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Lease Case

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LEASE CASE
Basic Concepts:
1. On January 1, 2013, Flying High Airlines leased a new airplane for a term of 10 years. The expected life of the airplane is 20 years. There are no rights to purchase the asset at the end of the term, no bargain purchase option, and no residual value guarantee. The lease stipulates that Flying High makes annual payments of $650,000 beginning at the end of the first year (December 31, 2013). Flying High has an incremental borrowing rate of 4.5% and the fair market value of the airplane on January 1, 2013 is $6,250,000 (for simplicity, assume the lessor’s implicit rate is greater than 4.5%).
a. What journal entries related to the lease arrangement should be recorded during 2013 (assume Flying High’s fiscal year end is December 31).
b. Identify any effects the lease arrangement and the associated reporting would have on the balance sheet, income statement, and statement of cash flows for 2013.
c. What is the annual lease payment that results in a present value of minimum lease payments equal to 90% of the fair market value of the airplane ($6,250,000)?
2. Now assume that the lessor decided to require the lease payments at the beginning of the year as opposed to the end of the year. Also assume that the lease arrangement had a bargain purchase option under which the lessee could purchase the airplane at the end of the contract for $250,000.
a. What journal entries related to the lease arrangement should be recorded during 2013.
b. Identify any effects the lease arrangement and the associated reporting would have on the balance sheet, income statement, and statement of cash flows for 2013.
Basic Analysis:
1. Compute the following ratios for Southwest Airlines for the most recent fiscal year (2013). Briefly interpret each ratio.
a. Debt to Total Assets (include current and long-term maturities of long-term debt and capital lease obligations in the numerator)
b. Return on Assets (Net Income/Total Assets))
2. For Southwest Airlines determine the following:
a. Operating lease payment (or expense) made during the 2013 fiscal year
b. Total undiscounted operating lease payments due in the future (ignore subleases) c. Total undiscounted capital lease payments due in the future
d. Total capital lease liability at the end of 2013
e. Net capital lease asset (book value) at the end of 2013
Extended Analysis:
1. Calculate the present value of operating lease payments for Southwest Airlines (and explain your calculations) using a rate of 6% for discounting (ignore subleases). Assume the minimum lease payments due after 2018 will be paid evenly over four years (2019 – 2022). If the operating leases were capitalized, Southwest would report an asset and liability approximately equal to the present value. Re-compute the debt-to-total assets and ROA ratios for Southwest. Include the effects of the leases as both assets and debt in recalculating the ratios. Ignore any income differences that could result from capital versus operating leases. Discuss how this capitalization changes your interpretations of the ratios from before.
2. A significant difference between operating leases and capital leases is the calculation of a liability and asset on the balance sheet. Discuss why the FASB might prefer a rule that places these amounts (for both types of leases) on the balance sheet.

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