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Chapter 21: 5CA (page 1252)

(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 \(1,000,000 under a 10-year term loan agreement at an annual interest rate of 12%. The lessor鈥檚 implicit interest rate is not expressly stated in the lease agreement, but this rate appears to be approximately 8% based on 10 net rental payments of \)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

  1. What is the appropriate amount that Albertsen Corporation should recognize for the leased aircraft on its balance sheet after the lease is signed?

Short Answer

Expert verified

The appropriate amount for the leased aircraft is $1,000,000.

Step by step solution

01

Meaning of Bargain purchase option (BPO)

A BPO is alessee's contractual right to acquire a leased asset at a fixed price that is much lower than its projected fair value when the option becomes exercisable at the end of the basic lease period, with the option priced to assure execution.

02

Explaining the appropriate amount that Albertsen Corporation should recognize for the leased aircraft on its balance sheet after the lease is signed.

The proper amount of the leased aircraft should be recorded as $1,000,000 on the balance sheet of Albertson Corporation. In this case, the present value of net rental payments plus the purchase option ($1,022,226) is less than the fair value. The thing is appraised at its fair market value when this happens..

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Most popular questions from this chapter

(Lessor Entries; Direct-Financing Lease with Option to Purchase) Castle Leasing Company signs a lease agreement on January 1, 2017, to lease electronic equipment to Jan Way Company. The term of the noncancelable lease is 2 years, and payments are required at the end of each year. The following information relates to this agreement:

  1. Jan Way Company has the option to purchase the equipment for \(16,000 upon termination of the lease.
  2. The equipment has a cost and fair value of \)160,000 to Castle Leasing Company. The useful economic life is 2 years, with a salvage value of \(16,000.
  3. Jan Way Company is required to pay \)5,000 each year to the lessor for executory costs.
  4. Castle Leasing Company desires to earn a return of 10% on its investment.
  5. Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor.

Instructions

  1. Prepare the journal entries on the books of Castle Leasing to reflect the payments received under the lease and to recognize income for the years 2017 and 2018.

(Lessee Entries and Balance Sheet Presentation, Capital Lease) Ludwick Steel Company as lessee signed a lease agreement for equipment for 5 years, beginning December 31, 2017. Annual rental payments of \(40,000 are to be made at the beginning of each lease year (December 31). The taxes, insurance, and the maintenance costs are the obligation of the lessee. The interest rate used by the lessor in setting the payment schedule is 9%; Ludwick鈥檚 incremental borrowing rate is 10%. Ludwick is unaware of the rate being used by the lessor. At the end of the lease, Ludwick has the option to buy the equipment for \)1, considerably below its estimated fair value at that time. The equipment has an estimated useful life of 7 years, with no salvage value. Ludwick uses the straight-line method of depreciation on similar owned equipment.

Instructions

(b) Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2018, by Ludwick. (Prepare the lease amortization schedule for all five payments.)

Winston Industries and Ewing Inc. enter into an agreement that requires Ewing Inc. to build three diesel-electric engines to Winston鈥檚 specifications. Upon completion of the engines, Winston has agreed to lease them for a period of 10 years and to assume all costs and risks of ownership. The lease is noncancelable, becomes effective on January 1, 2017, and requires annual rental payments of \(413,971 each January 1, starting January 1, 2017.

Winston鈥檚 incremental borrowing rate is 10%. The implicit interest rate used by Ewing Inc. and known to Winston is 8%. The total cost of building the three engines is \)2,600,000. The economic life of the engines is estimated to be 10 years, with residual value set at zero. Winston depreciates similar equipment on a straight-line basis. At the end of the lease, Winston assumes title to the engines. Collectibility of the lease payments is reasonably certain; no uncertainties exist relative to unreimbursable lessor costs.

Instructions

(c) Prepare the journal entry or entries to record the transaction on January 1, 2017, on the books of Ewing Inc.

(Lessee Computations and Entries, Capital Lease with Guaranteed Residual Value) Assume the same data as in P21-13 and that Chambers Medical Center has an incremental borrowing rate of 10%.

Lessor Computations and Entries, Sales-Type Lease with Guaranteed Residual Value) Amirante Inc. manufactures an X-ray machine with an estimated life of 12 years and leases it to Chambers Medical Center for a period of 10 years. The normal selling price of the machine is \(411,324, and its guaranteed residual value at the end of the noncancelable lease term is estimated to be \)15,000. The hospital will pay rents of \(60,000 at the beginning of each year and all maintenance, insurance, and taxes. Amirante Inc. incurred costs of \)250,000 in manufacturing the machine and $14,000 in negotiating and closing the lease. Amirante Inc. has determined that the collectibility of the lease payments is reasonably predictable, that there will be no additional costs incurred, and that the implicit interest rate is 10%.

Instructions

(c) Prepare all of the lessee鈥檚 journal entries for the first year.

(Accounting for an Operating Lease) On January 1, 2017, a machine was purchased for \(900,000 by Young Co. The machine is expected to have an 8-year life with no salvage value. It is to be depreciated on a straight-line basis. The machine was leased to St. Leger Inc. on January 1, 2017, at an annual rental of \)210,000. Other relevant information is as follows.

  1. The lease term is for 3 years.
  2. Young Co. incurred maintenance and other executory costs of \(25,000 in 2017 related to this lease.
  3. The machine could have been sold by Young Co. for \)940,000 instead of leasing it.
  4. St. Leger is required to pay a rent security deposit of \(35,000 and to prepay the last month鈥檚 rent of \)17,500.

Instructions

(b) What amount should St. Leger Inc. report for rent expenses for 2017 on this lease?
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