Hire Purchase System, Meaning, Accounting Treatment, Key differences between Hire Purchase System and Instalment Payment System

The hire purchase system is a method of buying goods where the buyer gets immediate possession of the product but becomes the owner only after paying all instalments. The buyer pays an initial amount called down payment and the remaining balance is paid in regular instalments that include interest. Till the final payment, the seller keeps the ownership rights. If the buyer fails to pay instalments, the seller can take back the goods. This system helps people purchase costly items like vehicles, machines and appliances without paying the full amount at once. It provides financial flexibility and encourages easy access to essential goods while allowing the buyer to use the product during the payment period.

Functions of Hire Purchase System:

• Facilitating Asset Acquisition with Credit

The primary function is to enable buyers (hirers) to acquire and use expensive capital or consumer assets immediately without paying the full price upfront. It breaks the total cost into manageable, periodic installments (rentals), making assets like vehicles, machinery, or appliances accessible to individuals and businesses with limited initial capital. This function stimulates demand for high-value goods and expands the seller’s market, effectively acting as a powerful sales financing tool that bridges the gap between customer need and purchasing power.

• Establishing Legal Ownership and Risk Framework

The system clearly delineates the legal rights and risks between the seller (financier/vendor) and the hirer. Legal ownership remains with the seller until the final installment and option fee (if any) are paid. Consequently, the risk of damage, loss, or obsolescence remains largely with the seller during the hire period, often requiring them to insure the asset. This framework protects the seller’s title to the asset while granting the hirer equitable rights and the exclusive option to purchase.

• Creating a Secured Financing Mechanism

Hire Purchase functions as a self-secured loan. The asset itself serves as collateral. If the hirer defaults, the owner can legally repossess the asset without a complex foreclosure process, as ownership never transferred. This security reduces the financier’s risk, often allowing for more flexible credit assessments than unsecured loans. It provides lenders with a tangible recovery option, making them more willing to extend credit, especially to customers with weaker credit histories.

• Providing Structured Cash Flow Management

For the hirer, it functions as a structured cash flow management tool. Fixed, regular payments allow for precise budgeting and financial planning, avoiding large, lump-sum outlays. For the seller/financier, it ensures a predictable stream of future income comprising both interest (profit) and principal recovery. This steady cash flow from a portfolio of agreements aids in the financier’s own liquidity management and investment planning.

• Enabling Profit from Financing Activities

Beyond sales profit, the system functions as a source of financing income for the seller or a separate finance company. The total hire purchase price is significantly higher than the cash price, with the difference representing interest or financing charges. This allows vendors to earn revenue from two streams: the profit on the sale of goods and the interest income from extending credit, thereby increasing overall profitability from a single transaction.

• Transferring Economic Benefits of Ownership

While legal title remains with the seller, the hire purchase agreement transfers virtually all the economic benefits and burdens of ownership to the hirer from the start. The hirer has exclusive possession and use of the asset, bears the costs of maintenance and operation, and enjoys the economic utility derived from it. This functional transfer is why, in accounting (per AS 19/Ind AS 116), such an agreement is often treated as a finance lease or sale, recognizing the substance over the legal form.

Accounting Treatment of Hire Purchase System:

Journal Entries in the Books of Hire Purchaser (Buyer)

1. When Asset is Purchased on Hire Purchase

2. When Down Payment is Made

3. When Instalment is Paid

4. Recording Depreciation on Asset

Journal Entries in the Books of Hire Vendor (Seller)

1. When Goods Are Sold on Hire Purchase

2. When Down Payment is Received

3. When Instalment is Received