Early settlement of hire purchase accounts

One of our readers, Rosli, asked about the accounting treatment when hire purchase accounts are settled early.

In a previous post, we discussed the how to handle hire purchase transactions, but did not touch on the topic posed by Rosli.

If a hire purchase account is settled early, the only accounting impact will be on the HP Creditor liability account and the Hire Purchase Interest Suspense asset account.

Taking the example from our previous discussion, say the hire purchase amount was settled early after 24 months.

Our hire purchase account would now look like this:

	<---- Per instalment ---->
Repayments	Interest	Principal	Total	Total
24 instalments paid	33.33	208.33	241.66	5,799.84
23 repayments due	33.33	208.33	241.66	5,558.18
Final payment due	33.49	208.49	241.98	241.98
Grand total				11,600.00

We would have paid off 5,799.84 of the 11,600.00 due, and our ledger accounts would look like this:


The balance outstanding would therefore be RM5,800.16, but this includes an interest amount that is payable only if you continue with the hire purchase arrangement.

For an early settlement therefore the interest would be reduced from the amount payable, which in our example would be RM5,800.16 less RM800.08 leaving a balance of RM5,000.08.

So, when we make payment, we would credit the bank account and debit the Hire Purchase creditor's account. We would then need to journalise the interest amount. The result would be as shown below:

	Hire Purchase creditor's account
	Debit				Credit
	Date	Description	Amount		Date	Description	Amount
		Early settlement payment	5,000.08			Balance b/fwd	5,800.16
		HP interest account	800.08
			5,800.16				5,800.16
	Hire Purchase interest suspense account
	Debit				Credit
	Date	Description	Amount		Date	Description	Amount
		Balance b/fwd	800.08			HP creditor's account	800.08
			800.08				800.08

In reality, of course, the hire purchase company would not cancel all the interest. They would also charge an "admin fee" for early settlement. Just charge out the interest to the relevant expense account and journalise the balance.

Do note that early settlement of hire purchase accounts do not impact on the actual asset account.

Treatment of hire purchase transactions

Hire purchase transactions require the:

1. Capitalisation of the asset
2. recording of the liability to the hire purchase company
   

This in itself is straight forward:

1. Debit Asset account
2. Credit Hire purchase company
   

But, in book-keeping, we need to capitalise the asset at cost (i.e. net of the interests) and state the liability to the hire purchase company in full (i.e. cost + interest). Assuming that we purchase an asset as follows:

	Cost of asset	10,000.00
	Period of hire purchase	4 years
	Hire purchase interest .	4% p.a
	The total would therefore be:
	Cost of asset	10,000.00
	Interest over 4 years	1,600.00
	Total hire purchase amount	11,600.00

		<---- Per instalment ---->						Grand
	Repayments	Interest		Principal		Total		Total
	47 payments	33.33		208.33		241.66		11,358.02
	Final payment	33.49		208.49		241.98		241.98
	Total							11,600.00

	The accounting entry for this would then be:
	Account	Type		Debit		Credit
	Asset account	Asset		10,000.00
	HP Interest account	Asset		1,600.00
	Hire purchase co	Liability				11,600.00
				11,600.00		11,600.00

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Note on calculating the interest and principal components of repayments:

1. Cost of asset / number of repayments (10,000/48)
2. Total interest / number of repayments (1,600/48)

Round off the amounts and ensure that the interest + principal = repayments as specified in the hire purchase company's repayment schedule.

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The HP interest account and Hire purchase company account will reduce as we make the periodical payments and will be become zero when all payments have been made.

We will need one other account to expense off the hire purchase interest as we make progressive payments. Let's call this the HP Interest Expense account.

There are two ways to record payments to the Hire Purchase company:

1. Credit the full amount paid (in this case 241.66) to the hire purchase company liability account and create a journal to reduce and expense off the hire purchase interest

   	The accounting effect of payment made is as follows:
   		Debit	Credit
   	Hire Purchase company	241.66
   	Bank		241.66
   	The journal entry would be:
   		Debit	Credit
   	HP Interest Expense	33.33
   	HP Interest Account		33.33

   
   
2. Make all the relevant entries at the time of recording the payment. Our payment screen would therefore look like this:
   

   	Hire purchase company	241.66
   	HP interest expense	33.33
   	HP interest	(33.33)
   		241.66
   	Accounting impact:
   	Bank		241.66
   	Hire purchase company	241.66
   	HP interest expense	33.33
   	HP interest		33.33
   		274.99	274.99

   
   The advantage to this is that you make both entries simultaneously and there is a lesser chance of overlooking the interest journal.
   

With some accounting software like MYOB and QuickBooks, we can save transaction templates. In MYOB it's called a recurring transaction, while in QuickBooks it's called memorizing a transaction. With this feature, you can save the template with all the necessary details and recall the template every time you need to make payment. Recording the transaction using the second method therefore allows you to recall and record in one step.

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