Lease Problem
Buildit Inc. recently entered into a contract with Prime to lease a bulldozer. Buildit is a growing construction company in Florida that specializes in building residential properties. The pertinent terms of the lease are as follows:
- The lease term is for 10 years, while the useful life of the bulldozer is estimated to be 15 years.
- Annual lease payments of $16,000 are due at the end of each year. Buildit is also responsible for all maintenance, insurance, and taxes arising from the lease of the bulldozer.
- The residual value of the bulldozer is estimated to be $24,000 at the end of the lease term. Prime does not have a residual value guarantee.
- The lease does not transfer ownership of the bulldozer to Buildit by the end of the lease term or does not provide an option for Buildit to purchase the equipment.
- The bulldozer costs Prime $100,000 to manufacture, and this model is currently listed for sale at $135,000 should customers wish to purchase it outright.
Prime believes that the lease payments for Buildit will be collected when they are due. In addition, the equipment is fully constructed and no additional costs will be incurred to complete production of the bulldozer before lease commencement.
As a result of a recent downturn that has directly affected the construction industry, a number of companies in the industry have modified their sales/lease terms to maintain profitability. Some of Prime's direct competitors have negotiated lower lease payments or reduced their selling prices in an effort to stimulate sales. For example, several bulldozers with the same specifications as the one leased to Buildit have recently sold for an average sales price of $125,000, as opposed to Prime's current list price of $135,000.
The rate implicit in the lease is 6.9336% assuming the fair value of the bulldozer is $125,000 at the beginning of the lease term and 5.45% assuming the fair value is $135,000.
(1) How should Prime classify the lease in its accounting records?
(2) Provide the journal entry that Prime should record to initially record the lease.
(3) Provide the journal entry that Prime should record to account of the first lease payment made to Prime at the end of year 1.