Glaus Leasing Company agrees to lease machinery to Jensen Corporation on January 1, 2010. 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 $525,000, and the fair value of the asset on January 1, 2010, is $700,000.
3. At the end of the lease term the asset reverts to the lessor. At the end of the lease term the asset has a guaranteed residual value of $100,000. Jensen depreciates all of its equipment on a straight-line basis.
4. The lease agreement requires equal annual rental payments, beginning on January 1, 2010.
5. The Collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor.
6. Glaus desires a 10% rate of return on its investments. Jensen's incremental borrowing rate is 11%, and the lessor's implicit rate is unknown.
(Assume the accounting period ends on December 31.)
(a) Discuss the nature of this lease for both the lessee and the lessor.
(b) Calculate the amount of the annual rental payment required.
(c) Compute the present value of the minimum lease payments.
(d) Prepare the journal entries Jensen would make in 2010 and 2011 related to the lease arrangement.
(e) Prepare the journal entries Glaus would make in 2010 and 2011.