Lessee Company leases heavy equipment on January 1, 2007 under a capital lease from Lessor Company with the following lease provisions:

The lease is non-cancelable and has a term of 10 years. The lease does not contain a renewal or bargain purchase option.

The annual rentals are $27,653.77, payable at the beginning of each year. The Lessee Company agrees to pay all executory costs. The interest rate implicit in the lease is 12%, which is known by Lessee Company. The residual value of the property at the end of 10 years is estimated to be zero.

The cost and fair value of the equipment to the lessor is $175,000. The lessor incurs no material initial direct costs. 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.

Lessee’s incremental borrowing rate is 15% and it uses the straight-line method to record depreciation on similar equipment. In 2007 the lessee pays insurance of $1,900, property taxes of $1,300, and maintenance of $600; and in 2008 the lessee pays insurance of $1,800, property taxes of $1,200, and maintenance of $500.

Required

1. Identify the type of lease involved for the lessee and the lessor, and give reasons for your classifications.

2. Prepare all the journal entries for both the lessee and the lessor for 2007 and 2008.