Question
Pharoah Industries and Novak Inc. enter into an agreement that requires Novak Inc. to build three diesel-electric engines to Pharoahs specifications. Upon completion of the
Pharoah Industries and Novak Inc. enter into an agreement that requires Novak Inc. to build three diesel-electric engines to Pharoahs specifications. Upon completion of the engines, Pharoah has agreed to lease them for a period of 10 years and to assume all costs and risks of ownership. The lease is noncancelable, becomes effective on January 1, 2017, and requires annual rental payments of $431,633 each January 1, starting January 1, 2017. Pharoahs incremental borrowing rate is 10%. The implicit interest rate used by Novak Inc. and known to Pharoah is 8%. The total cost of building the three engines is $2,693,000. The economic life of the engines is estimated to be 10 years, with residual value set at zero. Pharoah depreciates similar equipment on a straight-line basis. At the end of the lease, Pharoah assumes title to the engines. Collectibility of the lease payments is reasonably certain; no uncertainties exist relative to unreimbursable lessor costs.
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