Pharoah Leasing Company agrees to lease equipment to Novak Corporation on January 1, 2020. The following information relates to the lease agreement.
1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years.
2. The cost of the machinery is $502,000, and the fair value of the asset on January 1, 2020, is $739,000.
3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $45,000. Novak estimates that the expected residual value at the end of the lease term will be 45,000. Novak amortizes all of its leased equipment on a straight-line basis.
4. The lease agreement requires equal annual rental payments, beginning on January 1, 2020.
5. The collectibility of the lease payments is probable.
6. Pharoah desires a 10% rate of return on its investments. Novak's incremental borrowing rate is 11%, and the lessor's implicitrate is unknown.
1. Discuss the nature of this lease for both the lessee and the lessor.
2. Calculate the amount of the annual rental payment required.
3. Compute the value of the lease liability to the lessee.
4. Prepare the journal entries Novak would make in 2020 and 2021 related to the lease arrangement.
5. Prepare the journal entries Pharoah would make in 2020 and 2021 related to the lease arrangement.
Suppose Novak expects the residual value at the end of this lease term to be $40,000 but still guarantees a residual of $50,000. Compute the value of the lease liability at lease commencement.