Mario Automobile Company leases automobiles under the following terms. A 3-year lease agreement is signed in which the lessor receives annual rental of $4,000 (in advance). At the end of the three years, the lessee agrees to make up any deficiency in residual value below $3,500. The cash price of the automobile is $13,251. The implicit interest rate is 12%, which is known to the lessee, and the lessee’s incremental borrowing rate is 14%. The lessee estimates the residual value at the end of three years to be $4,200 and depreciates its automobiles on a straight-line basis.

1. Give the entries on the lessee’s books required in the first year of the lease, including the second payment on April 30, 2012. Assume the lease begins May 1, 2011, the beginning of the lessee’s fiscal year.

2. What balances relative to the lease would appear on the lessee’s balance sheet at the end of Year 3?

3. Assume that at the end of the three years, the automobile is sold by the lessee (with the permission of the lessor) for $3,800. Prepare the entries to record the sale and settlement with the lessor.