YOU Leasing Company agrees to lease machinery to ME Corporation on January 1, 2019. 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 $1,050,000, and the fair value of the asset on January 1, 2019, is $1,400,000.
3. At the end of the lease term, the asset reverts to the lessor and has a quaranteed residual value of $100,000. ME estimates that the expected residual value at the end of the lease term will be $100,000. ME depreciates all of its equipment on a straight-line basis.
4. The lease agreement requires equal annual rental payments, beginning on January 1, 2019.
5. YOU desires a 5% rate of return on its investments. ME’s incremental borrowing rate is 6%, and it is impracticable to determine the lessor’s implicit rate.
Required:
(Assume the accounting period ends on December 31)
a. Compute the value of the lease liability to the lessee!
b. Prepare the journal entries ME would make in 2019 and 2020 related to the lease arrangement!
c. Prepare the journal entries YOU would make in 2019 and 2020 related to the lease arrangement and explain the journal that you make!