Pearl Co. leases equipment to Martinez Inc. on January 1, 2020. The following information relates to the lease agreement. 1. The term of the lease is 5 years with no renewal option, and the machinery has an estimated economic life of 6 years. 2. The cost of the machinery is $733,000, and the fair value of the asset on January 1, 2020, is $1,030,000. 3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $75,000. Martinezdepreciates all of its 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 reasonably predictable, and there are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor. 6. Pearl desires a 9% rate of return on its investments. Martinez’s incremental borrowing rate is 11%. Pearl’s implicit rate is unknown to Martinez. Assume the accounting period ends on December 31. Determine the nature of this lease for both the lessee and the lessor. Calculate the amount of the annual rental payment required. Prepare the journal entries Pearl would make in 2020 and 2021. Compute the present value of the lease payments for Martinez. Martinez expects the fair value of the equipment to be greater than or equal to $75,000. Prepare the journal entries Martinez would make in 2020 and 2021 related to the lease arrangement.

FINANCIAL ACCOUNTING

10th Edition

ISBN:9781259964947

Author:Libby

Publisher:Libby

Chapter1: Financial Statements And Business Decisions

Section: Chapter Questions

Problem 1Q

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Pearl Co. leases equipment to Martinez Inc. on January 1, 2020. The following information relates to the lease agreement.

1.		The term of the lease is 5 years with no renewal option, and the machinery has an estimated economic life of 6 years.
2.		The cost of the machinery is $733,000, and the fair value of the asset on January 1, 2020, is $1,030,000.
3.		At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $75,000. Martinezdepreciates all of its 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 reasonably predictable, and there are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor.
6.		Pearl desires a 9% rate of return on its investments. Martinez’s incremental borrowing rate is 11%. Pearl’s implicit rate is unknown to Martinez.

Assume the accounting period ends on December 31.

Determine the nature of this lease for both the lessee and the lessor.

Calculate the amount of the annual rental payment required.

Prepare the journal entries Pearl would make in 2020 and 2021.

Compute the present value of the lease payments for Martinez. Martinez expects the fair value of the equipment to be greater than or equal to $75,000.

Prepare the journal entries Martinez would make in 2020 and 2021 related to the lease arrangement.

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