On January 1, 2011, Hein Corporation sells equipment to Liquidity Finance Corp. for $720,000

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.