Question

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 S650,000 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 ofthe airplane on January 1, 2017 is $6,250,000 (for simplicity, assume the lessors implicit rate is greater than 45%) a. What journal entries related to thelease arrangement should be recorded during 2017 (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 2017 c. What is the annual lease payment that results in a present value ofminimum lease payments equal to 90% of the fair market value of the airplane ($6,250,000)?

Answer 1

a. The journal entry would be as follows:

Debit Credit

December 31, 2017 Lease Rent Expense $650,000

Cash $650,000

b. The Lease rent expense of $ 650,000 will be reported on the 2017 income statement as an operating expense for computation of net operating income.

c. The annual lease payment that results in a present value ofminimum lease payments equal to 90% of the fair market value of the airplane is $710,883

Regarding The cash outflow of $ 650,000 will be reported in the Operating Activities section of the Statement of Cash Flows for the year ended December 31, 2017.

Step-by-step explanation:

In order to know what journal entries related to thelease arrangement should be recorded during 2017, first we need to calculate the Present Value Annuity as follows:

Present Value Annuity = [1-(1+r)^-n]/r

=[1-(1+.045)^-10]/0.045 = $7.9127

Hence, Present value of the minimum lease payments = $ 650,000 x 7.9127 = $ 5,143,255

a. The journal entry would be as follows:

Debit Credit

December 31, 2017 Lease Rent Expense $650,000

Cash $650,000

b. The Lease rent expense of $ 650,000 will be reported on the 2017 income statement as an operating expense for computation of net operating income.

Regarding The cash outflow of $ 650,000 will be reported in the Operating Activities section of the Statement of Cash Flows for the year ended December 31, 2017.

c. In order to calculate the annual lease payment that results in a present value ofminimum lease payments equal to 90% of the fair market value of the airplane we would have to use the following formula:

Annual lease payments that would result in present value of minimum lease payments of 90 % of the fair market value of the airplane = $ (6,250,000 x 90% ) / 7.9127 = $ 710,883