Sale-Leaseback Exercise

Subject: Business    / Accounting
Question

Sale-Leaseback Exercise

On January 1, 2010, the AirFly Company sells an airplane to Banker Corp. for $14.5 million dollars, and then immediately leases it back. The relevant information is as follows:

The airplane was carried on AirFly balance sheet at a value of $13 million.

The term of the non-cancelable lease is 20 years.

The lease agreement requires equal rental payments of $1,645,393.60 at the end of each year.

The incremental borrowing rate of AirFly Company is 11%. AirFly is aware that Banker set the annual rental to ensure a rate of return of 9.5%.

The airplane has a fair value of $14.5 million as of January 1, 2010.

AirFly has the option of purchasing the airplane for $1,000 at the end of the lease term.

AirFly pays all executory costs. These costs consist of insurance and property taxes and property taxes amounting to $125,000 per year.

There are no important uncertainties surrounding additional obligations of the lessor and the collectability of the lease payments is reasonably assured.

Address the following:

Determine how this transaction would be accounted for under GAAP.
Create the journal entries that both the lessee and lessor would make for each of the years 2010, 2011, and 2012.
Explain how the lease would be disclosed in the financial statements for the lessee.