A city is having fiscal problems in 2018. It expects to report a deficit in its general fund, the only fund that is statutorily required to be balanced.
To eliminate the anticipated deficit the city opts to "sell" its city hall-to itself-for $5 million. The city establishes a "capital asset financing agency." The agency is a separate legal entity but will have to be reported as a component unit (per standards to be discussed in Chapter 11). As such it will be accounted for in a fund other than the general fund. The city structures the transaction as follows:
• The financing agency pays the city $5 million in 2018 in exchange for "ownership" of city hall. The city hall has been carried as general capital asset.
• The agency acquires the necessary cash by issuing 20‐year, 6 percent notes. The notes will be repaid in 20 annual installments of $435,920. The notes are guaranteed by the city at large. Hence, they are ultimately a liability payable from the general fund.
• The agency leases the city hall back to the city at large. Lease payments are to be paid out of general fund resources.
1. Prepare journal entries in the general fund to record the sale and concurrent lease‐back of the city hall. The lease‐back satisfies the criteria of a capital lease transaction.
2. Prepare journal entries in the general fund to record the first lease payment, which was made in 2018.
3. Will the transaction, in fact, reduce the 2018 anticipated fund deficit? Briefly justify the accounting principles that underlie this type of accounting.