C a bond contract with a stated rate of interest equal

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Unformatted text preview: ounted future cash flows and the present value is as follows. $45,636,480 = $6,000,000 {[1– (1 + i)­15] ÷ i]} Solving for i mathematically or by trial and error indicates that the annual effective interest rate is 10%. b. Cash (+A) 45,636,480 Note Payable (+L) 45,636,480 Issued note payable. Airplane (+A) 45,636,480 Cash (–A) 45,636,480 Purchased airplane. c. Airplanes Capitalized Under Leases (+A) 45,636,480 Lease Liability (+L) 45,636,480 Leased airplane. d. If Southwest Airlines borrows the necessary funds and then purchases the airplane, Southwest's fixed assets and liabilities would both increase by $45,636,480. In addition, Southwest would have to depreciate the airplane. The effect on the financial statements would be identical if Southwest leases the airplane, and the lease is considered to be a capital lease. e. Southwest Airlines would not have to prepare any journal entry when it signs the lease if the lease is considered to be an operating lease. ID11–3 Concluded f. Structuring the leasing arrangement as an operating lease would be an example of off­balance sheet financing. With an operating lease, the substance of the lease arrangement is that Southwest is renting the airplane from the Boeing Company. Thus, Southwest is not considered to have any obligation to Boeing until Southwest actually uses the airplane. As Southwest uses the airplane, Southwest should record rent expense. This means that Southwest would never report any liability on its balance sheet associated with the future payments required under the lease agreement. Thus, Southwest would be able to finance the "acquisition" of an airplane without having to report any liability associated with acquiring the a i rp l a n e . Southwest would most likely engage in off­balance sheet financing in order to prevent an increase in the amount of reported debt. By limiting any increases in reported debt, the company decreases the chance it would violate any debt covenants that specify a maximum debt/equity ratio. In addition, reporting less debt...
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