Presented
below are four independent situations. All the companies involved use private
enterprise GAAP.
1.
On December 31, 2011, Zarle Inc. sold equipment to Daniell Corp. and
immediately leased it back for 10 years. The equipment’s selling price was $520,000,
its carrying amount $400,000, and its estimated remaining economic life 12 years.
2.
On December 31, 2011, Tessier Corp. sold a machine to Cross Ltd. and
simultaneously leased it back for one year.
The
machine’s selling price was $480,000, its carrying amount was $420,000, and it
had an estimated remaining useful life of 14 years. The rental payments’
present value for one year is $35,000.
3.
On January 1, 2011, McKane Corp. sold an airplane with an estimated useful life
of 10 years. At the same time, McKane leased back the plane for 10 years. The
airplane’s selling price was $500,000, the carrying amount $379,000, and the
annual rental $73,975.22. McKane Corp. intends to amortize the leased asset using
the straight-line depreciation method.
4.
On January 1, 2011, Barnes Corp. sold equipment with an estimated useful life
of five years. At the same time, Barnes leased back the equipment for two years
under a lease classified as an operating lease. The equipment’s selling price (fair
value) was $212,700, the carrying amount was $300,000, the monthly rental under
the lease was $6,000, and the rental payments’ present value was $115,753.
Instructions
(a)
For situation 1: Determine the amount of deferred profit to be reported by
Zarle Inc. from the equipment sale on December 31, 2011.
(b)
For situation 2: At December 31, 2011, how much should Tessier report as
deferred profit from the sale of the machine?
(c)
For situation 3: Discuss how the gain on the sale should be reported by McKane
at the end of 2011 in the financial statements.
(d)
For situation 4: For the year ended December 31, 2011, identify the items that
would be reported on Barnes’s income statement related to the sale-leaseback
transaction.
(a) Sale-leaseback arrangements are treated as
though two transactions were a single financing transaction if the lease
qualifies as a capital lease. Any gain or loss on the sale is considered
unearned and is deferred and amortized over the lease term (if possession
reverts to the lessor) or the economic life (if ownership transfers to the
lessee). In this case, the lease qualifies as a capital lease because the lease
term (10 years) is 83% of the remaining economic life of the leased property
(12 years). Therefore, at 12/31/11, all of the gain of $120,000 ($520,000 –
$400,000) would be deferred and amortized over 10 years. Since the sale took
place on 12/31/11, there is no depreciation for 2011.
(b) A sale-leaseback is usually treated as a single
financing transaction in which any profit on the sale is deferred and amortized
by the seller. However, the lease does not meet any of the criteria of a
capital lease for the property sold. In this case, the sale and the leaseback
are accounted for as separate transactions. Therefore, the full gain ($480,000
– $420,000, or $60,000) is recognized.
(c) The profit on the sale of $121,000 should be
deferred and amortized over the lease term.
The lease qualifies as a capital lease. Since the leased asset is being
amortized using the straight-line depreciation method, the deferred gain should
also be reported in the same manner. Therefore, in the first year, $12,100
($121,000 ÷ 10) of the gain would be recognized.
(d) In this case, Barnes Corp. would report a loss
of $87,300 ($300,000 – $212,700) for the difference between the book value and
lower fair value. The CICA Handbook requires that when the fair value of
the asset is less than the book value (carrying amount), a loss must be
recognized immediately. In addition, rent expense of $72,000 ($6,000 per month
X 12 months) should be reported.
