On January 1, 2010, the Orr Company sells heavy equipment to Foible Company for $3 million, then immediately leases it back. The relevant information is as follows:
The lease is noncancelable and has a term of eight years. The annual rentals are $603,908.50, payable at the end of each year. The seller-lessee agrees to pay all executory costs. The interest rate implicit in the lease is 12%. The cost of the heavy equipment to Orr Company is $2,100,000. The purchaser-lessor incurs no material initial direct costs. The collectibility of the rentals is reasonably assured, and there are no important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor. Orr’s incremental borrowing rate is 12% and the company estimates that the economic life of the equipment is eight years. The present value on January 1, 2010 of eight payments of $603,908.50, discounted at 12%, is $3 million ($603,908.50 x 4.967640). The executory costs for 2010 are:
Repairs and maintenance ........ $10,200
Property taxes ............. 20,500
Insurance ............... 18,000
1. What type of lease is this to the seller-lessee? Discuss.
2. Prepare the journal entries for both the seller-lessee and the purchaser-lessor for 2010 to reflect the purchase of the heavy equipment by Orr, and the sale and leaseback agreement. Assume that Orr Company uses the straight-line depreciation method.