On January 1, 2018, Lessor Able leased a machine to Lessee Baker on a six-year lease. The machine was purchased by Able immediately prior to the lease; the machine cost Able $400,000. The cash selling price of this machine is $400,000. The machine has a seven-year estimated useful life. The asset goes back to the lessor at the end of the lease term. The lessee guarantees that the residual value will be at least $30,000 when the asset is returned to the lessor at the end of year 6 and the lessee believes that the asset will be worth $20,000 at the end of the lease term. The lessor used a 4% percent target rate of return. The accounting period for each company ends on December 31 and lease payments will be made beginning on January 1, 2018 and each year thereafter. Collectability of the lease payments is not an issue. Assume a marginal tax rate of 20%.

REQUIRED:

1. Is this an operating or finance lease? Why? (Hint: you should determine this is a finance lease)

2. Calculate the lease payments.

3. Prepare the journal entries for the lessee & lessor for the first two years including any deferred tax entries. Assume the leased asset is returned to the lessor at the end of the lease term and is worth $75,000.

4. Prepare the balance sheet and income statement for the lessee & lessor as of December 31 for 2018.

5. Prepare the SCF for the lessee and lessor for the year ended 12/31/18 and 12/31/19 (using the indirect method for CF from Operating Activities).

6. Prepare the SCF for the lessee and lessor for the year ended 12/31/18 and 12/31/19 (using the direct method for CF from Operating Activities).