Presented below are four independent situations. All the companies involved use private enterprise GAAP

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.