Reference no: EM132740872

Lessor enters into a 7-year lease for equipment with Lessee. Lessor sells and leases the equipment, which is not specialized in nature and is expected to have an alternative use for Lessor at the end of the lease term. Under the lease:

1. Lessor receives annual lease payments of $25,000, with the first one payable at the commencement of the lease and one payment annually at the lease anniversary date thereafter.
2. Lessor expects the residual value of the equipment to be $75,000 at the end of the lease term.
3. Lessee provides an RVG that protects Lessor for the first $35,000 of loss below the estimated residual value at the end of the lease term of $75,000.
4. The equipment has an estimated remaining economic life of 9 years, a carrying amount of $150,000 and a fair value of $160,000.
5. Lessor incurred costs of $3,000 for a broker's commission as a result of obtaining the lease. These costs qualify as initial direct costs.
6. The lease does not transfer ownership of the underlying asset to Lessee at the end of the lease term or contain an option for Lessee to purchase the equipment.

At lease commencement, Lessor concludes that it is probable that it will collect the lease payments and any amount probable of being owed under the RVG provided by Lessee.

Problem 1. How should Lessor classify this lease?

Problem 2. Prepare the journal entries at the time of the lease commencement and for Years 1 and 2 of the lease term.