On January 1, 20X1, Seven Wonders Inc. signed a five-year noncancelable lease with Moss Company. The lease calls for five payments of $277,409.44 to be made at the end of each year. The leased asset has a fair value of $1,200,000 on January 1, 20X1. Seven Wonders cannot renew the lease, there is no bargain purchase option, and ownership of the leased asset reverts to Moss at the lease end. The leased asset has an expected useful life of six years, and Seven Wonders uses straight-line depreciation for financial reporting purposes. Its incremental borrowing rate is 12%. Moss’s implicit rate of return on the lease is unknown. Seven Wonders uses a calendar year for financial reporting purposes.

Required:

1. Why must Seven Wonders account for the lease as a finance lease?

2. Prepare an amortization schedule for the lease liability. Round the amount of the initial lease liability at January 1, 20X1, to the nearest dollar. Round all amounts in the amortization table to the nearest cent.

3. Prepare the journal entries to record (a) the lease as a finance lease on January 1, 20X1; (b) the lease payments on December 31, 20X1 and 20X2; and (c) the right-of-use asset amortization in 20X1 and 20X2. You do not need to make formal entries to reclassify the current portion of the lease liability.

4. What is the total amount of expense reported on Seven Wonders’s 20X1 income statement from the lease? Is this amount the same as, more than, or less than the amount that would have been reported if the lease had been classified as an operating lease? Why?