1) Leases
Southwest Airlines Co. (NYSE:LUV), headquartered in Dallas, Texas, operates Southwest
Airlines, a passenger airline. In May 2011, Southwest acquired AirTran Airways. As of
September 30, 2012, the Company serves 97 cities in 41 states, the District of Columbia, the
Commonwealth of Puerto Rico, and six near-international countries.
Required:
1) On January 1, 2011, Southwest and the Boeing Company (NYSE:BA), the aircraft
manufacturer, entered into a lease agreement to lease 3 new Boeing 737-800 passenger airplanes.
The lease term is 20 years, which is equal to the useful life of the airplanes. At the end of the
lease term the equipment will have zero residual value and will be returned to Boeing. The lease
specifies annual payments of $25 million beginning January 1, 2011, and then on January 1 of
each year through 2030. Southwest’s incremental borrowing cost is 12%. The implied interest
rate used by Boeing in structuring the lease is 10%, which is known to Southwest. Boeing’s cost
to manufacture the airplanes is $190 million. Both Boeing and Southwest use the straight-line
depreciation method. There is no uncertainty with collectability of the lease payments or any
additional cost to Boeing after the delivery of the airplane upon the inception of the lease.
Answer the following questions and show your work.
a. How should this lease be classified by Boeing and Southwest?
Capital Lease Requirement #4;
Since Boeing is a manufacturer, the fair value of the equipment in the lease is its selling
price of $190,000,000;
PV of Minimum Lease Payment $234,123,000
90% of fair value (190,000,000 x 90%) $171,000,000
234,123,000 =/> 171,000,000
• Boeing should classify this lease as a direct-financing lease as the lessor of the
transaction.
• Southwest, the lessee should classify this lease as a Capital Lease because the
lease term is greater than 75% of the economic life of the airplanes.
b. Show all the journal entries Southwest needs to prepare in 2011 and on January 1,
2012.
Calculating PV of the minimum lease payment (in thousands);
Using the lower implicit interest rate of 10%;
Minimum lease payment $25,000
PV of Annuity Due factor (20 periods @ 10%) x 9.3649
Present Value of the Minimum Lease Payment $234,123 (rounded)
Journal Entry;
Jan. 1, 2011 Leased Equipment 234,123,000
Lease Payable 234,123,000
Lease Payable 25,000,000
Cash 25,000,000
Dec. 31, 2011 Depreciation Expense 11,706,150*
Accumulated Depreciation 11,706,150
Interest Expense 20,912,300**
Interest Payable 20,912,300
Jan. 1, 2012 Lease Payable 4,087,700***
Interest Payable 20,912,300
Cash 25,000,000
Calculations;
* (234,123,000/20) = 11,706,150
** (234,123,000 – 25,000,000) x .10 = 20,912,300
*** (25,000,000 – 20,912,300) = 4,087,700
c. Show all the journal entries Boeing needs to prepare in 2011 and on January 1,
2012. If it is a direct financing lease, I don’t know if sales type lease is recorded
differently…Also, do I need to multiply 190 by 3 for the 3 airplanes?
