Darr Equipment Inc. is a company based in Irving, TX, that manufactures and supplies earthmoving and construction equipment. Darr Equipment either sells the equipment to customers or leases it under terms specific to a customer's needs. Hart Construction Inc. is a growing construction company in Arlington, TX, that specializes in building residential properties.
Hart Construction recently entered into a contract with Darr Equipment to lease a excavator, which Hart Construction will use for a new project involving the construction of several condominiums in the Metroplex area. The pertinent terms of the lease are as follows:
• The lease term is for 10 years, while the economic life of the excavator is estimated to be 15 years. The useful life of the excavator is also estimated to be 15 years.
• Annual lease payments of $16,000 are due at the end of each year. Hart Construction is also responsible for all maintenance, insurance, and taxes arising from the lease of the excavator.
• The residual value of the excavator is estimated to be $24,000 at the end of the lease term. Darr Equipment does not have a residual value guarantee.
• The lease does not transfer ownership of the excavator to Hart Construction by the end of the lease term or provide an option for Hart Construction to purchase the equipment.
• The excavator costs Darr Equipment $100,000 to manufacture and this model is currently listed for sale at $135,000 should customers wish to purchase it outright.
Darr Equipment believes that the lease payments from Hart Construction will be collected when they are due. In addition, the equipment is fully constructed and no additional costs will be incurred to complete production of the excavator before lease commencement.
As a result of a recent economic downturn that has directly impacted the construction industry, a number of companies in the industry have modified their sales or lease terms to maintain profitability. Some of Darr Equipment's direct competitors have negotiated lower lease payments or reduced their selling prices in an effort to stimulate sales. For example, several excavators with the same specifications as the one leased to Hart Construction have recently sold for an average sales price of $125,000, as opposed to Darr Equipment's current list price of $135,000.
The rate implicit in the lease is 6.93 percent assuming the fair value of the excavator is $125,000 at the beginning of the lease term and 5.45 percent assuming the fair value is $135,000.
Required: (Provide all calculations and Accounting Standards Codification citations to support your answers in each section)
1. How should Darr Equipment classify the lease in its accounting records? (minimum information should include ASC citation regarding lease classification you state as your answer; ASC criteria met to qualify as a capital-sales lease, capital-direct financing lease, or operating lease; calculations for gross investment in the lease, present value of the minimum lease payments, sales price, and cost of sales for BOTH interest rates and fair values)
2. Provide the journal entries that Darr Equipment should record to:
a. Initially record the lease.
b. Account for the first lease payment made to Darr Equipment at the end of year 1.