On 1 January 2007, Fountain sold equipment to Swanson Ltd and simultaneously leased it back for five
Question:
On 1 January 2007, Fountain sold equipment to Swanson Ltd and simultaneously leased it back for five years. The equipment’s fair value is $1,200,000, but its carrying value on Fountain’s books prior to the transaction was $960,000. The equipment has a remaining estimated useful life of six years and both Fountain and Swanson used 8% interest in evaluating the transaction. At the end of the lease term, Fountain has the option to purchase the machine from Swanson at $100,000, a price that is far lower than its expected fair value. Fountain classified the lease as an operating lease and agreed to make annual rental payments of $262,502 beginning January 1, 2007. The fountain had also recognized the gain of $240,000 from the sale of equipment in 2007. Fountain depreciates all its assets on a straight-line basis.
Mr. Koh was also concerned about whether these adjustments will affect the key accounting ratios of the firm. So he provided you with the following (unaudited) financial information for the fiscal year ending 31 December 2007 for your investigation: Net income before tax $ 500,000 Current assets $2,000,000 Current liabilities $2,000,000 Total liabilities $2,500,000 Total assets $5,000,000.
Required
(i) Provide the adjusting entries, if necessary, for the abovementioned transactions.
(ii) Consider each adjustment (if any) separately. Quantify the effects of each adjustment on return on assets (net income before tax divided by total assets), current ratio, and leverage (total liabilities divided by shareholders' equity) for the fiscal year ending December 2007. Support your answers with relevant workings. Ignore income tax effects.
HINT: Present value of annuity due (5 years, 8%) = 4.312127. Present value of single sum (5 years, 8%) = 0.680583]
Financial Reporting and Analysis
ISBN: 978-0078025679
6th edition
Authors: Flawrence Revsine, Daniel Collins, Bruce, Mittelstaedt, Leon