On January 1, 2007 the Amity Company leases a crane to Baltimore Company. The lease contains the following terms and 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 $4,000, payable at the beginning of each year. The Baltimore Company agrees to pay all executory costs.

The cost and fair value of the equipment to the lessor is $24,913.94. The lessor incurs initial direct costs of $1,364.98. The interest rate implicit in the lease is 12.5%. After including the initial direct costs, the implicit rate is 12%. 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. The lessor estimates that the fair value at the end of the lease term will be $3,000 and that the economic life of the crane is 12 years.

Required

1. What are initial direct costs? Discuss the accounting treatment of these costs. Are they treated in the same manner for (a) an operating lease, (b) a sales-type lease, and (c) a direct financing lease?

2. From the lessor’s viewpoint, is the preceding lease a sales-type or direct financing lease? Give reasons to support your conclusion.

3. Prepare the journal entries for Amity Company for 2007.