Capital Leases gin millions! Total 2017 $ 145 2018 85 2019 60 2020 43 2021 24 Thereafter 21 Total minimum lease payments 378 Less: amount of lease a…

Airline companies typically do not own their aircrafts. Rather, they lease aircrafts from commercial lessors (e.g. General Electric’s finance subsidiary). According to US GAAP, companies are required to disclose their lease information in the footnotes of their financial statements.

Recall from ACCT2011 that leases can be classified into finance leases (or capital leases in American English) and operating leases (US GAAP and IFRS apply virtually the same rules to leases). Airlines may structure their lease contracts to skilfully avoid the capitalization requirement for capital leases. The footnote on leases of the 2016 annual report of Delta Air Lines, a major US airline, is provided below:

——————————————2016 ANNUAL REPORT————————————————-

NOTE 7 . LEASE OBLIGATIONS

We lease aircraft, airport terminals, maintenance facilities, ticket offices and other property and equipment from third parties. Rental expense for operating leases, which is recorded on a straight-line basis over the life of the lease term, totaled $1.3 billion for the year ended December 31, 2016 and $1.2 billion for the years ended December 31, 2015 and 2014 . Amounts due under capital leases are recorded as liabilities, while assets acquired under capital leases are recorded as property and equipment. Amortization of assets recorded under capital leases is included in depreciation and amortization expense. Our airport terminal leases include contingent rents, which vary based upon facility usage, enplanements, aircraft weight and other factors. Many of our aircraft, facility and equipment leases include rental escalation clauses and/or renewal options. Our leases do not include residual value guarantees and we are not the primary beneficiary in or have other forms of variable interest with the lessor of the leased assets. As a result, we have not consolidated any of the entities that lease to us.

The following tables summarize our minimum rental commitments under capital leases and noncancelable operating leases (including certain aircraft flown by regional carriers) with initial or remaining terms in excess of one year for the years succeeding December 31, 2016 : 

——————————————2015 ANNUAL REPORT————————————————-

NOTE 7 . LEASE OBLIGATIONS

We lease aircraft, airport terminals, maintenance facilities, ticket offices and other property and equipment from third parties. Rental expense for operating leases, which is recorded on a straight-line basis over the life of the lease term, totaled $1.2 billion for the years ended December 31, 2015 and 2014 and $1.1 billion for the year ended December 31, 2013 . Amounts due under capital leases are recorded as liabilities, while assets acquired under capital leases are recorded as property and equipment. Amortization of assets recorded under capital leases is included in depreciation and amortization expense. Our airport terminal leases include contingent rents, which vary based upon facility usage, enplanements, aircraft weight and other factors. Many of our aircraft, facility and equipment leases include rental escalation clauses and/or renewal options. Our leases do not include residual value guarantees and we are not the primary beneficiary in or have other forms of variable interest with the lessor of the leased assets. As a result, we have not consolidated any of the entities that lease to us.

The following tables summarize our minimum rental commitments under capital leases and noncancelable operating leases (including certain aircraft flown by regional carriers) with initial or remaining terms in excess of one year for the years succeeding December 31, 2015 : 

Suppose you are an analyst following Delta Air Line, and you believe all its operating leases are of the nature of capital leases. Therefore, you decide to capitalize all its operating leases for your analysis.

Additional information & assumptions

  •  Recapitalized operating lease asset is 80% of the existing operating lease liability if the operating leases were capitalized. The difference between the lease asset and lease liability reflects accumulated depreciation and impairments from previous years.
  •  New leases initiated in 2016 are assumed to take effect from the end of 2016.
  •  Recapitalized lease assets are depreciated over a useful life of 10 years.
  •  Lease obligations due after 5 years from the reporting date (“thereafter”) are evenly
  • distributed to the next 8 years.
  •  Ignore any tax effect.

Required

Prepare the adjusting journal entries required to capitalize Delta’s operating leases, and verbally describe the impact of the recapitalization of operating leases on the 2016 financial statement of Delta Air Line. [For hints, read the notes below.] 



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