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Question: The following facts pertain to a noncancelable lease agreement between Faldo Leasing Company and Vance Company, a lessee.

Inception date	January 1, 2017
Annual lease payment due at the beginning of each year, beginning with January 1, 2017	\(124,798
Residual value of equipment at end of lease term, guaranteed by the lessee	\)50,000
Lease term	6 years
Economic life of leased equipment	6 years
Fair value of asset at January 1, 2017	\(600,000
Lessor’s implicit rate	12%
Lessee’s incremental borrowing rate	12%

The lessee assumes responsibility for all executory costs, which are expected to amount to \)5,000 per year. The asset will revert to the lessor at the end of the lease term. The lessee has guaranteed the lessor a residual value of $50,000. The lessee uses the straightline depreciation method for all equipment.

Instructions

(b) Prepare all of the journal entries for the lessee for 2017 and 2018 to record the lease agreement, the lease payments, and all expenses related to this lease. Assume the lessee’s annual accounting period ends on December 31 and reversing entries are used when appropriate.

Step by step solution

01

 Step 1: Meaning of Lease agreement

A lease agreement is a valid agreement made between the lessor and the lessee. The payment period is mentioned in the lease agreement. It is the lease agreement that gives the lessee the right to use the property.

02

Preparing journal entries

Date	Particular	Debit ($)	Credit ($)
Jan.1, 2017	Leased Equipment	600,000
	Lease Liability		600,000
Jan. 1, 2017	Lease Liability	124,798
	Cash		124,798
During 2017	Executory Costs	5,000
	Cash		5,000
Dec.31, 2017	Interest Expense	57,024
	Interest Payable		57,024
Dec.31, 2017	Depreciation Expense	91,667
	Accumulated Depreciation Capital Leases		91,667
Jan. 1, 2018	Interest Payable	57,024
	Interest Expense		57,024
Jan. 1, 2018	Interest Expense	57,024
	Lease Liability	67,774
	Cash		124,798
During 2018	Executory Costs
	Cash
Dec.31, 2018	Interest Expense	48,891
	Interest Payable		48,891
Dec.31, 2018	Depreciation Expense	91,667
	Accumulated Depreciation Capital Leases		91,667

Note: For the purposes of assessing the depreciable basis, the assured residual value was removed. The rationale for this is that, hopefully, at the conclusion of the lease period, this amount will be sufficient to cover the outstanding lease obligation balance. If the leased item has a value at least equal to the guaranteed amount, depreciating it to zero might result in a big gain in the last years.)

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