Question

General Tools is seeking ways to maintain and improve cash balances. As company controller, you have proposed the sale and leaseback of much of the company’s equipment. As seller-lessee, General Tools would retain the right to essentially all of the remaining use of the equipment. The term of the lease would be six years.

You previously convinced your CFO of the cash flow benefits of the arrangement, but now he doesn’t understand the way you will account for the transaction. “I really had counted on that gain on the sale portion of the transaction to bolster this period’s earnings. What gives?” he wondered. “Put it in a memo, will you? I’m having trouble following what you’re saying to me.”

Required:

Write a memo to your CFO. Include discussion of each of these points:

1. How the transaction should be accounted for.

2. Why General Tools will not get the gain the CFO had counted on.

Answer 1

To

The CFO

Dear Sir,

The proposed sale and lease back of the equipment will affect the balance sheet, income statement and the cash flow of the company. At the inception the sale of the equipment will be recorded and any gain or loss will be deferred till the end of the lease period. The deferred gain or loss will be amortized over the life of the lease. At the same time, the leaseback of the equipment will be recorded by recognizing the liability at the the sale value of the equipment. The following journal entries will have to be passed to record the relevant transactions in the proposed sale and leaseback of the equipment:

a) Journal Entry to Record the Sale of the Equipment and the gain at the inception:

Dr. Cash

Cr. Equipment

Cr. Deferred Gain

b) Journal Entry to Record the Leaseback at the inception:

Dr. Equipment (Leased Property: at sale value)

Cr. Lease Liability

(ii) General tools will not get the gain the CFO has counted on because after the 6 years when our lease period is completed then we need to purchase asset and also we can't get the claim of depreciation on it and we have to pay the tax on profit on sale of asset also if profit earned on sale of equipment

the sale and lease back situation can make better our position temporary but not permanently in the future we may be face risk of non availability of cash for purchasing of asset. Sale and Lease back situation gets benefit only for one or two year not more then that and also with the sale and lease back our equipment gets disposed off or gets eliminated from the assets in balance sheet