On January 1, 2011, Hein Corporation sells equipment to Liquidity Finance Corp. for $720,000 and immediately leases the equipment back. Both Hein and Liquidity use private enterprise GAAP. Other relevant information is as follows:
1. The equipment’s carrying value on Hein’s books on January 1, 2011, is $640,000.
2. The term of the non-cancellable lease is 10 years. Title will transfer to Hein at the end of the lease.
3. The lease agreement requires equal rental payments of $117,176.68 at the end of each year.
4. The incremental borrowing rate of Hein Corporation is 12%. Hein is aware that Liquidity Finance Corp. set the annual rental to ensure a rate of return of 10%.
5. The equipment has a fair value of $720,000 on January 1, 2011, and an estimated economic life of 10 years, with no residual value.
6. Hein pays executory costs of $11,000 per year directly to appropriate third parties.
Instructions
(a) Prepare the journal entries for both the lessee and the lessor for 2011 to reflect the sale and leaseback agreement. No uncertainties exist and collectibility is reasonably certain.
(b) What is Hein’s primary objective in entering a sale-leaseback arrangement with Liquidity Finance Corp.? Would you consider this transaction to be a red flag to creditors, demonstrating that Hein is in financial difficulty?