Locatelli Partners (LP) agreed to lease a piece of heavy equipment to Sonata Company on January 1. LP paid $ 195,100 to produce the machine and carried it at this amount in its inventory. The fair value (current selling price) of the machine is $ 210,002. The lease terms are listed below:
• Annual rental payments of $ 46,466 are due at the beginning of each year. These are the minimum rental payments and do not include any executory costs.
• Lease term is seven years.
• There is a bargain purchase option expected to be exercised to acquire the asset at the end of five years for $ 20,000.
• The lessor expects to recover the guaranteed residual value of $ 30,000 at the termination of the lease.
• The economic life of the asset is eight years.
• The lessor’s 9% implicit rate is known to Sonata Company.
• The lessee’s incremental borrowing rate is 12%.
• Annual maintenance is $ 8,000 and annual property tax is $ 9,500. The lessee pays both at the end of the year.
• LP has no material uncertainties regarding future costs to be incurred under the lease and collectability is reasonably assured.
• Sonata depreciates (amortizes) similar machinery owned using the straight- line method.
Required
a. Classify this lease agreement for both the lessor and the lessee.
b. Prepare an amortization table for the lease.
c. Prepare the journal entries for the lessor and the lessee during the first year of the contract.