On 12/31/16, ABC Corp. signed a 5-year non-cancelable lease for a machine.The terms of the lease called for ABC Corp. to make annual payments of $2,500 at the beginning of each year, starting 12/31/16.The machine has an estimated useful life of 7 years and a $500 unguaranteed residual value.The machine reverts back to the lessor at the end of the lease term.The fair market value (FMV) of the machine is $12,000. ABC Corp. uses the straight-line method of depreciation. ABC's incremental borrowing rate is 5%, and the lessor's implicit rate is unknown.The present value of the lease payments, rounded to the nearest dollar, is $11,365 (N = 5, I = 5%, PMT = 2,500, FV = 0, CPT PV using annuity due)

a)Use the lease classification test template below to determine whether this lease is a finance or operating lease.A response to each test must be shown to get full credit.

i.What type of lease is this (finance or operating)?

ii.Lease classification test (complete template with a YES/NO response for each):

1. Transfer of ownership

1. Purchase option (at end of lease term for < FMV)

1. Lease term is > =75% of its economic life (includes bargain renewal period if one exists)

4.If PV of lease payments > = 90% of FMV of asset at inception of lease. For lessee, in payment, include guaranteed residual value and cost of bargain purchase option; include only executory costs that are part of fixed lease payment (i.e. insurance). Discount rate is lessor's implicit rate (use lessee's incremental borrowing rate if impractical to determine implicit rate.)

5.Alternative Use Test

b)Prepare the journal entries for the lessee at the inception of the lease on 12/31/16, including the first lease payment: