Accounting Entries for HP Agreements: A Comprehensive Guide

Hire Purchase (HP) agreements are becoming an increasingly popular way of financing equipment, vehicles, and other assets for businesses. Under an HP agreement, the customer buys the asset on credit and gradually pays off the amount owed plus interest over a specified period of time.

For companies that offer HP agreements, proper accounting treatment is essential to ensure accurate financial reporting and compliance with accounting standards. In this article, we will take a look at the accounting entries involved in HP agreements and understand how they are treated in financial statements.

1. Initial Recording of the HP Agreement

The first step in accounting for an HP agreement is to record it in the company`s books of accounts. The entry is made as follows:

Dr. Asset Account

Cr. HP Liability Account

For example, let`s say a company sells a computer worth $1,000 to a customer on an HP agreement. The accounting entry would be:

Dr. Computer Account $1,000

Cr. HP Liability Account $1,000

2. Recognition of Interest Income

Since HP agreements involve payment of interest, the company must recognize interest income over the life of the agreement. The interest income is calculated using the effective interest rate method, which is the rate that exactly discounts the estimated future cash flows through the life of the agreement.

The accounting entry to recognize interest income is:

Dr. HP Interest Receivable Account

Cr. HP Interest Income Account

The HP Interest Receivable Account is a current asset account that represents interest that has been earned but not yet received. The HP Interest Income Account is a revenue account that records the interest income earned by the company.

3. Recognition of Principal Repayments

The principal repayments made by the customer are recorded as a reduction in the HP Liability Account. The accounting entry to record the principal repayment is:

Dr. HP Liability Account

Cr. Cash Account

4. Recording the Sale of the Asset

Once the customer has made all the necessary payments, the company transfers the ownership of the asset to the customer. The accounting entry to record the sale of the asset is:

Dr. Cash Account

Cr. Sales Account

Cr. Cost of Goods Sold Account

The Sales Account records the sale of the asset, while the Cost of Goods Sold Account represents the cost of the asset sold. The difference between the two is the company`s gross profit from the sale.

5. Accounting for Default

If the customer defaults on the HP agreement, the company must establish a provision for bad debt. The accounting entries for this are:

Dr. Bad Debt Provision Account

Cr. HP Interest Receivable Account

Cr. HP Liability Account

The Bad Debt Provision Account is a contra-asset account that reduces the HP Interest Receivable Account. At the same time, it reduces the HP Liability Account since the company is unlikely to recover the full amount outstanding.

Conclusion

Accounting for HP agreements can be complex, given the various entries involved. It is therefore essential that companies engage reputable accountants or tax professionals to ensure that their books of accounts are accurately maintained and comply with the relevant accounting standards. By following the steps outlined above, companies can ensure that their financial statements are reliable and provide a true picture of their financial position.