Chapter 20, Problem 1E

Determining Type of Lease and Subsequent Accounting On January 1, 2019, Caswell Company signs a 10-year cancelable (at the option of either party) agreement to lease a storage building from Wake Company. The following information pertains to this lease agreement:

1. 1. The agreement requires rental payments of $100,000 at the beginning of each year.
2. 2. The cost and fair value of the building on January 1, 2019, is $2 million. The storage building has not been specialized for Caswell.
3. 3. The building has an estimated economic life of 50 years, with no residual value. Caswell depreciates similar buildings according to the straight-line method.
4. 4. The lease does not contain a renewable option clause. At the termination of the lease, the building reverts to the lessor.
5. 5. Caswell’s incremental borrowing rate is 14% per year. Wake set the annual rental to ensure a 16% rate of return (the loss in service value anticipated for the term of the lease). Caswell knows the implicit interest rate.
6. 6. Executory costs of $7,000 annually, related to taxes on the property, are paid by Caswell directly to the taxing authority on Dec. 31 of each year.

Required:

1. 1. Determine what type of lease this is for the lessee.
2. 2. Prepare appropriate journal entries on the lessee’s books to reflect the signing of the lease agreement and to record the payments and expenses related to this lease for the years 2019 and 2020.