Problem
Lessor Accounting for a Direct Financing Lease
Garvey Company (the lessee) entered into an equipment lease with Richie Company (the lessor) on January 1 of Year 1.
1. The equipment reverts back to the lessor at the end of the lease, and there is no bargain purchase option.
2. The lease term is 5 years and requires Garvey to make annual payments of $65,949.37 at the end of each year.
3. The discount rate is 10%, which is implicit in the lease. Garvey knows this, and this rate is lower than its incremental borrowing rate.
4. The equipment's fair value at the lease inception is $250,000. The present value of an ordinary annuity of five payments of $65,949.37 each at 10% is $250,000.
5. The equipment has an estimated economic life of 7 years and has zero residual value at the end of this time. Straight-line depreciation is used for similar assets.
Required:
Prepare the journal entries that Richie Company (the lessor) would make in the first year of the lease assuming the lease is classified as a direct financing lease. Assume that Richie had purchased the equipment at a cost of $250,000.