On January 1, Year 1, Garrett Enterprises has a piece of equipment with a cost of $950,000 and a fair value of $950,000. On that date, Garrett Enterprises leases the asset to Sowell Company for a 4-year term at an interest rate of 12%. The annual lease payment is due at the beginning of each year, and the first payment is to be collected at the inception date.

The leased asset will revert back to Garrett Enterprises at the end of the lease term. The equipment has an estimated residual value of $25,000 which is not guaranteed by the lessee. The asset has an estimated useful life of 5 years. Both Garrett Enterprises and Sowell Company have a calendar-year reporting period.

INSTRUCTIONS

Part A. Assume the lease transfers substantially all of the risks and rewards of ownership to Sowell Company.

1. What type of lease is this to the lessee and to the lessor? Briefly describe why.

2. Compute the amount of the annual lease payments to be collected by the lessor.

3. Prepare the amortization schedule for this lease.

4. Determine the cost of the lessees Right of Use asset.

5. Prepare all of the journal entries for the lessor for Years 1 and 2.

6. Determine what amounts would be reported on the lessors balance sheet and income statement for (a) Year 1, (b) Year 2, and (c) Year 4.

7. Prepare all of the journal entries for the lessee for Years 1 and 2.

8. Determine what amounts would be reported on the lessees balance sheet and income statement for (a) Year 1, (b) Year 2, and (c) Year 4.

9. Prepare the journal entries required by the lessee and the lessor on 12/31/Year 4.

Part B. Go back to the original set of facts with one exception: Assume that the asset has an estimated residual value of $25,000, which is guaranteed by the lessee. The lessee expects the fair value of the asset to be $21,500 at the end of the lease.

1. Compute the amount of the annual lease payments to be collected by the lessor.

2. Prepare the amortization schedule for this lease for the Lessor and Lessee. Only need to prepare a new amortization schedule for the respective party if different from Part A.