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Unformatted text preview: refers to financing agreements that require future payments, yet are structured
so that the financing arrangement does not meet any of the criteria for the financing arrangement to be
reported as a liability. The substance of an operating lease is considered to be a rental agreement. This
implies that a company does not incur an obligation under the lease until it actually uses the item being
leased. Thus, the future obligations under the lease should not be reported as a liability. Alternatively, the
substance of a capital lease is considered to be a purchase agreement. This implies that the company
has, in substance, acquired an asset and that the lease is simply a note payable for the acquisition of that
asset. Thus, the present value of the future cash outflows specified in the lease agreement should be
reported as a liability. The difference between operating and capital leases provides a way for companies
to engage in offbalancesheet financing. That is, by structuring a lease agreement as an operating lease,
the lessee can engage in offbalance sheet financing. E11–24
a. Since the face value of the bank loan equals the proceeds of the loan (i.e., $149,388), the effective interest
rate is equal to the stated interest rate. Therefore, the appropriate effective interest rate for Watts Motors
for a tenyear borrowing arrangement is 12%. This rate should also be used for the lease.
The annual lease payments would be an ordinary annuity for i = 12% and n = 10. Setting up the following
formula and solving for the payment amount gives us the annual lease payment that would equate the two
financing options. $149,388 = $149,388
Lease payment Lease Payment Present Value of an Ordinary Annuity Factor for i =
12% and n = 10 = Lease Payment 5.65022 (from Table 5 in Appendix A) = $26,439.32 (rounded) b. With the lease payment, Watts Motors would pay $26,439.32 at the end of each year for ten years. With
the bank loan, Watts Motors would make interest payments of $17,926.56 ($149,388 12%) at the end of
each year for te...
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This homework help was uploaded on 03/03/2014 for the course ACCT 5053 taught by Professor Staff during the Fall '08 term at Oklahoma State.
- Fall '08