On December 31, 2010, Shell hammer Co. sold 6-month old equipment at fair value and leased it back. There was a loss on the sale. Shell hammer pays all insurance, maintenance, and taxes on the equipment. The lease provides for eight equal annual payments, beginning December 31, 2011, with a present value equal to 85% of the equipment’s fair value and sales price. The lease’s term is equal to 80% of the equipment’s useful life. There is no provision for Shell hammer to reacquire ownership of the equipment at the end of the lease term.

(a) (1) Why is it important to compare an equipment’s fair value to its lease payments’ present value and its useful life to the lease term?

(2) Evaluate Shell hammer’s leaseback of the equipment in terms of each of the four criteria for determination of a capital lease.

(b) How should Shell hammer account for the sale portion of the sale-leaseback transaction at December 31, 2010?

(c) How should Shell hammer report the leaseback portion of the sale-leaseback transaction on its December 31, 2011, balance sheet?