Glaus Leasing Company agrees to lease equipment to Jensen Corporation on January 1, 2020. The following information relates to the lease agreement.

1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years.

2. The cost of the machinery is $525,000, and the fair value of the asset on January 1, 2020, is $700,000.

3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $50,000. Jensen estimates that the expected residual value at the end of the lease term will be $50,000. Jensen amortizes all of its leased equipment on a straight-line basis.

4. The lease agreement requires equal annual rental payments, beginning on January 1, 2020.

5. The collectibility of the lease payments is probable.

6. Glaus desires a 5% rate of return on its investments. Jensen’s incremental borrowing rate is 6%, and the lessor’s implicit rate is unknown.

Instructions

(Assume the accounting period ends on December 31.)

a. Discuss the nature of this lease for both the lessee and the lessor.

b. Calculate the amount of the annual rental payment required.

c. Compute the value of the lease liability to the lessee.

d. Prepare the journal entries Jensen would make in 2020 and 2021 related to the lease arrangement.

e. Prepare the journal entries Glaus would make in 2020 and 2021 related to the lease arrangement.

f. Suppose Jensen expects the residual value at the end of the lease term to be $40,000 but still guarantees a residual of $50,000. Compute the value of the lease liability at lease commencement.