The directors of Apple Pie plc at the September 20X5 board meeting were expressing concern about falling sales and the lack of cash to meet a dividend for the current year ending 31 December at the same rate as the previous year. They suggested to the Finance Director that:
● equipment with a book value of £40 million as at the beginning of the year and an estimated useful economic life of three years should be sold for £62.5 million;
● the £62.5 million and £40 million should be included in the sales and cost of sales for the period resulting in an improvement of £22.5 million in profit which would cover the proposed dividend;
● the equipment should then be leased back at 1 October 20X5 for the remainder of its economic life. The commercial rate of interest for a similar lease agreement had been 10%.
Draft the Finance Director’s response to their suggestion and indicate the effect on the financial statements as at 31 December 20X5 if the lease agreement is entered into on 1 October 20X5.