Rand Medical manufactures lithotripters. Lithotripsy uses shock waves instead of surgery to eliminate kidney stones. Physicians' Leasing purchased a lithotripter from Rand for $2,000,000 and leased it to Mid-South Urologists Group, Inc., on January 1, 2016.

Lease description:

Quarterly lease payments of $125,000 are due at the beginning of each period.

The lease term is set at 5 years (20 periods).

The implicit interest rate, which is known to Mid-South, is 12%, and the lessee's incremental borrowing rate is 10%.

The fair value of the asset is $2,000,000.

The lease contains a bargain purchase option. Mid-South is expected to pay $6,000 at the end of the 5 years to purchase the equipment.

The residual value of the equipment after 10 years is expected to be $5,000.

Collectibility of the lease payments is reasonably assured, and there are no lessor costs yet to be incurred.

Required:

1. How should this lease be classified by Mid-South Urologists Group and by Physicians' Leasing? Explain.

2. Prepare appropriate entries for both Mid-South Urologists Group and Physicians' Leasing from the inception of the lease through the second rental payment on April 1, 2016. Depreciation is recorded at the end of each fiscal year (December 31).

3. Assume Mid-South Urologists Group leased the lithotripter directly from the manufacturer, Rand Medical, which produced the machine at a cost of $1.7 million. Prepare appropriate entries for Rand Medical from the inception of the lease through the second lease payment on April 1, 2016.