Landlord Company and Tenant Company enter into a non-cancelable, direct financing lease on January 1, 2007 for new heavy equipment that cost the Landlord Company $300,000 (useful life is six years with no residual value). The fair value is also $300,000. Landlord Company expects a 14% return over the six-year period of the lease. Lease provisions require six equal annual amounts payable each January 1, beginning with January 1, 2007. The Tenant Company pays all executory costs. The heavy equipment reverts to the lessor at the termination of the lease. Assume that there are no 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.

Required

1. (a) Show how the Landlord Company should compute the annual rental amounts. (b) Discuss how the Tenant Company should compute the present value of the lease rights. What additional information would be required to make this computation?

2. Prepare a table summarizing the lease and interest receipts that would be suitable for the Landlord Company. Under what conditions would this table be suitable for the Tenant Company?

3. Assuming that the table prepared in Requirement 2 is suitable for both the lessee and the lessor, prepare the journal entries for both firms for the years 2007 and 2008. Use the straight-line depreciation method for the leased equipment. The executory costs paid by the lessee in 2007 are: insurance, $700 and property taxes, $800; in 2008: insurance, $600 and property taxes, $750.

4. Show the items and amounts that would be reported on the comparative 2007 and 2008 income statements and ending balance sheets for both the lessor and the lessee. Include appropriate notes to the financial statements.