CA21-5.
(Lessee Capitalization of Bargain-Purchase Option)
Albertsen Corporation is considering proposals for eitherleasing or purchasing aircraft. The proposed lease agreementinvolves a twin-engine turboprop Viking that has a fair value of$1,000,000. This plane would be leased for a period of 10 yearsbeginning January 1, 2017. The lease agreement is cancelable onlyupon accidental destruction of the plane. An annual lease paymentof $141,780 is due on January 1 of each year; the first payment isto be made on January 1, 2017. Maintenance operations are strictlyscheduled by the lessor, and Albertsen Corporation will pay forthese services as they are performed. Estimated annual maintenancecosts are $6,900. The lessor will pay all insurance premiums andlocal property taxes, which amount to a combined total of $4,000annually and are included in the annual lease payment of $141,780.Upon expiration of the 10-year lease, Albertsen Corporation canpurchase the Viking for $44,440. The estimated useful life of theplane is 15 years, and its salvage value in the used plane marketis estimated to be $100,000 after 10 years. The salvage valueprobably will never be less than $75,000 if the engines areoverhauled and maintained as prescribed by the manufacturer. If thepurchase option is not exercised, possession of the plane willrevert to the lessor, and there is no provision for renewing thelease agreement beyond its termination on December 31, 2026.
Albertsen Corporation can borrow $1,000,000 under a 10-year termloan agreement at an annual interest rate of 12%. The lessor'simplicit interest rate is not expressly stated in the leaseagreement, but this rate appears to be approximately 8% based on 10net rental payments of $137,780 per year and the initial fair valueof $1,000,000 for the plane. On January 1, 2017, the present valueof all net rental payments and the purchase option of $44,440 is$888,890 using the 12% interest rate. The present value of all netrental payments and the $44,440 purchase option on January 1, 2017,is $1,022,226 using the 8% interest rate implicit in the leaseagreement. The financial vice president of Albertsen Corporationhas established that this lease agreement is a capital lease asdefined in GAAP.
Instructions
(a)
What is the appropriate amount that Albertsen Corporation shouldrecognize for the leased aircraft on its balance sheet after thelease is signed?
(b)
Without prejudice to your answer in part (a), assume that theannual lease payment is $141,780 as stated in the question, thatthe appropriate capitalized amount for the leased aircraft is$1,000,000 on January 1, 2017, and that the interest rate is 9%.How will the lease be reported in the December 31, 2017, balancesheet and related income statement? (Ignore any income taximplications.)
CA21-5.
(Lessee Capitalization of Bargain-Purchase Option)
Albertsen Corporation is considering proposals for eitherleasing or purchasing aircraft. The proposed lease agreementinvolves a twin-engine turboprop Viking that has a fair value of$1,000,000. This plane would be leased for a period of 10 yearsbeginning January 1, 2017. The lease agreement is cancelable onlyupon accidental destruction of the plane. An annual lease paymentof $141,780 is due on January 1 of each year; the first payment isto be made on January 1, 2017. Maintenance operations are strictlyscheduled by the lessor, and Albertsen Corporation will pay forthese services as they are performed. Estimated annual maintenancecosts are $6,900. The lessor will pay all insurance premiums andlocal property taxes, which amount to a combined total of $4,000annually and are included in the annual lease payment of $141,780.Upon expiration of the 10-year lease, Albertsen Corporation canpurchase the Viking for $44,440. The estimated useful life of theplane is 15 years, and its salvage value in the used plane marketis estimated to be $100,000 after 10 years. The salvage valueprobably will never be less than $75,000 if the engines areoverhauled and maintained as prescribed by the manufacturer. If thepurchase option is not exercised, possession of the plane willrevert to the lessor, and there is no provision for renewing thelease agreement beyond its termination on December 31, 2026.
Albertsen Corporation can borrow $1,000,000 under a 10-year termloan agreement at an annual interest rate of 12%. The lessor'simplicit interest rate is not expressly stated in the leaseagreement, but this rate appears to be approximately 8% based on 10net rental payments of $137,780 per year and the initial fair valueof $1,000,000 for the plane. On January 1, 2017, the present valueof all net rental payments and the purchase option of $44,440 is$888,890 using the 12% interest rate. The present value of all netrental payments and the $44,440 purchase option on January 1, 2017,is $1,022,226 using the 8% interest rate implicit in the leaseagreement. The financial vice president of Albertsen Corporationhas established that this lease agreement is a capital lease asdefined in GAAP.
Instructions
(a)
What is the appropriate amount that Albertsen Corporation shouldrecognize for the leased aircraft on its balance sheet after thelease is signed?
(b)
Without prejudice to your answer in part (a), assume that theannual lease payment is $141,780 as stated in the question, thatthe appropriate capitalized amount for the leased aircraft is$1,000,000 on January 1, 2017, and that the interest rate is 9%.How will the lease be reported in the December 31, 2017, balancesheet and related income statement? (Ignore any income taximplications.)
