Hire Purchase Agreements
Buying Assets on Installments
A hire purchase agreement is a particular type of agreement between a buyer and seller. The asset being sold in this case is generally a fixed asset. Also, the amount that has to be paid, is not paid in one single payment. Rather the payment is done in instalments over a period of time.
It needs to be mentioned that it is not a financial institution that is buying the asset in full and hypothecating it while the buyer uses it.
Rather, in this kind of arrangement, the seller (hire purchase vendor) directly provides financing to the buyer (hire purchase buyer). Obviously, the vendor either has to borrow money on interest to lend to the buyer or else they are foregoing interest on their own money. Therefore, the hire purchase vendor is clearly entitled to charge interest on the amount owed by the hire purchase buyer to compensate for this loss.
The hire purchase agreement is a widely used financial service particularly in Commonwealth countries like the United Kingdom, Australian, Canada and India. In this article we will have a closer look at the concept of hire-purchase agreements.
Transfer of Ownership
When a person buys a car on loan, the title of the car immediately transfers to their name and the bank has a hypothecation on the car. However, if the same car was purchased using a hire purchase agreement, the title of the car would not change until the entire agreement was over and the very last payment was made!
In case of a hire-purchase agreement, the hire purchase buyer keeps making periodic rental payments to the hire purchase vendor. It must be noted that these payments are considered to be rent paid for the use of the asset. These payments are not the result of an amortization schedule.
However, when the hire purchase buyer makes all the payments that were due, the ownership of the asset is transferred to them. The ownership of the asset is an important consideration in business matters. This is because the owner of the asset is legally entitled to charge off depreciation on the asset. Depreciation is a non-cash outflow and hence can be strategically used to lower tax payable. Therefore, the exact moment when ownership changes hands has an impact on the cash flows of the parties involved.
On the other hand, some companies may want to use the asset but keep their balance sheet deleveraged. In such a case, the fact that ownership is not immediately transferred becomes an advantage. Corporations who want to finance their fixed assets using off balance sheet method of financing are the ones that are more interested in the hire purchase system.
How it Works ?
The accounting for hire purchase agreements can get considerably complicated. However, the complexity is beyond the scope of this article. We will simply explain the common sense approach that is used behind such transactions.
- Down Payment: The buyer starts by making a down payment to the hire purchase vendor. This is when the possession of the assets may actually change hands. The down payment is not recorded towards revenue obtained by selling goods. Instead, the down payment is recorded as rental revenue.
- Instalments: The hire purchase buyer than keeps on making monthly payments to the vendor. However, these payments reflect the rent that is being paid to use the fixed asset rather than amortization payments reducing the balance of a loan.
- Loss/Transfer of Ownership: The hire purchase agreement creates no loan liability on the books! However, one must understand that there is indeed a theoretical loan being made here. A hire purchase buyer cannot stop making monthly payments to the vendor. If they do, the vendor can just repossess the goods, and all the payments that they made in the past will be worthless. The ownership of goods only changes hands if all the instalments are paid as agreed upon. Only at the end of such payments does an option become active when the hire purchase buyer can purchase the asset at a pre-determined nominal sum.
Thus, even though technically there is no loan, nonpayment of monthly dues can lead to loss of control over the asset as well as loss of sums that were made as rental payments previously. Hire purchase buyers will therefore not default on their obligations unless they have no other alternative since they have gone bankrupt or they no longer value the asset.
- Pre-closure of the Deal: The hire purchase agreement need not necessarily run its entire course of time. The hire purchase buyer does have the option of closing the deal when they wish to do so. They just have to pay all the pending instalments as a lump sum and the option of buying the asset for a nominal price immediately becomes active. The interest on such instalments may be waived off. In addition, the hire purchase vendor may give a certain rebate to encourage early repayment of the loan.
Hire purchase agreement is, therefore, a mechanism wherein a company can acquire fixed assets without acquiring any kind of debt obligation on its balance sheet. The liquidity and tax benefits provided by hire purchase make it a popular arrangement.
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