Pharoah Leasing Company agrees to lease equipment to Novak Corporation on January 1, 2020. The following information relates to the lease agreement. 1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years.
2. The cost of the machinery is $502,000, and the fair value of the asset on January 1, 2020, is $739,000.
3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $45,000. Novak estimates that the expected residual value at the end of the lease term will be 45,000. Novak amortizes all of its leased equipment on a straight-line basis.
4. The lease agreement requires equal annual rental payments, beginning on January 1, 2020.
5. The collectibility of the lease payments is probable.
6. Pharoah desires a 10% rate of return on its investments. Novak's incremental borrowing rate is 11%, and the lessor's implicitrate is unknown.
1. Discuss the nature of this lease for both the lessee and the lessor.
2. Calculate the amount of the annual rental payment required.
3. Compute the value of the lease liability to the lessee.
4. Prepare the journal entries Novak would make in 2020 and 2021 related to the lease arrangement.
5. Prepare the journal entries Pharoah would make in 2020 and 2021 related to the lease arrangement.
Suppose Novak expects the residual value at the end of this lease term to be $40,000 but still guarantees a residual of $50,000. Compute the value of the lease liability at lease commencement.

1. Novak Corporation is the lessee and this is a Capital Lease for it. Lease for Pharoah Leasing Company is the lessor and this is an Operating Lease for it.

2. Annual rental payment required = $133,683

3. Lease Liability to the lessee = $720,909

4. See the attached excel file.

5. See the attached excel file.

Explanation:

1. Discuss the nature of this lease for both the lessee and the lessor.

Novak Corporation is the lessee and this is a Capital Lease for it. The reason this is a capital lease to Novak Corporation is that the lease of the equipment will be treated as an asset in the books of accounts of Novak Corporation.

Lease for Pharoah Leasing Company is the lessor and this is an Operating Lease for it. The reason this is an operating lease to  Pharoah Leasing Company is that the ownership of the asset is not transferred by  Pharoah Leasing Company to Novak Corporation and the useful life of the asset will remains after the lease term expires.

2. Calculate the amount of the annual rental payment required.

Note: See L in the attached excel file for the calculation of the amount of the annual rental payment required.

From the attached excel file, we have:

Annual rental payment required = $133,683

3. Compute the value of the lease liability to the lessee.

Note: See O in the attached excel file for the computation of the value of the lease liability to the lessee.

From the attached excel file, we have:

Lease Liability to the lessee = $720,909

4. Prepare the journal entries Novak would make in 2020 and 2021 related to the lease arrangement.

Note: See the attached excel file for the journal entries Novak would make in 2020 and 2021 related to the lease arrangement.

5. Prepare the journal entries Pharoah would make in 2020 and 2021 related to the lease arrangement.

Note: See the attached excel file for the journal entries Pharoah would make in 2020 and 2021 related to the lease arrangement.

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