Ramey Corporation is a diversified public company with nationwide interests in commercial real estate development, banking, copper mining, and metal fabrication. The company has offices and operating locations in major cities throughout Canada. With corporate headquarters located in a metropolitan area of a western province, company executives must travel extensively to stay connected with the various phases of operations. In order to make business travel more efficient to areas that are not adequately served by commercial airlines, corporate management is currently evaluating the feasibility of acquiring a business aircraft that can be used by Ramey executives. Proposals for either leasing or purchasing a suitable aircraft have been analyzed, and the leasing proposal was considered more desirable. The proposed lease agreement involves a twin-engine turboprop Viking that has a fair value of $1 million. This plane would be leased for a period of 10 years, beginning January 14, 2011. The lease agreement is cancellable only upon accidental destruction of the plane. An annual lease payment of $141,780 is due on January 14 of each year, with the first payment to be made on January 14, 2011. Maintenance operations are strictly scheduled by the lessor, and Ramey 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 business 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, Ramey can purchase the Viking for $44,440. The plane’s estimated useful life is 15 years, and its value in the used plane market is estimated to be $100,000 after 10 years. The residual 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; there is no provision for renewing the lease agreement beyond its termination on December 31, 2020.
Ramey can borrow $1 million 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 market value of $1 million for the plane. On January 14, 2011, the present value of all net rental payments and the purchase option of $44,440 is $886,215 using the 12% interest rate.
The present value of all net rental payments and the $44,440 purchase option on January 14, 2011, is $1,019,061 using the 8% interest rate implicit in the lease agreement. The financial vice-president of Ramey Corporation has established that this lease agreement is a financing lease as defined by the IFRS standards followed by Ramey.
Instructions
(a) IFRS indicates that the crucial accounting issue is whether the risks and benefits of ownership are transferred from one party to the other, regardless of whether ownership is transferred. What is meant by “the risks and benefits of ownership,” and what factors are general indicators of such a transfer?
(b) Have the risks and benefits of ownership been transferred in the lease described above? What evidence is there?
(c) What is the appropriate amount for Ramey Corporation to recognize for the leased aircraft on its balance sheet after the lease is signed?
(d) Independent of your answer in part (c), assume that the annual lease payment is $141,780 as stated above, that the appropriate capitalized amount for the leased aircraft is $1 million on January 14, 2011, and that the interest rate is 9%. How will the lease be reported on the December 31, 2011 balance sheet and related income statement? (Ignore any income tax implications.)