THE DIFFERENT TYPES OF FINANCE

From time to time you may want to buy an expensive piece of equipment or a motor vehicle for your business. Depending on the financial state of the business you may need to raise extra finance. One method is to approach your bank. If you only want short-term finance (up to a year) you will probably do best to try and negotiate an overdraft facility. But if you need finance over a longer period then your options are:

• bank loan (as distinct from overdraft)
• hire purchase
• asset leasing.

There are many variations on these options. Your choice will depend upon several factors:

• the period of the finance required
• the nature of the asset to be acquired
• interest rates, and what they will cost.

If you are buying property then a loan from a bank or other financial institution is probably the only real option. Of course, you may be able to rent premises but you will never become the owner.

For other assets you may be able to use any of the methods of finance. Let’s examine them in turn.

Bank loan (often called a development loan)

The bank makes you a loan so that you can buy the asset. The interest and repayments can be handled in various ways; for example:

Fixed interest, fixed repayment

The interest rate will be fixed at the start of the loan and will stay the same for the whole period of the loan. The repayments can also be set at a fixed amount (e.g. per month).

Fixed interest, reducing repayments

The interest rate is fixed at the start of the loan. The payments then made to the bank consist of two parts: the repayment of a fixed proportion of the sum originally borrowed, plus payment of interest at the agreed rate on the outstanding (and reducing) balance. For example:

Loan £6,000 over 5 years at 8% interest with monthly repayment of capital £100

Quarterly interest	Monthly repayments	Total per month
	£100	£100
	£100	£100
1st quarter £118	£100	£218
	£100	£100
	£100	£100
2nd quarter £112	£100	£212
	£100	£100
	£100	£100
3rd quarter £106 (and so on)	£100	£206

Floating interest rate

This system works very like the fixed interest, reducing repayment system outlined above. But instead of the interest rate being fixed at the start of the loan it varies throughout the period of the loan. Interest rates are normally expressed as so many per cent above bank Base Rate. The actual rate will depend upon the risk involved for the bank in the loan but typically it might be 2.5% to 3% above Base Rate.

Hire purchase

Under a hire purchase contract the HP company buys the asset on your behalf. You can then use the asset but ownership does not pass to you until the end of the repayment period. At that time you’ll have to pay a small option fee actually to exercise your option to buy the asset. A charge is made for the finance and you’ll usually have to pay this by monthly instalments along with the repayment of the capital. For example:

New motor van – cost £8,000: £1,000 deposit and balance over 3 years

	£
Cost	8,000
Hire charges (finance charge)	1,010
	_____
Total HP cost	9,010
	_____
Repayments
Deposit	1,000
36 monthly payments of £222.50	8,010
	_____
Total	9,010
	_____

The accounting treatment and taxation for HP are discussed below. You should note that for both purposes you are treated as if you acquired the asset at the start of the agreement, even though from a legal point of view this is not the case.

Asset leasing

In a lease the goods never become your own property: they always belong to the leasing company. The lease will normally be for a period between 2 and 5 years. During this period you pay a rent for the use of the asset. At the end of the period you can normally continue to use the asset for which you pay a peppercorn (nominal) rent. These periods are respectively called the primary and secondary lease periods. For example:

Motor van on lease over 3 years

Primary – 36 monthly rentals of £250.00

Secondary – Thereafter annual (peppercorn) rental of £25.

When you eventually stop renting the asset it is sold by the leasing company and the proceeds divided between the lessor (the leasing company) and the lessee (you or your business). If, for example, you use the van for four years (and so were in the secondary lease period), and the lease then ceased, the position might be:

	£
Proceeds of sale of van	1,000
	_____
Kept by leasing company	100
Leasing premiums returned to lessee	900

The exact arrangements would depend upon the terms of the lease, which you’d have to look at carefully.

ACCOUNTING TREATMENT

Bank loans

How do we record a bank loan in a full double entry system? It’s relatively simple.

		Example
		Dr	Cr
1.	Debit the bank account (main cash book) with the amount of the loan received	6,000
	Credit a new bank loan account (to set up the initial loan transaction)		6,000
2.	Debit the bank loan a/c with the capital portion of the monthly repayments	100 per month
	Debit the bank interest a/c with the interest portion of the monthly repayments or the quarterly interest charge	118 in the first quarter
	Credit the bank account with the monthly		100 &
	repayments or the quarterly interest charge		118

This records the loan repayments.

At the end of each financial year you’ll transfer the balance on your Bank Interest account to your profit and loss account, and write it off.

Hire purchase

In order to enter hire purchase contracts in your accounts it’s important to keep two aspects in mind:

• you need to account for the monthly repayments
• you need to account separately for the hire charges (finance cost).

The accounting entries would be as shown in Figure 47.

Example

Let’s take it step by step.

	Dr	Cr
Step 1 Set up the accounts for the transaction Debit the asset a/c with the cost of the asset (excluding HP charges)	8,000.00
Debit the hire purchase interest a/c with the total of the HP charges	1,010.00
Credit the hire purchase a/c with the cost of the asset and the HP charges		8,000.00 1,010.00
Step 2 Record payment of the deposit Debit the hire purchase creditor a/c and Credit the bank account with the payment of the deposit	1,000.00	1,000.00
Step 3 Record repayments made in the year (7× £222.50) Debit the hire purchase creditor a/c and Credit the bank account with the monthly repayments	1,557.50	1,557.50
Step 4 Charge the HP finance (interest) costs in your profit and loss account
Debit the profit & loss account	196.38
and credit the hire purchase interest a/c		196.38
with the proportion of the hire purchase charges relating to the year (see notes below).

Notes

There are several ways of apportioning the HP charge for the accounting year (Step 4). Here we have applied the fraction:

	No. of instalments paid
	__________________	x HP charges
	Total no. of instalments
	7/36× £1010 = £196.38

This is not particularly accurate but it does for most purposes. To reflect the actual interest pattern accurately you’d have to take account of the fact that the interest would be proportionately higher in the early months of the agreement when most of the capital is still outstanding.

Leases

The accounting treatment of leases has changed in recent years. In the past the accounting treatment followed the legal position and the monthly rentals paid were written off as a charge in the profit and loss accounts each year.

However, it was felt that outsiders looking at accounts were getting a false impression of a business; they couldn’t tell the value of the assets used by the business even though they were owned by an independent leasing company. Accordingly Statement of Standard Accounting Practice 21 now recommends leases should be treated like HP transactions. This is obligatory for company accounts but optional for sole traders and partnerships.

TAXATION TREATMENT

The taxation treatment of assets acquired on HP or leasing is very different.

Hire purchase

When you acquire assets under an HP agreement, the Inland Revenue treats you as owning the assets from the outset. You can thus claim capital allowances (see Chapter 10) on the cash value of the asset. You can also claim tax relief for the hire charges (i.e. interest/finance costs) because you have to deduct them from your profit and loss account. You can also get the whole of the VAT back at the time of the acquisition (if appropriate).

Leasing

The tax treatment for assets acquired under a lease has changed in recent years. If you acquire an asset under a lease, you will not be able to claim any capital allowances (since you don’t own the asset and never will). Instead you can deduct the whole of the amount that you pay to the leasing company (except the VAT) from your business profits. This, however, must be averaged over the life of the asset and not just over the period of the lease as was the case previously.

Thus if a piece of equipment with an expected life of 5 years is acquired on a lease requiring 24 monthly payments of £250 (excluding VAT) then the company will pay £6,000 (plus the VAT) to the leasing company over the 2 years. For taxation purposes, however, the company will only be able to claim tax relief at the rate of £1,200 for 5 years.

VAT is charged on each leasing instalment and so can only be reclaimed over the period of the lease – not in one lump sum as with HP.

It will be seen that the timing of the tax relief depends on whether the asset is acquired by lease or HP.

The capital allowances system gives relief on plant and equipment over a number of years, but the amount of the relief reduces each year. The relief is actually as follows:

Year	% of cost in year	Cumulative % relieved
1	25	25
2	19	44
3	14	58
4	10	68
5	8	76
6	6	82
7	4	86
8	3	89

After 8 years, 11% of the cost is still left unrelieved.

As you will appreciate, the amount allowed each year for an asset acquired on lease will depend not only on its cost but also on its expected life. Using the above example it is likely that there will be higher relief in the early years by using the HP route but in the long term there will be no effect on your overall tax liability.

SUMMARY

• There are three ways of financing the purchase of new assets: bank loan, hire purchase and leasing.
• The method you choose will depend on the period of the finance required, the nature of the asset and interest rates.
• Each method has to be accounted for in a different way.