On January 1, 2016, Amity Company leases a crane to Baltimore Company. The lease contains the following terms and provisions:
• The lease is noncancelable 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.
• Baltimore 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 for 2016.