Reference no: EM132888892

Lessee accounting

Heathcote Company on January 1, 2021, enters into a nine-year noncancelable lease for equipment having an estimated useful life of 10 years and a fair value to the lessor, Ally Corp., at the inception of the lease of $4,000,000. Ally establishes the terms of the lease to provide for a 7% rate of return, however, this rate is not known to Heathcote. Heathcote's incremental borrowing rate is 8%. Heathcote uses the straight-line method to depreciate its assets.

The lease contains the following provisions:

1. Rental payments of $266,000 are payable at the beginning of each six-month period.
2. An option allowing the lessor to extend the lease one year beyond the lease term.
3. A guarantee by Heathcote Company that Ally Corp. will realize $200,000 from selling the asset at the expiration of the lease. However, the actual residual value is expected to be $120,000.

Instructions

Problem 1: What kind of lease is this to Heathcote Company? Please show the analysis of consideration of all applicable lease classification tests

Problem 2: What should be considered the lease term?

Problem 3: What is the present value of the lease payments (1) for classification of the lease and (2) for measurement of the lease liability? (Round to nearest dollar.)

Problem 4: What journal entries would Heathcote record during the first year of the lease? (Include an amortization schedule through 1/1/22 and round to the nearest dollar.)