Lee Industries and Lor Inc. enter into an agreement that requires Lor Inc. to build three diesel-electric engines to Lee’s specifications. Both Lee and Lor follow ASPE. Upon completion of the engines, Lee has agreed to lease them for a period of 10 years and to assume all costs and risks of ownership. The lease is non-cancellable, becomes effective on January 1, 2014, and requires annual rental payments of $620,956 each January 1, starting January 1, 2014.

Lee’s incremental borrowing rate is 10%, and the implicit interest rate used by Lor Inc. is 8% and is known to Lee. The total cost of building the three engines is $3.9 million. The engines’ economic life is estimated to be 10 years, with residual value expected to be zero. Lee depreciates similar equipment on a straight-line basis. At the end of the lease, Lee assumes title to the engines. Collectibility of the lease payments is reasonably certain and there are no uncertainties about unreimbursable lessor costs.

Instructions
Answer the following questions, rounding all numbers to the nearest dollar.

(a) Discuss the nature of this lease transaction from the viewpoints of both the lessee (Lee Industries) and lessor (Lor Inc.).
(b) Prepare the journal entry or entries to record the transactions on January 1, 2014, on the books of Lee Industries.
(c) Prepare the journal entry or entries to record the transactions on January 1, 2014, on the books of Lor Inc.
(d) Prepare the journal entries for both the lessee and lessor to record interest expense (income) at December 31, 2014. (Prepare a lease amortization schedule for the lease obligation for two years using a computer spreadsheet.)
(e) Show the items and amounts that would be reported on the balance sheet (ignore the notes) at December 31, 2014, for both the lessee and the lessor.
(f ) Identify how the lease transactions would be reported on each company’s statement of cash flows in 2014.
(g) Provide the note disclosure concerning the lease that would be required for the lessee, Lee Industries, on its financial statements for the fiscal year ending December 31, 2014.
(h) Provide the note disclosure concerning the lease that would be required for the lessor, Lor Inc., on its financial statements for the fiscal year ending December 31, 2014.