On January 1, 2011, Palmer Company leased equipment to Woods Corporation. The following information pertains to this lease.
1. The term of the non-cancelable lease is 6 years, with no renewal option. The equipment reverts to the lessor at the termination of the lease.
2. Equal rental payments are due on January 1 of each year, beginning in 2011.
3. The fair value of the equipment on January 1, 2011, is $200,000, and its cost is $150,000.
4. The equipment has an economic life of 8 years, with an unguaranteed residual value of $10,000. Woods depreciates all of its equipment on a straight-line basis.
5. Palmer sets the annual rental to ensure an 11% rate of return. Woods incremental borrowing rate is 12%, and the implicit rate of the lessor is unknown.
6. Collectibility of lease payments is reasonably predictable, and no important uncertainties surround the amount of costs yet to be incurred by the lessor.
(Both the lessor and the lessee accounting period ends on December 31)
(a) Discuss the nature of this lease to Palmer and Woods.
(b) Calculate the amount of the annual rental payment.
(c) Prepare all the necessary journal entries for Woods for 2011.
(d) Prepare all the necessary journal entries for Palmer for 2011.