Archive bhd acquired a franchise on finance lease. it is required to pay 200000 per annum in advance for five years. the implicit interest rate is 10%. the franchise could be bought for 800000. the legal life is five years but can be renewed at 5000 for another five years. discuss the accounting treatment for the franchise.
To discuss the accounting treatment for the franchise acquired by Archive BHD on finance lease, we need to understand the concept of finance leases and how they are accounted for.
A finance lease is a type of lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee (Archive BHD, in this case). In this scenario, Archive BHD will pay an annual payment of 200,000 in advance for five years, and the implicit interest rate is 10%. The franchise can be bought for 800,000 and has a legal life of five years, which can be renewed for another five years at a cost of 5,000.
The accounting treatment for a finance lease involves recognizing the leased asset and the corresponding liability on the lessee's balance sheet. Here are the steps involved:
1. Initial Recognition:
- Archive BHD will recognize the franchise as an asset on its balance sheet at its fair value, which is the purchase price of 800,000. This amount represents the present value of the lease payments over the lease term, discounted at the implicit interest rate of 10%.
- Archive BHD will also recognize a liability for the same amount (800,000) on its balance sheet. This liability represents the present value of the lease payments.
2. Subsequent Measurement:
- Archive BHD will depreciate the leased asset over its expected useful life. In this case, since the legal life of the franchise is five years and it can be renewed for another five years, the total expected useful life would be ten years.
- Archive BHD will charge depreciation expense each year, typically using a systematic method like straight-line depreciation, to allocate the cost of the franchise over its expected useful life.
3. Lease Payments:
- Archive BHD will make annual lease payments of 200,000 in advance for five years.
- Each year, the lease payment will be allocated between the reduction of the lease liability and the interest expense.
- The interest expense is calculated by multiplying the lease liability at the beginning of the year by the implicit interest rate of 10%.
- The reduction in the lease liability will be the difference between the lease payment and the interest expense.
4. Lease Renewal:
- If Archive BHD renews the lease after the initial five years for another five years at a cost of 5,000, the lease liability will be adjusted accordingly.
- The additional 5,000 would be added to the lease liability, and the remaining lease payments would be adjusted to reflect the renewal period.
Overall, the accounting treatment for the franchise acquired by Archive BHD on finance lease involves recognizing the leased asset and the corresponding liability on the balance sheet, depreciating the asset over its expected useful life, and recording annual lease payments as a reduction of the liability and interest expense.
The accounting treatment for the franchise acquired by Archive BHD on finance lease can be discussed as follows:
1. Initial Measurement:
- The initial cost of acquiring the franchise is 800,000.
- The payment of 200,000 per annum is considered as an annuity payment.
- The implicit interest rate is 10%.
- The legal life of the franchise is five years, with a renewal option for another five years at a cost of 5,000.
2. Present Value Calculation:
- To determine the present value of the annuity payment, we need to discount each annual payment at the implicit interest rate of 10%.
- Using the present value of an annuity formula, the present value of the annuity payment for five years is calculated.
- The present value of the annuity payment represents the value of the franchise.
3. Initial Recognition:
- The present value of the annuity payment, representing the value of the franchise, is recognized as a non-current asset on the balance sheet.
- The corresponding entry would be to debit "Franchise" and credit "Finance Lease Liability" or "Finance Lease Payable" for the present value amount.
4. Subsequent Measurement:
- Each year, Archive BHD will pay 200,000 in advance, which includes both the interest and principal component.
- The interest expense is calculated based on the outstanding lease liability and the implicit interest rate, which will decrease over time.
- The principal component is the difference between the total payment and the interest expense.
- The lease liability is reduced by the principal component each year, representing the repayment of the finance lease obligation.
5. Interest Expense Recognition:
- At the end of each accounting period, an interest expense is recognized in the income statement.
- The interest expense is calculated by multiplying the outstanding lease liability at the beginning of the period by the implicit interest rate.
- The interest expense is debited, and the interest payable or accrued account is credited.
6. Reduction of Lease Liability:
- Each year, the lease liability is reduced by the principal component of the payment.
- The lease liability is credited, and the finance lease payable or finance lease liability account is debited.
7. Renewal Option:
- If Archive BHD exercises the renewal option after five years, the lease term is extended, and the 5,000 cost to renew the franchise is capitalized.
- The cost of renewal is added to the carrying value of the franchise asset, and the lease liability is adjusted accordingly.
It is important for Archive BHD to consult with their accountant or financial advisor to ensure proper accounting treatment and compliance with relevant accounting standards.