Problem: On January 1, 2011, Seven Wonders Inc. signed a five-year non-cancelable lease with Moss Company. The lease calls for five payments of $277,409.44 to be made at the end of each year. The leased asset has a fair value of $1,200,000 on January 1, 2011. Seven wonders cannot renew the lease, there is no bargain purchase option, and ownership of the leased asset reverts to Moss at the lease end. The leased asset has an expected useful life of six years, and Seven Wonders uses straight-line depreciation for financial reporting purposes. Its incremental borrowing rate is 12%. Moss's implicit rate of return on the lease is unknown. Seven Wonders uses a calendar year for financial reporting purposes.
1. Why must Seven Wonders account for the lease as a capital lease?
2. Prepare an amortization schedule for the lease liability. Round the amount of the initial lease liability at January 1, 2011, to the nearest dollar. Round all amounts in the amortization table to the nearest cent.
3. Make the journal entry to record (a) the lease as a capital lease on January 1, 2011; (b) the lease payments on December 31, 2011 and 2012; and (c) the leased asset's depreciation in 2011 and 2012.