When acquiring an asset, companies have several options to finance it. The most common form of finance is the company’s internal resources. Usually, companies have surplus assets that they can invest into new acquisitions. Most companies track these resources to ensure they can acquire new assets based on them. These assets generate from the company operations, equity finance, or debt finance.
For most larger purchases, however, a company’s internal resources may not be sufficient. In these cases, companies will acquire external finance. This finance may come from equity or debt sources. Companies also have the option to obtain lease finance. However, companies can also fund new acquisitions through internal resources without paying a lump sum amount. In these cases, hire purchase agreements may be crucial.
Hire purchase agreements to fall close to lease agreements when it comes to the accounting treatment. Before understanding how these agreements work, it is crucial to discuss lease agreements.
A lease agreement is a contract between two parties for the use of an underlying asset. This contract gives one party the right to operate an asset that the other party owns. In exchange, the owner gets regular payments which include both principal and interest amounts. In some cases, these payments may only constitute rent paid in exchange for the asset’s usage.
A lease agreement allows a party to acquire an asset without the need to pay a lump-sum amount. Similarly, it offers the lessee the option to get the asset barring the substantial initial acquisition costs. In most cases, lease agreements exist between individuals or companies and financial institutions. The first parties are the lessee, while the financial institutions provide finance to fund the asset’s purchase.
Some lease companies also exist that acquire assets and provide them for usage to others. In some situations, companies may also lease their assets to others when they don’t need them. Regardless of who the lessor and lessee are, lease agreements have similar features. These contracts can last for a few months up to many years.
Lease agreements are legal and binding contracts. These agreements outline the terms under which both parties agree to rent the underlying asset. The most common form of lease contracts includes property leases. However, it may also consist of other assets, such as vehicles, machinery, equipment, etc. Some lease contracts also allow the transfer of the underlying asset to the lessee at maturity.
READ: Accounting for ChargebacksA hire purchase agreement is a type of leasing contract in which the lessee gets control of the asset during the agreed term. In essence, the lessee hires these assets and uses them during a specific period. During this period, they provide the lessor with several payments, which include interest and principal amounts. The lessee gets control of the underlying asset at the end of the term.
Hire purchase agreements are essentially contracts in which the lessee pays for an asset in installments. At or during the agreement period, the underlying asset remains the lessor’s property. Once the lessee completes the agreed payments, they get control over it. These agreements have all the characteristics and benefits that come from leases.
Hire purchase agreements are crucial for parties that can’t afford substantial purchases. Through these contracts, lessees make a down payment during the purchase. After that, they continue making regular payments or installments to cover the asset’s cost. These agreements are similar to how mortgages work. However, there are critical differences between both processes.
Overall, hire purchase agreements to allow companies and individuals to acquire an asset without bearing the initial cost. Instead, they divide these costs into several installments that they repay the lessor. During these agreements, the lessee “hires” the asset and pays rent in exchange for using it. This rent becomes a part of the finance that helps the lessee “purchase” the underlying asset.
The accounting for hire purchase agreements falls under the scope of IFRS 16. The standard defines a lease as a contract that conveys “the right to control the use of an identified asset for a period of time in exchange for consideration”. Hire purchase agreements to meet this definition. The first part is the right to control the use of an identified asset for some time. Similarly, the second condition is the consideration paid.
READ: What is Fixed Overhead Spending Variance?Hire purchase agreements involving the use of an underlying asset for a specific time in exchange for payments. Therefore, these contracts fall under the scope of IFRS 16. When it comes to hire purchase agreements, the accounting will differ based on the lessee and lessor. For lessors, it involves recording the rent payments as income. For the lessee, the process includes the related expenses.
Similarly, there are several steps involved in accounting for hire purchase agreements. The first step is when a company enters a contract and acquires the asset. During this period, the lessee must recognize a lease liability measured at the present value of the lease payments. In exchange, the lessor must recognize a right-of-use asset. Its value will be at the initial measurement of the lease liability.
Subsequently, the company also recognizes the interest payments associated with the agreement. This process involves expensing out any related charges and increasing the lease liability. Eventually, when the lessee repays the lessor an installment amount, it must reduce the lease liability for the paid value. If the lease agreement changes during the period, the lessee must adjust the carrying amount.
Lastly, the right-of-use asset will remain on the lessee’s balance sheet. Lessees can measure this asset at the cost model or any other chosen model. For this asset, the lessee must also charge depreciation based on the asset’s remaining useful life. The treatment for the right-of-use asset will be the same as other assets and will not change due to the lease liability.
For the lessee, the journal entries for a hire purchase agreement will differ based on the stage of the process. When a lessee enters a hire for purchase agreement, they get the right to use the underlying asset. Due to this, the lessee must recognize a lease liability and a right-to-use asset. The journal entries for this process will be as follows.
Subsequently, when the lessee must recognize an interest charge on the lease liability. The accounting entries will include the following.
READ: What is Sales Price Operational Variance?When the lessee repays the lease liability, the accounting entries will be as follows.
A company, ABC Co., enters into a hire purchase agreement to acquire an asset. After sorting out the initial contract, the company gets the asset. ABC Co. calculates the present value of the lease payments to be $100,000. Therefore, the company must recognize a lease liability and a corresponding asset. The journal entries will be as follows.
After a year, ABC Co. calculates the interest payments for the first year to be $5,000. Therefore, the company must recognize an expense and increase the corresponding lease liability. The accounting treatment for it will be as follows.
At the year-end, ABC Co. repays the lessor the installment amount of $10,000 through the bank. For this transaction, the company must reduce the lease liability. The journal entries will be as follows.
This accounting for hire purchase will continue until the end of the contract. When the agreement is over, the lease liability will become nil. Similarly, the company must calculate the depreciation on the right-to-use asset every year until the end of its useful life. This useful life may extend beyond the lease agreement period.
ABC Co. recognizes a depreciation for the right-to-use asset based on a useful life of 5 years. Therefore, the accounting entries for it will be as follows.
As mentioned, this treatment will continue until the useful life of the underlying asset comes to an end. It does not depend on when the lease contract concludes. The treatment for the asset will not link up with the lease liability after the initial recognition.
A hire purchase agreement is a lease contract where a lessee gets the underlying assets after it ends. In exchange, the lessee makes regular payments to the lessor. In accounting, hire purchase agreements to fall under the scope of IFRS 16 Leases. There are several stages to accounting for hire purchase agreements, as demonstrated above.