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. A gain would result on the sale portion of the transaction. The lease portion would be classified appropriately as a capital lease.
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 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 sale portion of the sale-leaseback transaction should be accounted for at the lease's inception.
2. How the gain on the sale portion of the sale-leaseback transaction should be accounted for during the lease.
3. How the leaseback portion of the sale-leaseback transaction should be accounted for at the lease's inception.
4. The conceptual basis for capitalizing certain long-term leases.