LEASE CASE

Basic Concepts:

1. On January 1, 2017, 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, 2017). Flying High has an incremental borrowing rate of 4.5% and the fair market value of the airplane on January 1, 2017 is $6,250,000 (for simplicity, assume the lessors implicit rate is greater than 4.5%).
   1. What journal entries related to the lease arrangement should be recorded during 2017 (assume Flying Highs fiscal year end is December 31).
   2. Identify any effects the lease arrangement and the associated reporting would have on the balance sheet, income statement, and statement of cash flows for 2017.
   3. 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.
   1. What journal entries related to the lease arrangement should be recorded during 2017.
   2. Identify any effects the lease arrangement and the associated reporting would have on the balance sheet, income statement, and statement of cash flows for 2017.

Basic Analysis:

1. Compute the following ratios for Southwest Airlines for the most recent fiscal year (2017). Briefly interpret each ratio.
   1. Long-term Debt to Total Assets (make sure current and long-term maturities of long-term debt and capital lease obligations are included in the numerator)
   2. Return on Assets (Net Income/Total Assets))

2. For Southwest Airlines determine the following (Hint: Note 7 will be very useful here):
   1. Operating lease payment (or expense) made during the 2017 fiscal year
   2. Total undiscounted operating lease payments due in the future (ignore subleases, i.e. do not use the operating leases, net number)
   3. Total undiscounted capital lease payments due in the future
   4. Total capital lease liability at the end of 2017 (excluding the lease incentive obligation of $105 million)
   5. Net capital lease asset at the end of 2017

Extended Analysis:

1. Calculate the present value of operating lease payments (use the gross amounts, not the amounts net of subleases) for Southwest Airlines using a discount rate of 6%. Assume the minimum lease payments due after 2022 are split evenly over 2023 and 2024. If the operating leases were capitalized, Southwest would report an asset and liability approximately equal to the present value of future operating lease payments. Re-compute the long-term debt-to-total assets ratio and ROA for Southwest. Include the present value of the future operating lease payments as both assets and long-term debt in recalculating the ratios. Ignore any income differences that could result from capital versus operating leases (i.e., leave net income unchanged). Discuss how adding assets and liabilities (to the balance sheet) for the operating leases 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 decided to implement the new lease standard (for fiscal periods beginning after December 15, 2018) that places assets and liabilities on the balance sheet for both operating and capital/financing leases.