Financial Accounting Exam

FINANCIAL ACCOUNTING Financial Accounting 1 HIRE PURCHASE AND INSTALMENT ACCOUNTS Introduction Hire purchase is a way of buying non-current assets where the buyer is not required to pay full amount at the time of purchase. Thus the buyer pays a down payment (deposit) and the remainder is paid in installments. In the agreement for hire purchase the following must be stated:- - The hire purchase price and the cash price. - The amount of installment and the date of payment. - A description of the goods sufficient to identify them. Differences between hire purchase and the normal purchase Hire purchase Normal purchase - Ownership remains with the seller - The ownership is transferred to buyer till last installment is made immediately - The buyer pays in installments over - The payments may be lump sum at once. a period of say years/months - The cost is higher to include - The cost is lower since hire purchase hire purchase interest. interest is not included NB: If the buyer does not pay all the installments the asset would be repossessed by the seller. In this case there is no refund of the amount already paid. Credit sale In credit sale agreement, the title of goods passes to the buyer immediately on delivery and the purchase price is payable in installments. In the event of default in payment, the seller can only sue for unpaid installments. Thus he cannot repossess the goods. This is normally for less durable goods like clothes. ACCOUNTING OF HIRE PURCHASE TRANSACTIONS Accounting treats assets bought on hire purchase as though they belonged immediately to the purchaser. This is because the business normally acquires assets on hire purchase with the intention of paying all the installments so that the asset finally belongs to them. This is an illustration of the substance over form FINANCIAL ACCOUNTING Financial Accounting 2 concept. Legally the purchaser does not own the asset (form) but economically the asset used by the business (substance). The total price will be split into cash price and interest component. Hire purchase transactions in the Buyer books. It is recorded in the following books: (i) Asset account (ii) Hire purchase company account (Creditor) (iii) Hire purchase interest suspense account. (a) For asset purchased on hire purchase terms:- Dr: Asset account with cash price Dr: Hire purchase interest suspense A/c with interest Cr: Hire purchase A/c with total amount payable under agreement (b) For deposit and installments paid to the hire purchase company Dr: Hire purchase company account Cr: Bank (c) Hire purchase interest written off. Dr: Profit and Loss Cr: Hire purchase interest suspense account (d) Balance sheet presentation The balance on hire purchase company account less the balance on hire purchase interest suspense account is shown as a current liability in the balance sheet (e) Asset account This is maintained at cash price and depreciation is charged in normal way. Disposal of asset is also treated in the normal. (f) For early repayment to hire purchase company. (i) Amount paid on early termination Dr: Hire purchase Company account Cr: Bank (ii) Balance remaining on hire purchase company account which represents interest waived: Dr: Hire purchase company account Cr: Hire purchase interest suspense account (iii) Balance remaining in hire purchase interest suspense account. FINANCIAL ACCOUNTING Financial Accounting 3 Dr: Profit and Loss account Cr: Hire purchase interest suspense account Methods of writing off hire purchase interest There are three methods:- (i) Straight line method This is also known as equal installments method. The interest is written off on straight line over the period of hire purchase agreement. Example: Bidii Traders bought a machine on hire purchase at Kshs. 460,000. The cash price of the machine was shs. 400,000. He paid a down payment of Kshs 100,000 and the remainder was to be paid within 24 months. Required: (i) Determine the amount of each installment. (ii) Determine the interest written off per installment. Solution: (i) Hire purchase price Kshs. 460,000 Cash price Kshs. 400,000 Hire purchase interest 60,000 Hire purchase price Kshs. 460,000 Deposit Kshs. 100,000 Total amount payable 360,000 Each installment = 360,000 24 = 150,000 Interest on each installment = 60,000 = 2500 24 (ii) Sum of digit method This is also known as rule of 78 method. It is an arithmetical method that apportions the interest in approximate proportion to the amount outstanding at any time. This method is as follows:- - Number the installments, giving the highest digit to the first installments and digit 1 to the last installments. FINANCIAL ACCOUNTING Financial Accounting 4 - Add up the digits - A portion to each accounting period a proportion of the hire purchase interest for each installment divided by the sum of the digits as indicated above. Illustration: For an asset purchased on hire purchase terms as follows:- Cash price shs. 300,000 Hire purchase price shs. 450,000 Payments: Deposit shs. 150,000 12 months installments shs 2500 Assuming a calendar year, the installments are numbered as followed:- Jan 12 Feb 11 March 10 April 9 May 8 June 7 July 6 Aug 5 Sept 4 October 3 Nove 2 Dec 1 78 Hire purchase price 450,000 Cash price 300,000 Hire purchase 150,000 Interest written off (i) For Jan = 12/78 x 150,000 = 23,077 (ii) For May = 8 /78 x 150,000 = 15,385 (iii) For fourth quarter 3 + 1 + 1 x 150,000 = 11,538 FINANCIAL ACCOUNTING Financial Accounting 5 78 NB:- If the number of installments is 24 then you add up the sum of digits starting from 24 to 1. Students to read on Actuarial method. Example: Prime Ltd acquired two machines under hire purchase agreements with the following details: Machine A Machine B Date of purchase 30/06/2005 31/01/2006 Cash price 650,000 450,000 Deposit 150,000 120,000 Hire purchase interest 250,000 150,000 Both agreements provide for payment to be made in 24 equal monthly installments starting on the last day of the month following purchase. Interest is deemed to accrue evenly over the period of agreement. On 1st August 2006 Machine A was totally damaged. In full settlement on 10th August 2006. (i) Insurance Company paid shs. 580,000 under a comprehensive policy and (ii) The hire purchase company accepted shs 270,831 for termination of the agreements. The firm prepared accounts annually to 31st December and provided depreciation on a straight line basis at a rate of 20% for motor vehicle, with full years depreciation in the year of purchase, no depreciation in the year. All installments were paid on the due dates: Required: (a) Machine account (b) Deprecation provision on machine account (c) Hire purchase company account (d) Hire purchase interest suspense account (e) Disposal of machine account. Carrying down the balances as on 31st December 2006