Problem
Winston Industries and Ewing Inc. enter into an agreement that requires Ewing Inc. to build three diesel-electric engines to Winston's specifications. Upon completion of the engines, Winston has agreed to lease them for a period of 10 years and to assume all costs and risks of ownership. The lease is noncancelable, becomes effective on January 1, 2014, and requires annual rental payments of $413,971 each January 1, starting January 1, 2014.
Winston's incremental borrowing rate is 10%. The implicit interest rate used by Ewing Inc. and known to Winston is 8%. The total cost of building the three engines is $2,600,000. The economic life of the engines is estimated to be 10 years, with residual value set at zero. Winston depreciates similar equipment on a straight-line basis. At the end of the lease, Winston assumes title to the engines. Collectibility of the lease payments is reasonably certain; no uncertainties exist relative to unreimbursable lessor costs.
Instructions
(a) Discuss the nature of this lease transaction from the viewpoints of both lessee and lessor.
(b) Prepare the journal entry or entries to record the transaction on January 1, 2014, on the books of Winston Industries.
(c) Prepare the journal entry or entries to record the transaction on January 1, 2014, on the books of Ewing Inc.
(d) Prepare the journal entries for both the lessee and lessor to record the first rental payment on January 1, 2014.
(e) Prepare the journal entries for both the lessee and lessor to record interest expense (revenue) at December 31, 2014. (Prepare a lease amortization schedule for 2 years.)
(f) Show the items and amounts that would be reported on the balance sheet (not notes) at December 31, 2014, for both the lessee and the lessor.