MSG Team's other articles

11882 What is Payback Period ?

We have earlier discussed the fact that Net present Value (NPV) is considered to be the gold standard when it comes to financial decision making. If a project has an NPV greater than zero then it is supposed to be a financially viable project and the firm must invest its resources towards that project, if […]

11379 Step Up Bonds: Pros and Cons

Step-up bonds are special types of fixed income instruments. They help investors partially offset the risks of rising interest rates. This is because when investors invest in a bond, they typically lock in an interest rate. If the interest rate rises beyond that number, then the investors are at a loss because their money has […]

8755 Money Market – Definition, Participants and its Types

Retail investors across the world do not have a high level of knowledge when it comes to money markets. This is because of the fact that money markets have been largely invisible to retail investors. For a significant amount of time, money markets have only been used by large corporations, banks, and other entities to […]

10052 Issues in Determining Discount Rate for Valuation of Sports Franchises

In the previous article, we have already understood the method used for deriving the discount rate which is used while deriving the valuation of sports franchises. The method was described in detail. However, even though theoretically, there is a method available to derive the discount rate, there are several practical issues that make it difficult […]

10554 Over the Counter Markets

Over the counter markets are a particular type of financial market. Generally, financial markets are centralized. This means that there is one central body that is a counterparty to all the trades being made. For instance, if A wants to trade with B, the transaction does not happen directly. Instead, A trades with the centralized […]

Search with tags

  • No tags available.

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.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

China’s Predatory Lending

MSG Team

Why Should Central Banks Be Independent?

MSG Team

Central Banking in the United States

MSG Team