Case 3

Jedi Transport Company:

Sale-Leaseback

You arethe financial controller for Jedi Transport Company and has been approached by the company president, Mr. Yoda, who has heard that a company can profit and increase cash flow by a device known as a sale-leaseback. Your company owns an aircraft and the president thinks that the company would be better off by selling the aircraft and leasing it back over its useful life. In fact, Mr. Yoda is now negotiating a financing deal with a bank called Gringotts, whereby the conditions are as follows:

The sale price of the aircraft is $26,000,000, with a book value of $22,000,000.

The term of the lease is seven years. The lease agreement is non-cancelable, requiring equal rental payments of $4,881,448 at the end of each year (ordinary annuity basis), beginning December 31, 2019.

The lease contains no renewal or purchase options.

The fair value of the aircraft is $26,000,000 on January 1, 2019, and an estimated remaining economic life of 8 years, The residual value (unguaranteed) at the end of the lease is $13,000,000.

The annual payments assure the lessor an 8 percent return (which is the same as Jedi's incremental borrowing rate).

Discussion Questions

Answer each of the following questions presented to you by the president.

1.I am not very familiar with lease accounting.What is the nature of a sale-leaseback transaction?

2.What difference does it make if Jedi leases the aircraft back or not? Should the sale and the lease be treated as two separate transactions?

3.Under what circumstances, if any, must Jedi report the aircraft and the related lease obligation on a sale-leaseback on its financial statements?