On January 1, 2010, Metcalf Company sold equipment for cash and leased it back. As seller-lessee, Metcalf retained the right to substantially all of the remaining use of the equipment. The term of the lease is eight years. There is a gain on the sale portion of the transaction. The lease portion of the transaction is classified appropriately as a capital lease.

Required

1. Explain the theoretical basis for requiring lessees to capitalize certain long-term leases. Do not discuss the specific criteria for classifying a lease as a capital lease.

2. a. Explain how Metcalf should account for the sale portion of the sale-leaseback transaction at January 1, 2010.

b. Explain how Metcalf should account for the leaseback portion of the sale-leaseback transaction at January 1, 2010.

3. Explain how Metcalf should account for the gain on the sale portion of the sale-leaseback transaction during the first year of the lease.