Cascade Industries and Barbara Hardy Inc. enter into an agreement that requires Barbara Hardy Inc. to build three diesel-electric engines to Cascade’s specifications. Upon completion of the engines, Cascade 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, 2008, and requires annual rental payments of $620,956 each January 1, starting January 1, 2008. Cascade’s incremental borrowing rate is 10%, and the implicit interest rate used by Barbara Hardy Inc. and known to Cascade is 8%. The total cost of building the three engines is $3,900,000. The economic life of the engines is estimated to be 10 years with residual value set at zero. Cascade depreciates similar equipment on a straight-line basis. At the end of the lease, Cascade assumes title to the engines. Collectibility of the lease payments is reasonably certain and no uncertainties exist relative to unreimbursable lessor costs.

Instructions

(Round all numbers to the nearest dollar.)

(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, 2008, on the books of Cascade Industries.

(c) Prepare the journal entry or entries to record the transaction on January 1, 2008, on the books of Barbara Hardy Inc.

(d) Prepare the journal entries for both the lessee and lessor to record the first rental payment on January 1, 2008.

(e) Prepare the journal entries for both the lessee and lessor to record interest expense (revenue) at December 31, 2008. (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, 2008, for both the lessee and the lessor.