On January 1, 2016, Caswell Company signs a 10-year cancelable (at the option of cither party) agreement to lease a storage building from Wake Company. The following information pertains to this lease agreement:
1. The agreement requires rental payments of $100,000 at the end of each year.
2. The cost and fair value of the building on January 1, 2016, is $2 million.
3. The building has an estimated economic life of 50 years, with no residual value. Caswell depreciates similar buildings according to the straight-line method.
4. The lease does not contain a renewable option clause. At the termination of the lease, the building reverts to the lessor.
5. Caswell’s incremental borrowing rate is 14% per year. Wake set the annual rental to ensure a 16% rate of return (the loss in service value anticipated for the term of the lease).
6. Executory costs of $7,000 annually, related to taxes on the property, arc paid by Wake.
Required:
1. Examine and evaluate each capitalization criteria and determine what type of lease this is for the lessee.
2. Prepare appropriate journal entries on the lessee’s books to reflect the signing of the lease agreement and to record the payments and expenses related to this lease for the years 2016 and 2017.