cost, and cash flow 7) is leasehold improvement that would be not treated as cost but expense finally by Company A. On the contrary, what cash flow should be regard as proceeds from view of Company B? Cash flow 1), 2), 3), 5) and additional cash flow 4) would be treated as proceeds by Company B. Nevertheless, Company B would hope the value at the end of 5 year be $98,750 (cost of equipment 255,000- total Company B’s depreciation in 5 years $156,000) this figure should be deducted by the cash flow 5), the remains $78,750 should be the unguaranteed residual value accruing to the lessor, which never covert into cash in the transaction.

61. Minimum lease payments (MIP) MLP is defined as the minimum requirements that consist of an inevitable value that ensure the transfer ownership from seller to buyer. In this case, following would be MLP 1.Deposit for the transactions 2.Normally rent or instalments in the lease period. 3.Residual value guaranteed by lessee. 4.Pre-emptive bid if any.

62. Accounting treatment of the buyer Because, there is no information about the marketable interest rate, only we can do is taking the fair value of the equipment as cost of the buyer. And then take the MLP as account payable. So, the journal entry from the buyer would be:

63. First Journal Entry of Example 8.7 Dr Cr Equipment 213,231 Deferred expense 36,506 Account payable 249,737* Note * Deposit 5,000 Rent instalments ( 40,000×5) 200,000 Residual value ensured by Company A 10,000 Pre-emptive bid 34,737 and the amount of 213,231 as a present value of the MIP. this amount should be regarded as MIP

64. Seller’ books 1.Step 1. calculate the investment and net investment in the hire purchase. 2.Step 2. determine the IRR between net investment and investment as amortization rate during the lease term.

65. Investment and net investment Investment --- total payments in the future or total receivable in the future, which ensure to transfer the ownership to buyer Net investment --- the cost of the investment from the lessor

66. Investment in the case Deposit Rent or instalments Residual value guaranteed by Company C Pre-emptive bid Residual value at the end of lease term

67. Net investment in the case Net investment in this case would be the book value of cost of the equipment.

68. Journal Entry of seller Take and debit the investment as receivable a/c. And credit the net investment. Difference between them as unearned revenue.

69. At the end of lease period If the buyer complete the MLP, the ownership should be transferred from seller to buyer. However, from the view of the seller, the total debited amount of investment usually more than the MLP from view of the buyer, the difference between them should be written off against to the seller’s P/L a/c as unrealized earning.

70. If any amount of payment in MLP has failed The buyer should return the leasing asset to the seller. But the returned value should be taken into consideration. Which would fallen into following four situations. 1.Returned value is less than the guaranteed value 2.Returned value is more than the guaranteed value but less than the residual value guaranteed by the third party. 3.Returned value is more the residual value guaranteed by the third party. but less than that unguaranteed value. 4.Returned value is more the that unguaranteed value.

71. Illustration of the four situations Situation 1 situation2 situation3 situation 4 The residual the residual guaranteed by guaranteed by Unguaranteed Company A Company C Residual value

72. Journal entry for situation 1 Dr Cr Fixed assets 8,000 Company A 2,000 Company C 10,000 Profit and Loss a/d 78,750 Investment 98,750

73. Journal entry for 2 Dr Cr Fixed assets 15,000 Company C 5,000 Profit and loss a/c 78,750 Investment 98,750

74. Journal entry for 3 Dr Cr Fixed assets 30,000 Profit and loss a/c 68,750 Investment 98,750

75. Journal 4 Dr Cr Fixed assets 100,000 Investment 98,750 Profit and loss a/c 1,250

76. Repossessions in Hire purchase Considerations in the Repossession 1.How much the debtors account become a bad debt? 2.How much the repossessed assets values? 3.Do you resold the repossessed assets and how much?

77. How much the debtors account become a bad debt? This question is concern with the amount that will need writing off from the debtors account, it would not be writing off against the profit and loss a/c. because is would be not regarded as loss directly.

78. How much the repossessed assets values This figure usually concerned with settlement of the repossession, and finally affection of how much the real loss would be in the hire purchase transaction.

79. Do you resold the repossessed assets and how much This figures would concern with how much loss could recover.

80. Steps in the Repossession The procedure of repossession would be quite similar with the in the disposal of fixed assets Step 1.Open repossession a/c Step 2. Transfer the outstanding balance of debtor’s a/c to the repossession a/c. Debit the repossession a/c. Step 3. Transfer the outstanding balance of unrealized earning a/c to the repossession a/c. credit the repossession a/c. Step 4. Journalize the repossessed assets and resold assets, and credit the repossession a/c. Step 5. finally, settlement of the repossession a/c against the profit and loss a/c

81. Disclosure requirement for hire purchase The net investment in (i) finance leases and (ii)hire purchase contracts at each balance sheet date. The gross amounts of assets held for use in operating leases and the accumulated depreciation charges. The cost of assets acquired, whether by purchase or finance lease, for the purpose of letting under finance leases The aggregate rentals receivable in respect of an accounting period in relation to (i) finance leases and (ii) operating leases The policy for accounting for finance leases income

82. Tax Effect of net investment 30,000 Rental 10,000 10,000 10,000 CA 7,500 7,500 7,500 Profit 2,500 2,500 2,500 Tax effect 625 625 625 Net investment would be 30,000-3×(10,000- 625)