On
January 1, 2011, Hein Corporation sells equipment to Liquidity Finance Corp.
for $720,000 and immediately leases the equipment back. Both Hein and Liquidity
use private enterprise GAAP. Other relevant information is as follows:
1.
The equipment’s carrying value on Hein’s books on January 1, 2011, is $640,000.
2.
The term of the non-cancellable lease is 10 years. Title will transfer to Hein
at the end of the lease.
3.
The lease agreement requires equal rental payments of $117,176.68 at the end of
each year.
4.
The incremental borrowing rate of Hein Corporation is 12%. Hein is aware that
Liquidity Finance Corp. set the annual rental to ensure a rate of return of
10%.
5.
The equipment has a fair value of $720,000 on January 1, 2011, and an estimated
economic life of 10 years, with no residual value.
6.
Hein pays executory costs of $11,000 per year directly to appropriate third
parties.
Instructions
(a)
Prepare the journal entries for both the lessee and the lessor for 2011 to
reflect the sale and leaseback agreement. No uncertainties exist and
collectibility is reasonably certain.
(b)
What is Hein’s primary objective in entering a sale-leaseback arrangement with
Liquidity Finance Corp.? Would you consider this transaction to be a red flag
to creditors, demonstrating that Hein is in financial difficulty?
Hein Corporation (Lessee)*
1/1/11 Cash....................... 720,000.00
Equipment
(net)......... 640,000.00
Deferred
Profit on Sale-
Leaseback............. 80,000.00
Equipment
Under Capital
Leases................... 720,000.00
Obligations
Under Capital
Leases................ 720,000.00
($117,176.68 X 6.14457**)
**Present value of annuity of 1 for 10 periods at 10%
|
Excel formula =PV(rate,nper,pmt,fv,type)
|
|
PV
|
$
?
|
Yields $720,000
|
|
I
|
10%
|
|
|
N
|
10
|
|
|
PMT
|
$
(117,176.68)
|
|
|
FV
|
$
0
|
|
|
Type
|
0
|
Throughout 2011
Executory
Costs............ 11,000.00
Accounts
Payable or Cash 11,000.00
12/31/11 Deferred
Profit on Sale-
Leaseback................ 8,000.00
Depreciation
Expense***. 8,000.00
($80,000 ÷ 10)
**Lease should be treated as a capital lease because
present value of minimum lease payments equals the fair value of the computer.
The lease term is greater than 75% of the economic life of the asset, and title
transfers at the end of the lease.
***The credit could
also be to a gain account.
12/31/11 Depreciation
Expense....... 72,000.00
Accumulated
Depreciation 72,000.00
($720,000 ÷ 10)
Interest
Expense........... 72,000.00
Obligations
Under Capital
Leases*.................. 45,176.68
Cash.................... 117,176.68
Note to instructor:
1. The present value of an ordinary annuity at 10%
for 10 periods should be used to capitalize the asset. In this case, Hein would
use the implicit rate of the lessor because it is lower than its own
incremental borrowing rate and known to Hein.
2. The deferred profit on the sale-leaseback
should be amortized on the same basis that the asset is being amortized.
|
Partial Lease Amortization Schedule
|
||||||||
|
|
|
|
|
|
|
|
|
|
|
Date
|
|
Annual
Lease
Payment
|
|
Interest
(10%)
|
|
Amortization
|
|
Balance
|
|
|
|
|
|
|
|
|
|
|
|
1/1/11
12/31/11
|
|
$117,176.68
|
|
$72,000.00
|
|
$45,176.68*
|
|
$720,000.00
674,823.32
|
Liquidity
Finance Corp. (Lessor)*
1/1/11 Equipment.................. 720.000.00
Cash.................. 720,000.00
Lease
Payments
Receivable................ 1,171,766.80
($117,176.68 X 10)
Unearned
Interest
Income—Leases........ 451,766.80
Equipment............. 720,000.00
12/31/11 Cash ...................... 117,176.68
Lease
Payments
Receivable........... 117,176.68
Unearned
Interest Income—
Leases.................... 72,000.00
Interest
Income—
Leases............... 72,000.00
* Lease should be treated as a direct financing
lease because the present value of the minimum lease payments equals the fair
value of the equipment, and (1) collectability of the payments is reasonably
assured, (2) no important uncertainties surround the costs yet to be incurred
by the lessor, and (3) the cost to the lessor equals the fair market value of
the asset at the inception of the lease.
(b)
The
primary reason for Hein to enter into a sale and leaseback arrangement for its
equipment is to borrow cash. This transaction is similar to the purchase of new
equipment using capital leases, except that in this case, Hein is using an
asset it is already using and is familiar with. Hein wishes to obtain some
leverage by borrowing funds for an amount that exceeds the carrying value of
the asset at the time of the sale.
Since the carrying value of the equipment on the
books of Hein at the time of the sale represents the amortized cost of the
asset in use, this value is not intended to correspond to its fair market
value. Hein can continue with its intention to use the asset to the completion
of its planned useful life. The sale and leaseback arrangement will not disturb
this plan. Hein is taking advantage of the increase in value to obtain
additional financing at preferential rates. Creditors will not view this action
as a desperate measure since the gain on the sale is being deferred and
amortized.
