Aldridge Enterprises has a long-standing policy of acquiring company equipment by leasing. Early in 2013, the company entered into a lease for a new milling machine. The lease stipulates that annual payments will be made for five years. The payments are to be made in advance on December 31 of each year. At the end of the 5-year period, Aldridge may purchase the machine. Company financial records show the incremental borrowing rate to be less than the implicit interest rate. The estimated economic life of the equipment is 12 years. Aldridge uses the calendar year for reporting purposes and straight-line depreciation for other equipment. In addition, the following information about the lease is also available:
Annual lease payments........................................................................................... $55,000
Purchase option price.............................................................................................. $25,000
Estimated fair value of machine after five years.................................................... $75,000
Incremental borrowing rate................................ .......................................................... 10%
Date of first lease payment............................................................................... Jan. 1, 2013
Instructions:
1. Compute the amount to be capitalized as an asset for the lease of the milling machine.
2. Prepare a schedule that shows the computation of the interest expense for each period.
3. Give the journal entries that would be made on Aldridge's books for the first two years of the lease.
4. Assume that the purchase option is exercised at the end of the lease. Give the Aldridge journal entry necessary to record the exercise of the option. The actual fair value of the milling machine at the end of the lease is $95,000. On the date the purchase option is exercised, the undiscounted sum of future cash flows expected from the machine is $125,000.