Question

(Lessee Capitalization of Bargain-Purchase Option) Albertsen Corporation is considering proposals for either leasing or purchasing aircraft. The proposed lease agreement involves a twin-engine turboprop Viking that has a fair value of \(1,000,000. This plane would be leased for a period of 10 years beginning January 1, 2017. The lease agreement is cancelable only upon accidental destruction of the plane. An annual lease payment of \)141,780 is due on January 1 of each year; the first payment is to be made on January 1, 2017. Maintenance operations are strictly scheduled by the lessor, and Albertsen Corporation will pay for these services as they are performed. Estimated annual maintenance costs are \(6,900. The lessor will pay all insurance premiums and local property taxes, which amount to a combined total of \)4,000 annually and are included in the annual lease payment of \(141,780. Upon expiration of the 10-year lease, Albertsen Corporation can purchase the Viking for \)44,440. The estimated useful life of the plane is 15 years, and its salvage value in the used plane market is estimated to be \(100,000 after 10 years. The salvage value probably will never be less than \)75,000 if the engines are overhauled and maintained as prescribed by the manufacturer. If the purchase option is not exercised, possession of the plane will revert to the lessor, and there is no provision for renewing the lease agreement beyond its termination on December 31, 2026.

Albertsen Corporation can borrow \(1,000,000 under a 10-year term loan agreement at an annual interest rate of 12%. The lessor’s implicit interest rate is not expressly stated in the lease agreement, but this rate appears to be approximately 8% based on 10 net rental payments of \)137,780 per year and the initial fair value of \(1,000,000 for the plane. On January 1, 2017, the present value of all net rental payments and the purchase option of \)44,440 is \(888,890 using the 12% interest rate. The present value of all net rental payments and the \)44,440 purchase option on January 1, 2017, is \(1,022,226 using the 8% interest rate implicit in the lease agreement. The financial vice president of Albertsen Corporation has established that this lease agreement is a capital lease as defined in GAAP.

Instructions

(b) Without prejudice to your answer in part (a), assume that the annual lease payment is \)141,780 as stated in the question, that the 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, balance sheet and related income statement? (Ignore any income tax implications.)

Short answer

Answer

Depreciation, Interest, maintenance and repair, and insurance property tax expenses should be reflected in the balance sheet.

Step-by-step solution

Step-by-Step Solution

Step 1: Meaning of Balance sheet

The term balance sheet refers to a financial statement that illustrates a company's financial situation. After the creation of trade and profit and loss accounts, it reflects the business's assets and liabilities at the conclusion of the accounting period.

Reporting of leased aircraft on Albertsen Corporation’s balance sheet

The leased aircraft will be reflected on Albertsen Corporation’s balance sheet as follows:

Noncurrent assets
Leased equipment	$1,000,000
Less: Accumulated depreciation—capital leases	61,667
	$ 938,333
Current liabilities
Interest payable	$ 77,600
Lease liability	60,180
	$ 137,780
Noncurrent liabilities
Lease liability	$ 802,040

The following items relating to the leased aircraft will be reflected on Albertsen Corporation’s income statement

Depreciation expense	$61,667
Interest expense	77,600
Maintenance and repairs expense	6,900
Insurance and property tax expense	4,000

Note: The firm has a capital lease on a Viking turboprop aircraft. The lease will be in effect until December 31, 2026. The yearly lease payment is $141,780 and is paid in advance on January 1st, with $4,000 for insurance and property taxes. Over the asset's economic life, the aircraft is depreciated on a straight-line basis. The cumulative depreciation on the aircraft and the depreciation reflected in the current year's depreciation charge total $61,667.

Working notes:

Computation of depreciation expense

Depreciation expense:
Capitalized amount	$1,000,000
Less: Salvage value	75,000
	$ 925,000
Economic life	15 years
Annual depreciation	$61,667

Computation of liability amount

Liability amounts:
Lease liability 1/1/17	$1,000,000
Less: Payment 1/1/17	137,780
Lease liability 12/31/17	862,220
Less: Lease payment due 1/1/18 $137,780
Interest on lease ($862,220 X .09) (77,600)
Reduction of principal	(60,180)
Noncurrent liability 12/31/17	$ 802,040