Reference no: EM132935072

Problem - 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 -

(a) What kind of lease is this to Heathcote Company? Please show the analysis of consideration of all applicable lease classification tests

(b) What should be considered the lease term?

(c) 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.)

(d) What journal entries would Heathcote record during the first year of the lease?