Farrington Company leases a computer from the Wilson Company. The lease includes the following provisions:

The lease is non-cancelable and has a term of eight years. The annual rentals are $60,000, payable at the end of each year. The Farrington Company agrees to pay all executory costs and has an option to purchase the computer for $1,000 at the end of the life of the lease. The interest rate implicit in the lease is 12%, which is known to Farrington. Farrington estimates that the computer has an economic life of 12 years and a value of $70,000 at the end of eight years. Farrington’s incremental borrowing rate is 16% and it uses the straight-line method to record depreciation on similar equipment. The computer cost Wilson $200,000 to manufacture. The lessor incurs initial direct costs of $10,000. The collectibility of the rentals is reasonably assured, and there are no important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor.

Required

1. What is the correct classification of the lease for the lessee and lessor? Explain whether the lease meets each of the required criteria.

2. Assuming that the lease is signed on January 1, 2007, prepare all journal entries for 2007 for the lessor.

3. After six years, because of changes in the technology, the lessee and lessor independently conclude that the expected residual value of the computer at the end of the life of the lease is only $10,000. Discuss how the lessor should account for the change.